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Reliance IPCL merger: Our view - Views on News from Equitymaster
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Reliance IPCL merger: Our view
Mar 12, 2007

Recently, the boards of Reliance Industries (RIL) and IPCL approved the merger of the latter with the former at a swap ratio of 1:5, i.e., for every 5 shares of IPCL; the shareholders shall be given 1 share of Reliance. The effective date of the merger is April 1st 2007. The management of Reliance industries has also declared a dividend of Rs 11 per share, while IPCL has declared a dividend of Rs 6 per share. Let us analyse the benefits of the merger from the point of view of both these companies and see as to who stands to gain from the merger.

About IPCL

IPCL (Indian Petrochemical Corporation Limited) is a Reliance group company. It was a public sector enterprise till 2002, when it was acquired by Reliance Industries. IPCL is the second largest producer of polymer products (PP, PVC and PE) and has a market share of 27%. Polymers form a major portion of the companyís topline (70%). The company has been increasing its production of polymers on the back of strong prices and domestic demand. Together with RIL, which has a 46% stake in IPCL, it accounts for 70% of the petrochemicals capacity in the country. IPCLís revenues have growth at a CAGR of 22% between FY02 and FY06.

About Reliance industries

RIL is the countryís largest private sector company having interests across the hydrocarbon value chain. The company has a 26% share of the total refining capacity in India and along with its subsidiary, IPCL, controls over 70% of the country's domestic polymer capacity. RIL is also a major player in the polyester fiber and yarn with a combined capacity of 2 million tonnes. RIL has also ventured into the upstream sector, whereby it has participating interests in existing oil and gas fields in India. RIL is the largest exploration acreage holder in the country with 34 domestic exploration blocks in addition to 1 exploration block each in Yemen and Oman. RIL also has exploration and production rights to 5 coal bed methane (CBM) blocks. The company also has a presence in the downstream segment and has commissioned 1,339 outlets out of 5,849 permitted outlets (FY06). It recently forayed into the organised retailing sector, which offers great potential for growth.

Benefits of merger for Reliance shareholders

Stronger balance sheet: The merger with IPCL is likely to strengthen the balance sheet of RIL. IPCL had operating cash flows of over Rs 20 bn (roughly 12% to 14% of RILís expected FY07 cash flows) and balance sheet size of Rs 77 bn in FY06. With RIL planning to spend US$ 14 bn as capex over the next 3-4 years in oil exploration, development and organised retailing, the merged entity would be able to fund it in a much better way, as IPCL is virtually a debt free company.

Earnings accretive merger: The merger is likely to be earnings accretive for RILís shareholders. While the merger is likely to dilute around 4.3% of the companyís equity, it is still going to add significantly to its bottomline. The table below shows that the earnings of RIL are likely to increase by approximately 8% by the way of the merger.

Impact of merger on RILís profitabilityÖ
Particulars Amount (Rs,m)
Annualised 9mFY07 PAT of Reliance 107,400
Annualised 9mFY07 PAT of IPCL 13,520
Current number of share of Reliance 1,394
Current number of share of IPCL 302
Annualised 9mFY07 PAT of Reliance( post merger) 120,920
Number of share of Reliance (post merger) 1,454.4
Annualised 9mFY07 EPS of Reliance pre-merger 77
Annualised 9mFY07EPS of Reliance post-merger 83

Benefits on transfer pricing front: We do not foresee any significant operational synergies from this merger, as both the companies are under the same management and work in an integrated manner. However, the prime catalyst for the merger is the benefit on the transfer-pricing front. Currently, RIL supplies naphtha to IPCL for petrochemical manufacturing which, for obvious reasons, is treated as sales and thus attracts sales tax. However, post merger, such a transaction would be treated as an internal transfer, thus leading to savings on the tax front.

Going forward, we might also see RIL supplying gas from the KG (Krishna - Godavari) basin to the current units of IPCL, resulting into further savings.

Benefits of merger for IPCL shareholders

Derisking business risk: IPCL is current non-integrated petrochemical company. Non-integrated players are relatively more vulnerable to downturn in the petrochemical cycle. As such, the merger is likely to provide IPCL an opportunity to diversify its business risks as well as gain from RILís new ventures (oil and gas exploration and retailing of merchandise).

Who benefits from the merger?

As per the arrangement at the time of divestment of IPCL by the government, RIL could have merged IPCL with itself post July 2005. However, it was delayed as the petrochemical cycle was at its peak and this would have resulted into an adverse swap ratio for RIL shareholders, which would have led to greater equity dilution.

Furthermore, RILís share price has also risen appreciably in recent month on the back of value of upstream exploration venture, thus depriving IPCL shareholders of an opportunity of benefiting from the gain.

As far as the specifics of the deal are concerned, IPCLís book value is around Rs 300 per share and the stock is currently trading at 6 times its annualised 9mFY07 EPS. Whereas, based on the current price of Rs 1,322 for RIL, the value of IPCL turns out to be only Rs 264 per share (based on the 1:5 swap ratio). While RIL has paid IPCL shareholders an amount less than the companyís net worth, the fundamentals of IPCL seem to be much better than anticipated. Newer capacities coming up in the Middle East are witnessing execution problems and hence the petrochemical cycle, which is a major determinant of profits for IPCL is expected to soften much latter than earlier estimated. However, it is equally true that with reduction in import duties in order to bring them in line with the ASEAN region, the effective protection has reduced for petrochemicals units. This requires them to be integrated so as to harness benefits of economies of scale and efficiently manage their resources. Thus, while the merger seems to be a good long-term move, the timing of it could have been much better.

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