Sesa Goa has announced its intention to acquire a 20% stake, valued at $3 billion, in oil exploration major Cairn India?s fully diluted share capital through an open offer. This follows an announcement by its parent company, Vedanta, that it would acquire a cumulative holding of 51% to 60% (including group entities) in Cairn India for an aggregate cash consideration of $8.5-9.6 billion. Vedanta management hopes to close the deal by Q1CY11, subject to the approval being received in time.
What is in this deal for Sesa Goa shareholders? We see neither any synergy between oil and iron ore nor any rationale for Sesa Goa taking on a minority stake in Cairn India. Further, the use of the entire cash surplus (projected at $1.9 billion by end-FY11) and additional cash generation over the next 12 months to acquire this minority interest could lead investors to believe that growth options in the company?s iron ore business are muted and that it is unlikely to deliver on its 50-million tonne production target by FY12. This target was set to be achieved through a combination of organic as well as inorganic growth.
In our view, with no perceived synergy in this deal, the only reason that Sesa Goa is partnering with its parent Vedanta in the latter?s strategic extension into oil exploration is its balancesheet strength, cash surplus and projected cash generation. In an ideal scenario, we believe Vedanta should have been the only entity involved in the deal.
The deal raises minority shareholder concerns on Vedanta?s corporate structure. While investors remain highly impressed by Sterlite/Vedanta?s volume growth, execution ability and cost leadership in its core businesses, there have been concerns on its overall group structure (particularly with multiple cross-holdings and a large number of listed entities), raising issues of a potential conflict of interest among divisions/group companies and fears over group companies being used as vehicles for the group?s strategic objectives.
Unfortunately, Sesa Goa?s use as a vehicle to partner with Vedanta in its bid will increase concerns over this tangled group structure and the alignment of interest between its promoter and minority shareholders across all group companies.
Deal likely to be EPS accretive for Sesa Goa in FY12: Assuming a successful completion of the deal by Q1CY11, we have incorporated the Cairn deal into our FY11 and FY12 estimates for Sesa Goa. As per our analysis, the deal is likely to be EPS (earnings per share) accretive for Sesa Goa in FY12, as the low-yielding cash on books will now be invested in an asset with much higher return ratios. As we incorporate the minority stake acquisition in our FY12 estimates, we increase our EPS estimates for FY12 by 13%.
Though EPS-accretive for Sesa Goa, investor sentiment could take a hit on account of the deployment of surplus cash in an unrelated business, in which the management has no expertise and which offers little synergies with the current operations. While management maintains that the deal is unlikely to affect their capacity ramp-up plan, Sesa Goa?s resource position remains too low for investor comfort (seven years of mine life at 50 million tonnes of annual production). Investors were hoping for the surplus cash flow to be gainfully deployed for the acquisition of iron ore assets, both domestically and globally, in order to add to its resource base, and are likely to be disappointed by this strategic investment. The deal also raises concerns on the possible avenues of the deployment of the company?s future cash flows.
Balance sheet likely to be levered to finance the deal: Sesa Goa currently holds $1.6 billion of cash on its balance sheet and needs additional funds of $ 1.4 billion to fully fund the acquisition. While the management remains confident of meeting all the fund requirements from internal accruals, we believe that Sesa will need to raise additional debt if the acquisition is to be completed by the target time of Q1FY11.
Following our expectation of the completion of the acquisition of the proposed minority stake by Q1CY11, we now use a SOTP (sum-of-the-parts) valuation to arrive at a target price for Sesa Goa. We value Sesa Goa?s iron ore business at FY11E EV/Ebitda of 4.6x, a 20% discount to the corresponding valuation of global iron ore miners, leading to a value of Rs 255/share for Sesa?s iron ore business. We have increased the valuation discount to global miners from 5% to 20% to arrive at a target valuation multiple for Sesa Goa. We believe this is justified on account of the increased regulatory overhang over iron ore exports and continuing group structure overhang for minority shareholders. Our oil & gas analyst has assigned a fair value of Rs 360 per share for Cairn India stock, which values Sesa?s minority stake in Cairn India at Rs 166 per share. Our SOTP valuation gives a target price of Rs 421 per share.