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Cairn India report Vedanta buys majority stake in Cairn India

Contributed by Angel Broking

By Angel Broking

Deal details: Cairn Energy Plc has entered into an agreement with Vedanta Resources Plc for sale of 40-51% stake in Cairn India. The success of the 20% mandatory open offer to minorities will determine the extent of stake sale by Cairn Energy Plc. The all-cash deal is being executed at Rs405/share, wherein Rs355/share will be towards the sale and purchase agreement and the balance Rs50/share constituting the non-compete fee. Thus, the open offer to the minorities will be at the lower price of Rs355/share, which is at 6.7% premium to the close price. Thus, the minority shareholders are at a disadvantage. The offer is subject to the government approval. The open offer will be made through Sesa Goa. Post the transaction, Sesa Goa will hold 20% in Cairn India, with Vedanta holding 31- 40%.

Acceptance ratio contingent on Petronas stance: If Petronas tenders its share, the acceptance ratio in case of 100% tendering, will be 53%. However, if Petronas does not tender its share, the acceptance ratio would be higher at 88%. Under both scenarios, at our target price for the stock, we believe that there are limited upsides from current levels in case one decides to tender the shares. Thus, one should be indifferent between tendering the shares in the open offer or retaining them.

Outlook and Valuation: We believe the transfer of the ownership of Cairn India from Cairn Energy Plc to Vedanta Resources Plc is unlikely to impact the company’s financials. However, the key risk is Vedanta’s lack of experience in managing the E&P asset portfolio being a new player in the segment. Further, we believe that returns to investors will be quite similar in case of tendering the share in the open offer or otherwise. Our NAV-based Fair Value of Rs315 assumes long-term crude oil price of US $75/bbl, whereas the current stock price is discounting long-term average crude price of US $79.1/bbl. Thus, upsides from current levels are limited. We recommend Neutral on the stock.

Details of the deal

Cairn Energy Plc has entered into an agreement with Vedanta Resources Plc for sale of 40-51% stake in its Indian subsidiary, Cairn India. The success of the 20% mandatory (as per the Indian takeover regulations) open offer to minorities will determine the extent of stake sale by Cairn Energy Plc. The all-cash deal is being executed at Rs405/share (US $8.66 as of August 13, 2010 closing exchange rate) wherein Rs355/share (US $7.59) will be towards the sale and purchase agreement and the balance Rs50/share (US $1.07) constituting the non-compete fee. Thus, the 20% mandatory open offer to the other shareholders (except Cairn Energy Plc) will be at the lower price of Rs355/share, which is at 6.7% premium to the close price. Thus, the minority shareholders are at a disadvantage in terms of receiving lesser compensation for selling their stake. The offer is subject to the government approval. The open offer will be made through Sesa Goa. At the end of the transaction, Sesa Goa will hold 20% of Cairn India, with Vedanta itself holding between 31- 40%. Cairn Energy Plc has guided for transaction completion in 1QCY2011. Stake sale will fetch Cairn Energy Plc a premium of 21.7% over the current market price. According to our understanding, deal price reflects the long term crude oil prices of US $96.7/bbl.

The transaction will result in Cairn Energy Plc receiving cash consideration of between US $6,651mn (for 40% stake sale) and US $8,480mn (for 51% stake sale). The final amount of the consideration payable to Cairn by Vedanta will be determined once the open offer has closed and the number of Cairn India shares subject to valid acceptance under the open offer is known. Thus, post the deal, Cairn Energy Plc on a fully diluted equity base will hold a minority 21.6-10.6% stake in Cairn India.

The companies have also entered into a non-compete undertaking, which will cover the territories of Bhutan, Sri Lanka, Pakistan and India, wherein for a period of three years, Cairn Energy Plc will not engage in the business of oil or gas extraction, its transport or processing and any other business, which competes with the business of Cairn India and its subsidiaries as at the completion date in any of those territories. Cairn has also agreed to a non-solicitation agreement for a period of three years with respect to any person who is or has been an officer or senior employee of the Cairn India Group within a year prior to completion.

Cairn and Vedanta have also entered into two reciprocal put and call options in respect of the difference in the number of Cairn India shares actually sold to Vedanta and 51% of Cairn India’s fully diluted share capital on completion (for instance, if only 40% of Cairn India’s shares are sold, then for the balance 11% (51% less 40%) the put and call option is applicable). One put and call option is exercisable after July 1, 2012 and the other after July 1, 2013, in both cases at a Rs405/share (US $8.66). Each option may be exercised to a maximum of 5% of the issued share capital of Cairn India, as at the date of exercise of the option. The put and call options will ensure that a majority interest in Cairn India can be sold to Vedanta.

Cairn Energy Plc has agreed to give Vedanta a matching pre-emption right over any subsequent disposal by it of any shares where such transaction would result in the intended recipient obtaining more than 20% of the issued share capital of Cairn India.

Acceptance ratio contingent on Petronas stance: Acceptance ratio of the open offer is contingent on the reaction of Petronas to the open offer. If Petronas also tenders its share, the acceptance ratio in case of 100% tendering, will be 53%. However, if Petronas does not tender its share, the acceptance ratio would be higher at 88%.

As the extent of the share sale from Cairn Energy Plc is contingent on the success of the open offer by Sesa Goa (Vedanta Group Company), the shareholding pattern post the deal will also vary. We highlight below the shareholding pattern of the company at various levels of acceptance of the open offer.

How does the open offer math stack up?

The open offer dynamics would continue to hinge on the acceptance ratio, which in turn is dependent on the action of Petronas (14.94% stakeholder in Cairn India). We outline below our working of the acceptance ratio (% of shares likely to accepted in the open offer) under the various scenario and the breakeven point at current levels. We also gauge the sensitivity analysis of the likely returns depending on where the stock price settles post the open offer.

Scenario – I: If Petronas does not tender its share in the open offer: In such a scenario, we believe there is likely to be a healthy acceptance ratio of 88.3% assuming all the shareholders agree to tender their shares.

Under both scenarios, at our target price for the stock, we believe that there are limited upsides from current levels in case one decides to tender the shares. Thus, one should be indifferent between tendering the shares in the open offer or retaining them. However, the given the speculation associated with the revision of the open offer price to Rs405/share in line with the price paid to Cairn Energy Plc, there could be decent upsides from current levels. However, chances of the same happening appear slim. As per the SEBI regulation, a promoter is entitled up to 25% of the deal price as the non-compete fees. However, we believe higher price in form of non-compete fees only to Cairn Energy Plc is unjustified.

Outlook and Valuation

We believe the transfer of the ownership of Cairn India from Cairn Energy Plc to  Vedanta Resources plc is unlikely to have any repercussion on the company’s financials. However, the key risk associated with the deal is Vedanta’s lack of expertise and experience in managing the asset portfolio as it is a new player in the segment. Also, Cairn Energy Plc’s superior exploratory capacities will also be a matter of deliberation. However, at the current juncture it is premature to assume the deal to have an adverse impact as Cairn India’s current management would continue to run the business in a professional manner.

With regards to the open offer, we believe that returns to the current investors will be quite similar in case of tendering the share in the open offer or otherwise. We recommend a Neutral on the stock.

On the fundamental aspect, the development work at the Rajasthan block is progressing well, with production from Train-I, II and III and pipeline for crude evacuation already commissioned, while Train-IV and the marine facility is likely to be commissioned in CY2011. The development work undertaken by the company highlights its superior execution skills. Cairn India has already tied up volumes of 1,43,000bpd with four buyers, viz. RIL, IOC, Essar and MRPL, which puts to rest concerns about users of the waxy crude produced from the Rajasthan field.

In the absence of any major discoveries and the company’s focus on development of the Rajasthan block, Cairn India’s stock price is likely to be driven by the direction of the crude oil prices, news flow associated with the developmental status and ramp up of sales. In the past, the CIL stock has demonstrated strong correlation with the crude oil prices, which we expect will continue going ahead too. Thus, in spite of our subdued outlook on oil prices, we believe that the stock will benefit from the positive development updates from the Rajasthan block. Thus, given the expected ramp up in production, the earnings-based valuation will increasingly provide a downward support to our valuations.

We have calculated Cairn India’s NAV by estimating cash flows on asset-by-asset basis, with associated assumptions for production profile, oil/gas pricing, royalty/cess, opex and fiscal terms. Our NAV calculation is based on long-term crude oil price of US $75/bbl, whereas the current stock price is discounting longterm average crude price of US $79.1/bbl. We ascribe a fair value of Rs315/share and thus upsides from current levels are limited. We recommend Neutral on the stock.