Cairn deal: In whose interest?
Munira Dongre 17 August 2010

The Cairn price is too expensive and Sesa Goa shareholders will suffer

Analysts have taken a negative view of the Vedanta takeover of Cairn India - both for Cairn and Sesa Goa. For Cairn the upside potential is limited. The open offer is too close to the market price and the business prospects are fully reflected in the stock price. The impact on Sesa Goa is negative as well.

Anil Agarwal, chairman, Vedanta Resources, is using the cash flow of Sesa Goa to fund the open offer which is not rewarding to Sesa shareholders. It is a typical empire-building move - good for the dominant shareholder but not necessarily for minority shareholders. Most analysts are urging investors to tender in their shares in the open offer. A key question that remains unanswered by most sector and industry experts -- why is Cairn PLC cashing out so early in the cash flow cycle? It has just started reaping the benefits of its investments in India.

Let's look at the deal first. The Vedanta Group will pick up 51% stake in Cairn India from Cairn Energy at Rs405/share. This includes Rs50/share (i.e., $1bn) as non-compete fee (Cairn Energy will not compete in India, Bhutan, Sri Lanka and Pakistan or poach senior management for three years).

Sesa Goa in which Vedanta has a 57% stake, will make a 20% open offer (possibly in October) to Cairn India's minority shareholders at Rs355/share. If the open offer is not fully subscribed, Sesa will purchase shares from Vedanta PLC to reach the 20% mark. In any case, Vedanta could tender shares in the offer to reduce its stake to 40%. The end result will be Vedanta PLC holding 31%-40% and Sesa Goa holding 20% in Cairn. Sesa will fork out $3 billion from its cash resources to fund the open offer, while Vedanta will look for debt.

Depending on how successful the offer is, Cairn Energy's stake will fall to a minimum of 40% but it has an option to raise this by 10% with two put-call options exercisable in July 2012 and July 2013 at Rs405/share. The Vedanta Group will shell out $8.5 billion-$11 billion by July 2013. Cairn UK holds 62% stake in Cairn India. Other major shareholders are Petronas at 15% (will be key in the success of the open offer) and LIC at 2.6%. Petronas invested $1.2 billion in Cairn - its investment value is now $1.8 billion.

According to analysts, the deal pegs Cairn India's enterprise value at around $16.5 billion and this implies a valuation of around $15/BOE (barrel of oil equivalent). The market has reacted mostly negatively about Sesa's use of its cash flow to fund the open offer. This is what Kotak told its institutional investors today: "Sesa's proposed acquisition of a 20% stake in Cairn India (CAIR) is value destructive. Not only has Sesa overpaid for CAIR, the utilisation of excess cash to fund group expansion plan/acquisition raises concern on shareholder friendliness. We compute value destruction of Rs35-58/share for Sesa Goa resulting from over-valuation of CAIR. A statement by the Sesa management about lack of growth opportunities to utilise excess cash does little to inspire confidence in the core business."

Possible regulatory issues:

* The difference in the price for the larger shareholders and minority shareholders
* The government may come in heavily since the deal involves transfer of natural assets from one entity to another
* It is possible that the government may use this as an opportunity to settle royalty and cess issues for the Rajasthan block before giving a regulatory okay for the stake sale.

Possible positives:

* Vedanta has revealed that there is an additional in-place resource potential of 7 billion BOE in the block in addition to the 6.5 billion BOE already disclosed by Cairn. This could propel oil production to 250-300kbpd - but to be honest, this is some way off
* Success in its eight other exploration assets - again, not a sure bet
* Open offer price revised to Rs405 for regulatory reasons. However, this also seems unlikely because the SEBI Takeover Code allows up to a 25% premium in non-compete fees without affecting the open offer price.

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