Vedanta Resources Plc’s proposal to buy a stake in Cairn India Ltd has caught investors unawares. Vedanta and Sterlite Industries Ltd’s share prices fell while Cairn’s gained.

The key concerns appear to be on the logic for diversifying from mining and metals into oil and gas, and funding for the proposed transaction. Cairn India’s market capitalization is around Rs67,000 crore, and a 26-51% stake (51% is what news reports are mentioning) will cost it around Rs17,000-34,000 crore.

Also See Funding Concerns (Graphic)

Why oil and gas? Vedanta’s appetite for acquisitions is no secret. Its strategy, as mentioned in a recent offer document, is to create a world-class metals and mining company, using four approaches: asset optimization and cost reduction, capacity expansion, consolidating its holdings and seeking acquisitions. It will seek opportunities where it can leverage its “transactional, project execution and operational skills and experience". It will seek complementary businesses too, such as coal mining and oil and gas, which though not really complementary, appear to fit in here.

Vedanta is not breaking new ground. Mining major BHP Billiton Ltd’s petroleum exploration business contributed 17% of its half-year ended December 2009 revenue and 27% of its segment profit. Brazil’s Vale SA is seeking to diversify its energy supplies by acquiring stakes in oil and gas exploration assets. It owns stakes in around 20 exploration blocks. Rio Tinto Group, however, does not have petroleum or gas exploration projects in its exploration schedule.

Utilizing captive energy resources can give a cost advantage. Even if operational or regulatory obstacles prevent captive usage, it could act as a hedge. When the mining division’s profits decline due to higher energy prices, the exploration division’s profits will go up. In a recession, however, the hedge will turn into a drag.

Why Cairn? Cairn is a good target, with a successful exploration business that is being scaled up, very little net debt and positive cash flows.

Vedanta may be able to use its stated strength of asset optimization and cost reduction to perhaps extract more profits. Its unstated, but equally important strength is the ability to operate in sectors where politics and policy impact business, especially so in its home country. In recent years, the Indian government’s role in the oil and gas sector has been a worry for exploration companies.

But funding is the main concern. Vedanta has spent nearly half its $17 billion (around Rs79,200 crore) capital investment plan, as of fiscal 2010. It plans to spend nearly $14 billion by fiscal 2013, including the pending capital expenditure, minority buyouts and debt repayment. Cash on hand is $7.2 billion, fresh debt will provide $4.9 billion and the rest will come from ongoing cash flows. This capex will expand its capacity in its existing businesses. So Vedanta is indeed cash-rich, but it has little to spare.

It could have well waited to finish its ongoing projects. Either the price should be very attractive or it anticipates having spare cash, perhaps due to a deferral. Till the air clears over these issues, shareholder anxiety over the proposed transaction will prevail.

Graphic by Ahmed Raza Khan/Mint

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