The acquisition of Cairn India Ltd by Vedanta Resources Plc had investors concerned about the huge acquisition cost of between $8.5 billion and $9.6 billion (Rs40,000- 45,000 crore) and what it will do to Vedanta’s balance sheet. The firm’s existing capex plan of around $14 billion till fiscal 2013 will continue, and the deal will not affect its other plans. While debt will balloon after the transaction, Vedanta hopes to make Cairn’s operations bigger and more profitable. That and improving cash flows from its existing businesses will aid in servicing the debt. Central to its rationale is a steady trend in commodity prices of the metals it sells and now crude oil, too, providing it with enough of a cushion to digest the acquisition. And a clever deal structure may ease the burden a bit.

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Sesa Goa Ltd’s open offer to Cairn’s shareholders plays an important part. If it succeeds in getting a 20% stake, Vedanta will buy a 40% stake to take its total to 60%. If the open offer were to get no response, Vedanta will buy a 51% stake. But Sesa Goa will buy a 20% stake from Vedanta. Thus the deal size will be cut by about $1 billion. Moreover, Vedanta’s direct exposure will be lower, as nearly 40% of the consideration will be funded by Sesa Goa.

If Vedanta has to buy a 40% stake, assuming the open offer meets full acceptance, it will raise $6.5 billion as bank finance to fund the transaction. This will drop to $5.2 billion if the open offer fails. The company expects its debt-related ratios to worsen initially but improve by 2012, as the size of its business grows, profitability improves and cash flows are used to repay debt. Sesa Goa, though, will have to pay about $3 billion. It has about $2 billion on its books and hopes to have the rest by the end of the year, when the deal is expected to be finalized. It may have to resort to bridge financing, if there is a shortfall, however.

Sesa Goa was the surprise factor. Vedanta’s entry into the oil and gas sector can be explained as taking exposure to another natural resource. But Sesa Goa’s acquisition of a 20% stake is difficult to justify. The main logic appears to be the cash pile on its books and, apparently, a lack of other opportunities. Recent developments, such as the proposed mining tax and a ban on iron exports in Karnataka, have already created uncertainty. The acquisition adds to this. A 20% stake will only give it proportionate profits of Cairn, and it will not reflect in its revenue. Dividend and capital appreciation are the two main paybacks. Cairn is still in the investment phase, and will need to reinvest cash into its business, and appreciation helps only if it sells its stake, which appears a remote possibility.

Cairn India’s shares fell by 6.3% on Monday to Rs332.85 reflecting investor disappointment at the price. But it rose by 7% last week, over Wednesday’s close, after rumours of the deal surfaced. The deal values Cairn India at about Rs78,000 crore or 23% higher than its current market capitalization. So, why did the stock correct?

Shareholders may have been expecting more. They may also feel let down by the Rs50 per share non-compete fee that goes to the promoters. With the existing management being retained in the company, and Cairn Energy stating it is not exiting India through this transaction, they could have paid a common price to all shareholders as well. Some profit-booking too may have caused the fall.

The deal values Cairn India at Rs355 or Rs405 a share (including the non-compete), though analysts have valued it much lower. Edelweiss Securities Ltd valued Cairn India at Rs323 on a sum-of-parts basis while Elara Securities (India) Pvt. Ltd had a target of Rs315 for Cairn India. According to Elara’s analysts, apart from its existing available reserves, Cairn India has reserves of 1.9 billion barrels of oil equivalent (boe), from which management had guided towards a 9% recovery. However, the recovery rates implied by the deal valuation are higher. Analysts say that improvement would take some time to be visible.

So, what should Cairn India’s shareholders do? The share is valued higher compared with peers such as Reliance Industries Ltd and Oil and Natural Gas Corp. Ltd (though not strictly comparable). It is also trading above analyst estimates. The open offer, therefore, provides a good opportunity to sell at least part of their holdings.

Graphic by Yogesh Kumar/Mint

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