• JUNE 18, 2003

L&T: Final tally

The final verdict regarding L&T's cement division has come. L&T has decided to demerge its cement division in favour of Grasim. For this Grasim is going to pay Rs 171.3 per share to L&T for an 8.5% stake in the cement division. As this will trigger the open offer code, Grasim is going to make an open offer for another 30% stake in the cement company at the same price.

We believe that this new valuation that Grasim has given for the cement division is good on a relative basis. Assuming a debt level of Rs 25 bn for the cement division, the enterprise value of the cement division works out to US$ 87 per tonne (US$ 85 for Gujarat Ambuja for FY03E). This is good considering the fact that Gujarat Ambuja is more operationally efficient and commands better realisations than L&T's cement business. However, we must bring to notice of the existing shareholders of L&T that the combined valuation of L&T as suggested by the new deal at Rs 291.3 may be only on paper.

This is because for every 100 shares in existing L&T company, shareholders will get 100 shares of the EPC business, but will get an estimated 80 shares in the cement company, Cemco. Also, post the open offer of Grasim, the valuation of Cemco on the stock exchanges may not be at Rs 171. Grasim has paid a higher price in order to secure control of a very large (16 m tonnes) capacity. Thus post the listing, market forces will determine the final price of the stock and it may be below the open offer price.

If you own 100 shares of L&T today
  No. of shares Value offered by Grasim M.Cap
EPC 100 120.0 12,000
Cemco 80 171.3 13,704

But Rs 171.3 for Cemco is open offer price. Supposing you tender all 80 shares to open offer, but Grasim buys back only 50%, I.e. 40 shares then you get Rs 6,852 and still hold 40 shares in Cemco. We believe, that the listed entity may not get Rs 171.3 post open offer.

Company FY03 sales (Rs m) M.Cap M.Cap/Sales
BHEL 69,782 64,925 0.9
ABB* 11,758 15,960 1.4
L&T** 74,453 29,760 0.4
** M.Cap at Rs 120 per share, Non cement revenues.
* December ending

However, on the other hand, the existing shareholders stand to benefit from their holding in the EPC division. This is because we believe, the EPC business shares post their listing are likely to appreciate. An indication to this effect is that fact that other engineering companies are getting better valuations compared to L&T EPC division's stock. BHEL at current market price is commanding a market capitalization to sales (FY03) ratio of 0.9x, while ABB on the other hand commands M cap to sales multiple of 1.4x. At a price of Rs 120 the M cap to sales ratio for L&T's other business (including EPC and electrical and electronics) works out to be just 0.4x. This indicates that upon listing the L&T stock could correct towards the sector valuations.

For the Grasim shareholders, it seems to be a fair deal where their company is going to get management control over a huge cement capacity. However, Grasim will have to shell out a significant amount for this. Assuming that the equity capital of the cement division is Rs 24.8 bn, Grasim will have to pay close to Rs 3.6 bn for an initial 8.5% stake in Cemco to L&T. Post that, for the open offer Grasim will have to pay Rs 12.7 bn for another 30% stake in Cemco. However, Grasim is also going to sell off its stake in L&T's other businesses at Rs 120. This works out to Rs 5 bn in cash inflows for Grasim. So the net outflow for Grasim works out to be nearly Rs 11.2 bn.

This outflow is likely to put pressure on Grasim's finances in the medium term as there may be a component of debt in the financing arrangement. However, we believe that the benefits of the deal outweigh the drawbacks. Grasim will get control of over 30 m tonnes of cement capacity which will give it benefits of scale that will involve operational cost savings. The control of such large capacity will also entail better pricing power for Grasim and this will further add to the operational efficiencies.

We would like to point out that while the open offer price is very attractive, the upside for the L&T stock from here on account of the demerger seems limited. Hence, we would recommend the retail shareholder to tender his shares to the open offer. While on the other hand it may be beneficial for the shareholder to hold on to the shares of L&T. All in all this seems to be an equitable deal for the shareholders of both Grasim and L&T.

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