Demerger as a strategic option

L&T has been pursuing the demerger since 2000 and has not had much success so far. The closest it came to was in the six months preceding the acquisition of a stake by Grasim in November 2001.

Thereafter, the demerger remained in the cold storage till the proposal was revived in the last month or so.

The L&T board has now indicated that it has received expressions of interest. It also has a proposal from the Commonwealth Development Corporation to pick up a stake in the cement business.

The demerger as a strategic option would enable L&T free cash flows and create two distinct units for cement and its other businesses.

The latter assumes importance since L&T's cement division has been a drag on profitability despite the vast sums of money (Rs **** crore) pumped into the business. The only way L&T can unlock the value in the cement business is by putting it up for a strategic sale.

Demerger and sale of strategic stake through competitive bidding maybe the best option to unlock value for the shareholders.

Its 17-million-tonne capacity may, on a conservative estimate, carry a value of at least around Rs 4,000 crore. The geographical spread, the brand value and the contemporary nature of capacities may also add some pep to the price tag. But if the demerger is not pursued seriously, L&T runs the risk of the cement business being acquired at much lower prices.

For example, if Grasim's open offer happens, it would get a sizeable controlling stake of around 35.5 per cent at Rs 1,710 crore for all of L&T's businesses.

Even if Grasim is asked to make an open offer at Rs 306.6 per share (the price paid to Reliance), it would still be an attractive deal from Grasim's perspective. This gives an idea of the kind of undervaluation that shareholders would have to suffer in a takeover situation.

More so, since appropriate control premium that is warranted in a takeover situation may not materialise in the absence of a strong promoter group, that would have negotiated a good price. So from a fundamental and takeover perspective, the demerger may be the more value-enhancing option.

In a takeover situation, one aspect that assumes significance is that only a small proportion of shareholders (20 per cent) would benefit from an open offer.

Moving ahead on demerger

L&T's plan for the demerger, as last indicated, was for a 37.5 per cent stake in the company (created for the cement business) to be held by itself, a similar stake for a strategic partner and the remaining 25 per cent for the shareholders.

At the recent board meeting for this purpose, the demerger plan had to be put on hold as the Grasim representatives sought more time to study the proposals. Grasim's intent may well be to protract the process so that it gets its open offer through.

On the other hand, a demerger with an equitable distribution on ownership stakes to all shareholders has the potential to create better value. If the earlier plan is put through, Grasim would get a stake of 3.75 per cent in the cement company. This obviously will not suit its interests. If L&T is intent on going ahead with the demerger, Grasim may prefer the entire share capital of the cement company to be distributed to the present L&T shareholders. That would give it a 15 per cent stake in the cement too. But this may defeat the very purpose of the demerger.

So the better course would be to stick to present plan where 37.5 per cent stake is to be offered to a strategic investor. If Grasim is interested in the cement business, it could be asked to bid for the 37.5 per cent stake and compete with the MNCs that have evinced interest.

If Grasim offers an attractive price, there is no reason why it should not get hold of the cement business. The proposal to offer stake to just a financial investor such as CDC may not be a value-enhancing plan.

That will still leave the door open for control over the company through a takeover at a later date for the demerged entity and at valuations that may not be as attractive as it would be in a strategic sale situation.

Demerger and Takeover Code

Grasim has protested against the demerger move saying it violates the spirit of the Takeover Code (notably L&T has not been charged with violating with the letter of the code) — notably the obligations of a target company. Quite apart from the irony of Grasim accusing somebody of violating the spirit of the Takeover Code, L&T may well be on clear course here.

The demerger has been on the agenda for a long time now. And there are indications that the revival of interest on the part of strategic investors has been before the board since July 2002.

If this is the case, L&T may not be in violation of the Takeover Code and could go ahead with the demerger proposal. This development may also have driven Grasim's move to hasten its plan to hike its stake and led to the open offer.

If, for some reason, the L&T board is unable to get the demerger through, the least it can do is inform shareholders that the Grasim open offer is unattractive on price. Also, a higher degree of transparency on the plans for the cement business may help shareholders.

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