The Hindu Business Line : Ambuja Cement Eastern: Reject

SHAREHOLDERS of Ambuja Cement Eastern can reject the open offer made by the Holcim group of Switzerland and Ambuja Cement India, which is now owned by Holcim and Gujarat Ambuja Cement. Our recommendation is predicated on a merger of Ambuja Cement Eastern and ACC. If this happens, we believe the swap ratio would not be adverse to the shareholders of Ambuja Cement Eastern. The acquirers have undertaken to sell a part of their holdings to ensure that the non-promoter holding remains at the pre-offer level and the stock listed. Given its strengthening fundamentals, we expect the stock to then trade at levels close to the open offer price of Rs 70 (the market price also hovers around this level); this would be a cushion for shareholders if the merger does not materialise.

The rapid improvement in the fundamentals of Ambuja Cement Eastern, the likely boost from active support by Holcim, which could lead to higher operating efficiencies, and the location of its units in the eastern markets where prices are likely to remain firm at higher levels, also underpin our recommendation. A merger would enhance the geographic footprint and the profitability and earnings quality of ACC. The principal risk to our recommendation is an adverse swap ratio (any ratio that involves less than three shares of ACC for every 20 in Ambuja Cement Eastern) to the merger. We believe that the probability of such a swap ratio is low and it may be worth the risk to remain invested in the Ambuja Cement Eastern stock.

Rationale for the merger: In the open offer for ACC by Holcim, the acceptance level was less than expected. Ambuja Cement India now holds 35.6 per cent of ACC. Had the offer been accepted in entirety, its stake would have risen to a tad in excess of 50 per cent. Holcim and Gujarat Ambuja Cements targeted this shareholding level.

Having failed to attain this mark, we expect the combine to push, over the next six months to ayear, for a merger of Ambuja Cement Eastern with ACC for the following reasons:

Holcim would want to put through a merger, as that would ensure that its stake in ACC would rise by a few percentage points. This would reduce the number of shares that Holcim would have to buy from the market via the creeping acquisition limit of 5 per cent every year, fast-track the process of gaining a stake in excess of 50 per cent in ACC and enable it pursue growth plans in India.

Gujarat Ambuja, too, would be favourably inclined towards this merger, as that would enhance the value of its shareholding in Ambuja Cement India. It had already pocketed a neat profit of Rs 285 crore when it transferred Ambuja Cement Eastern to Ambuja Cement India in 2000; in the deal with Holcim early this year, Gujarat Ambuja had further capitalised on this asset by negotiating an open offer price of Rs 70 per share.

This has increased its effective return from the acquisition of Ambuja Cement Eastern in the late 1990s. Gujarat Ambuja would now have an eye on further gains should it decide to exit Ambuja Cement India.

Gujarat Ambuja has the right to sell its stake in Ambuja Cement India between June 2005 and end-2007; beyond that, Holcim has a right to buy the stake. A merger of ACC and Ambuja Cement Eastern would fetch a superior return for Gujarat Ambuja, should it decide to exercise the put option towards the later part of 2007. With the demand-supply dynamics pointing to a gradually rising or firm trend in cement prices, the merged entity would carry a higher value.

A merger would also ensure a greater degree of institutional investor interest in the ACC stock, as it would have a capacity of close to 25 million tonnes. This company would also be a proxy MNC play in cement, and this could also lead to a higher valuation.

The fundamentals of Ambuja Cement Eastern have improved rapidly under the auspices of Gujarat Ambuja Cements. This trend is likely to continue with support from Holcim. But with a capacity of just two million tonnes, it cannot remain a standalone unit from a long-term perspective.

It still has sizeable debt, and its equity base is also too large to raise finances for any new capacities or acquisitions. Holcim would also prefer to route them through ACC once it acquires a stake in excess of 50 per cent.

A merger would also ensure that the legal requirement to keep Ambuja Cement Eastern listed — a condition that was imposed when Gujarat Ambuja acquired the company — is effectively satisfied.

Holcim would be able to deploy the funds that it has infused into Ambuja Cement India and would remain unused due to low acceptance level in the open offer for ACC, which would have otherwise had to spent on buying more shares in the latter to bankroll acquisitions.

The swap ratio

The Holcim group could raise its stake in ACC by 5-10 percentage points, depending on the swap ratio for the merger with Ambuja Cement Eastern. We believe that a swap ratio of three shares of ACC for every 20 shares of Ambuja Cement Eastern is likely, based on various valuation parameters. Why would this swap be acceptable for the various participants in the merger?

It would value Ambuja Cement Eastern at a substantial premium to peers on an enterprise value per tonne basis, even if one factors in its superior performance parameters and further improvement likely under Holcim's auspices.

Ambuja Cement India's stake in ACC would move close to the 45 per cent level. By May next year, it could comfortably go past 50 per cent by combining the merger with purchases of ACC shares from the market under the creeping acquisition route. It would otherwise have to wait till May 2008 to achieve this purpose.

Gujarat Ambuja would have an indirect stake of 16.3 per cent in ACC. This would represent a doubling of stake at zero cost, courtesy the strategic alliance with Holcim. This is also an important objective of the deal as it reduces its effective cost of ACC holdings to Rs 185 per share.

After the low acceptance in the open offer for ACC, its stake is a tad lower than 12 per cent and there is distance to be covered before its objective is attained. This swap will push its stake to about 15 per cent.

ACC's equity base would rise by about 15 per cent. Though on an enterprise value per tonne basis, this deal would be expensive, the other shareholders of ACC may support such a swap. That would be the price to acquire a two million tonne capacity company with healthy fundamentals from a strong promoter group that owns 94 per cent of the equity.

If they wish to pursue acquisition of another similar capacity, the effective costs may be on a par and with the prospect of a delayed contribution to earnings. Ambuja Cement Eastern is the best small play in cement now and that is why we believe that ACC shareholders would accept the merger. It would also translate into gains by way of a higher price earnings multiple for its stock.

Offer details: The open offer closes on June 6. DSP Merrill Lynch is the manager for the offer and Karvy Investor Services the registrar. The offer document forms and the list of service centres where applications can be tendered is available on the Web site of SEBI (www.sebi.gov.in).

Background to the offer

GUJARAT Ambuja Cement acquired Modi Cements as a sick company in the late 1990s and renamed it Ambuja Cement Eastern. It infused Rs 166 crore to whip the company into shape. In 1999, Gujarat Ambuja picked up a 14.4 per cent stake in ACC, by buying out the Tatas at a hefty Rs 370 per share. To lower its debt burden, Gujarat Ambuja floated Ambuja Cement India, in which it vested its ACC and Ambuja Cement Eastern (94.08 per cent of equity) holdings.

Forty per cent of the equity of Ambuja Cement India was sold to two strategic financial investors. This cash inflow helped prune debt quickly. Earlier this year, Gujarat Ambuja entered into a strategic partnership with Holcim of Switzerland.

Holcim has now acquired the stake held by the strategic financial investors leading to a change in management that has triggered the open offer. Holcim has also raised its stake in Ambuja Cement India to 67 per cent by infusing funds to bankroll the open offers for ACC and Ambuja Cement Eastern. Though its stake has declined from 60 per cent to 33 per cent, Gujarat Ambuja has gained; as it now indirectly has a larger stake in ACC that has come without any cash outflow.

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