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Making Elephants Dance
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Arvind Rao had mixed emotions when he heard about the merger of Reliance Petroleum (RPL) with its parent, Reliance Industries (RIL). An avid investor and investment advisor, Rao had pleaded with friends and clients to exit RPL when it hit a high of Rs 206 in April last year. “Having listed at Rs 60 in 2006, that was the best time,” says Rao. “But because of the bullishness then, hardly anyone sold.” The stock, which was also bought heavily at Rs 150-180, soon crashed to Rs 68.55 in November 2008.
The moot question is: why now? It is not clear that RPL shareholders are better off with the merger. Based on the 2006 listing price of Rs 60, RPL shareholders make Rs 15 on their investment after three years, more in line with returns on bank fixed deposits; those who bought above Rs 75 have lost. Rao wonders what the swap ratio might have been if RIL had waited for RPL to start production (in March 2009): what might have been a fair value based on its project strengths then?
Had it remained a separate entity, RPL’s revenues may have been at least as large as RIL’s, and that may have changed perceptions of its value. RPL’s refinery is also considered more efficient than RIL’s; both are almost the same size. But RIL is a diversified company, and RPL shareholders will benefit from the diversification of their portfolio risk.
Source: BW Research
“The refining industry is not likely to recover before 2011, given the current conditions of excess capacity,” says Niraj Mansingka, oil and gas analyst at Edelweiss Capital, a securities firm. “This would be true even if refining margins for RPL are likely to be higher compared to RIL.” Refining margins have fallen from about $14 a barrel in March 2008 to approximately $5-7 today, which might also explain why Chevron chose to sell back its 5 per cent stake to RIL, rather than increase its shareholding.
RIL owns almost 71 per cent of RPL, and the capital base of the parent company will go up by 4.4 per cent or so, which is matched by the growth in profits that RPL will bring, so earnings per share may not change much. But the deal still looks good for RIL.
Somshankar Sinha, an analyst at Credit Lyonnais Securities Asia, says the abatement of project risk in RPL, the consolidation of cash flow once RPL goes on stream, better operational flexibility and more integrated earnings in RIL balance sheet are the plausible reasons for the merger. Other analysts point to RIL’s past history. The original Reliance Petroleum (Reliance Refineries, renamed in 1993) was mandated to execute the Jamnagar refinery, and merged with RIL in 2002. The idea, analysts say, was to keep the project execution risk off the RIL balance sheet till a viable time, when it could be merged with RIL, with accruing benefits.
Both companies enjoy a tax holiday: RIL’s refinery has export-oriented unit status till March 2010, but after that, there is no clarity. RPL’s refinery will have tax benefits for five years from the first day of commercialisation, widely anticipated to be sometime in April at the latest. The merger also gives RIL an edge over its competition in another way. As a separate company, RPL would have to make public its refining margins; investors and rivals would have been able to compare the margins of RIL versus that of RPL, and perhaps discover where the companies had an edge. With the merger, RIL needs to publish just one number for its refining margins.
RIL Chairman Mukesh Ambani’s timing could not have been better.
(Businessworld Issue Dated 10-16 March 2009)