Monday, March 5, 2012

Sesa Sterlite Merger - Buy Sterlite

Vedanta Resources PLC on 25 February 2012 announced the merger of all its key investments in India into a single company called 'Sesa Sterlite'. The new holding company will own controlling stakes in all of Vedanta's companies in India and would be a metals, mining and natural resources giant. The merged entity would be India’s natural resources company and is expected to be seventh largest global diversified natural resources major on EBITDA basis. By this exercise, the group structure has also been simplified and cross holdings have been eliminated, which is expected to benefit the group through superior capital structure, increased flexibility to allocate capital, broader access to capital markets and enhanced visibility of earnings and cash-flow. In addition to this, increased diversification is expected to reduce volatility of earnings through commodity cycles, lowering the cost of capital and enhancing value. As per the management, the transaction is expected to be completed in CY12 and the synergies are expected to generate cost savings of Rs10bn per annum.

Restructuring done to lighten up Vedanta Plc balance sheet
Indiainfoline believes that restructuring has been done largely to lighten the parent company’s balance sheet, bring in synergies between VAL and Sterlite Energy (SEL), use the accumulated losses at VAL and reduce the financing costs for the company. Vendanta Resources Plc, the parent company had taken loan to the tune of US$2.8bn to acquire stake in Cairn India, which was to be repaid over the next two years. In addition to this, the parent company had to infuse equity in its loss making subsidiary VAL to fund its capex. Sterlite, 29.5% stake holder, had invested more capital in VAL than its equity contribution over the last two years.

Sterlite to witness buying
The merger ratio would boost Sterlite’s stock in the near term as it is done at a premium to Friday’s closing of Rs119. On the other hand, we expect it to be negative for Sesa Goa as the debt of VAL would be shared on its books. Indiainfoline believes the deal is largely done in a fair way except the valuation of VAL. The merged company would be a must own entity as it would provide a large diversified portfolio under one roof. Indiainfoline values the merged entity ‘Sesa Sterlite’ on sum-of-the-parts method. They have used EV/EBIDTA method to value the metal assets, price/book for the power and a holding company discount to Cairn India. They derive a target price of Rs217 per share for Sesa Sterlite (and Sesa Goa) which on an implied basis (swap ratio of 0.6x as per deal) indicates a target price of Rs130 for Sterlite. Indiainfoline maintains their ‘Market Performer’ rating on Sesa Goa and our ‘BUY’ rating on Sterlite.

Restructuring exercise
The restructuring exercise includes merger of four companies viz Sterlite Industries, Sesa Goa, Vedanta Alumina and MALCO and transfer of Vedanta’s stake in Cairn India to the merged entity with an associated debt. The steps for the proposed transaction are:

1) Sterlite will merge into Sesa Goa to create Sesa Sterlite, through the issue of Sesa Goa shares to shareholders of Sterlite. Sterlite shareholders as of the record date are expected to receive 3 Sesa Goa shares for every 5 existing Sterlite shares. Sesa Goa also intends to establish an ADS facility comparable to Sterlite’s current ADS. This would allow holders of Sterlite’s ADS as of the record date to receive Sesa Goa ADS with appropriate adjustments to reflect the foregoing exchange ratio. Each Sterlite ADS currently represents four equity shares of Sterlite.

2) Consolidation of VAL, via the merger of Ekaterina Limited (a Mauritius holding company for Vedanta’s 70.5% shareholding in VAL) into Sesa Sterlite and the issue of 72.3mn Sesa Goa shares to Vedanta after obtaining all necessary approvals. Based on Sesa Goa’s closing price on 24 Feb 2012 of Rs227/share, the equity value of VAL equates to Rs23.32bn (US$473mn).

3) MALCO to merge into Sesa Sterlite, through the issue of 78.7mn Sesa Goa shares to shareholders of MALCO as of the record date. Based on Sesa Goa’s closing price on 24 Feb 2012 of Rs227/share the value of MALCO equates to Rs17.9bn (US$363mn) including the value of MALCO’s existing 3.6% shareholding in Sterlite. As part of the merger MALCO’s existing shareholding in Sterlite will be cancelled by Sesa Sterlite.

4) Post the merger of Sesa Goa and Sterlite, Sterlite Energy Limited and VAL’s Aluminium business will be merged into the consolidated Sesa Sterlite. As wholly-owned subsidiaries no shares will be issued in consideration of the mergers. 

5) Vedanta will transfer its 38.8% direct shareholding in Cairn India to a wholly-owned subsidiary of Sesa Goa at a nominal consideration of US$1, together with the associated acquisition debt of $5.9bn (coupon of 5.2%). The debt will continue to be guaranteed by Vedanta. This transfer is not inter-conditional on the merger of Sesa, Sterlite, MALCO and VAL.

Positives of the deal:
- Consolidated balance sheet to be stronger and would reduce the cost of funds for the companies.
- Increased diversification is expected to reduce volatility of earnings through commodity cycles, lowering the cost of capital and would enhance value.
- Accumulated loss of Rs15bn at VAL would reduce the tax out flow for the group.
- Overhang of merger of VAL with Sterlite is over.
- With the merger of SEL and VAL aluminium, the capex for VAL’s power plants would reduce.
- Shareholders of Cairn India and HZL would receive higher dividend over the next two years as the merged entity has high debt repayment.
- Positive for Sterlite shareholders in the near term as the deal is done at a premium to Friday’s closing price of Rs124.

Our Recommendation :

If you are presently holding Sesa Goa shares look to sell around 225 levels.  Long term investors should buy Sterlite Industries on all dips and hold for 2-3 years for a 100% return

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