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Sesa Goa report Strategic investment in Cairn India

Contributed by Angel Broking

By Angel Broking

Deal structure: Vedanta Resources Plc, along with Sesa Goa, has entered into an agreement with Cairn Energy Plc to acquire a 51–60% stake in its Indian subsidiary, Cairn India, at a price of Rs405 per share. While Rs355per share is being paid towards the sale and purchase of the agreement, the balance Rs50 per share is being paid as non-compete fee. The non-compete fee will be paid in consideration for Cairn Energy agreeing not to engage in the business of oil or gas extraction in India, Sri Lanka, Pakistan and Bhutan, or any other business that competes with the business of Cairn India and its subsidiaries, for a period of three years. Vedanta, along with Sesa Goa, will make the 20% mandatory open offer to other shareholders (except Cairn Energy Plc) of Cairn India at Rs355 per share; Sesa Goa will make a strategic investment of 20% in Cairn India. The 20% stake will be acquired through a combination of share purchase from Vedanta (at a price of Rs405 per share) less the number of Cairn India’s shares acquired under the open offer (at a price of Rs355 per share).

Our take: Anil Agarwal, Chairman, Vedanta Group, has an exemplary track record of acquiring assets and turning them around (eg. Hindustan Zinc, Balco and Sesa Goa). However, Sesa Goa’s diversification into an unrelated business to utilise its excess cash raises concerns regards the growth prospects of its core iron ore business and the stock could take a hit in the short term. While management has reiterated that it expects to increase its iron ore sales volume to 50mn tonnes by FY2014E and the deal to be EPS accretive from FY2011E, we believe that with the cushion of excess cash now not available, the company would have to leverage its balance sheet for any potential acquisitions in its iron ore business going ahead. Also, cash which was 80% of its FY2010 balance sheet, will be replaced by a strategic investment in Cairn India. As the deal is still subject to regulatory approvals and requires a special resolution to be passed by Sesa Goa’s shareholders, we maintain our Neutral view on the stock.

Deal structure

Vedanta Resources Plc, along with Sesa Goa, has entered into an agreement with Cairn Energy Plc to acquire a 51–60% stake in its Indian subsidiary, Cairn India Ltd., at a price of Rs405 per share (US $8.66 as per Friday’s closing exchange rate). While Rs355 (US $7.59) per share is being paid towards the sale and purchase of the agreement, the balance Rs50 (US $1.07) per share is being paid as non-compete fee. The non-compete fee will be paid in consideration for Cairn Energy agreeing not to engage in the business of oil or gas extraction and/or transport or processing in India, Sri Lanka, Pakistan and Bhutan, or any other business that competes with the business of Cairn India and its subsidiaries, for a period of three years.

Cairn Energy and Vedanta have also entered into put and call options to ensure a 51% stake to Vedanta by FY2013E. The put and call options are exercisable in two tranches of up to 5% of the issued share capital of Cairn India at the time of the exercise, commencing on July 31, 2012, and July 31, 2013, for a six-month period each, respectively.

Vedanta, along with Sesa Goa, will make the 20% mandatory open offer to the other shareholders (except Cairn Energy Plc) of Cairn India Ltd. at Rs355 per share, which is at a premium of 6.7% to today’s closing price. Sesa Goa will make a strategic investment of 20% in Cairn India Ltd. The 20% stake will be acquired through a combination of share purchases from Vedanta (at a price of Rs405 per share) less the number of Cairn India’s shares acquired under the open offer (at a price of Rs355 per share)

The total cash consideration is expected to be in the Rs39,658–44,736cr range, depending upon the acceptance ratio. Cash outflow from Sesa Goa is expected to be in the Rs13,632–15,552cr range.

Regulatory approval still required

Vedanta’s share purchase is conditional to approval from Vedanta’s shareholders and Cairn Energy’s shareholders. However, the 20% open offer is subject to:

- Approval from Vedanta’s shareholders

- Approval from Cairn Energy’s shareholders

- Special resolution needs to be passed by Sesa Goa’s shareholders

- Approval from the Reserve Bank of India

Besides, the deal also requires an approval from the Directorate General of Hydrocarbons, who is yet to be approached by the companies.

Vedanta and Cairn have also agreed to a break-fee arrangement of 1% of Cairn India’s market capitalisation in case a) approval from Cairn Energy’s shareholders is not received by October 30, 2010, and b) Cairn Energy breaches the non-solicitation provisions.

Iron ore volume growth at risk

As on 1QFY2011, Sesa Goa’s cash position stood at Rs9,054cr including the inter-corporate deposit given to Vedanta Aluminium. We estimate the company to have cash and cash equivalents of Rs11,402cr and Rs14,697cr at the end of FY2011 and FY2012, respectively. In the current deal with the cash outflow expected to be in the range of Rs13,632–15,552cr, we believe the company will have to leverage its balance sheet for future acquisitions, if any, in its iron ore business. Further, we believe that management guidance of 20-25% iron ore volume growth for the fiscal is at risk on account of the ban on sale of iron ore from Karnataka and disturbances in Orissa owing to the illegal mining issue. In 1QFY2011, Sesa’s iron ore sales volume ex-Dempo stood lower at 11.7% yoy.

Outlook and Valuation

Anil Agarwal has an exemplary track record of acquiring assets and turning them around (eg. Hindustan Zinc, Balco and Sesa Goa). However, Sesa Goa’s diversification into an unrelated business to utilise its excess cash raises concerns regards the growth prospects of its core iron ore business and the stock could take a hit in the short term. While management has reiterated that it expects to increase its iron ore sales volume to 50mn tonnes by FY2014E and the deal to be EPS accretive from FY2011E, we believe that with the cushion of excess cash now not available, the company would have to leverage its balance sheet for any potential acquisitions in its iron ore business going ahead. Also, cash which was 80% of its FY2010 balance sheet, will be replaced by a strategic investment in Cairn India. As the deal is still subject to regulatory approvals and requires a special resolution to be passed by Sesa Goa’s shareholders, we maintain our Neutral view on the stock.