The Hindu Business Line : RIL-RPL merger: A dinosaur in the making

There was at least a façade of business synergies in the merger of the original RPL with RIL. Such a synergy is not evident between the new RPL and RIL.

Reliance Petroleum refinery’s crude complex at Jamnagar… state-of-the-art asset

Raghuvir Srinivasan

“We want a dinosaur that would fly.” Those were the words of a senior Reliance Industries (RIL) director addressing a group of presspersons visiting the company’s refinery in March 2006. “In terms of size,” he hastened to add, lest “dinosaur” be read to mean something else. The occasion was the IPO of the re-born Reliance Petroleum (RPL).

Three years hence and with RPLs new 29-million-tonne refinery commissioned, a dinosaur is indeed in the making through the merger of Reliance Petroleum (RPL) and RIL. The combined entity will boast a refining capacity of 62 million tonnes (1.24 million barrels a day) and status as India’s largest company in terms of revenue and earnings.

DéjÀ vu

The proposed merger fits in perfectly with the style perfected by the Reliance group in the last three decades and it is a feeling of déjÀ vu for those following the company and its fortunes. The Reliance Industries we now know is an amalgam of several companies that were floated for executing specific projects and then merged with the parent.

Thus, you had Reliance Petrochemicals Ltd., Reliance Polyethylene Ltd. and Reliance Polypropylene Ltd., all of which were floated to execute specific petrochemical projects in Hazira in the late 1980s and early 1990s but later merged with Reliance Industries.

The original Reliance Petroleum, which made its IPO in 1993, was merged with Reliance Industries in 2002. And now comes the merger of the re-born Reliance Petroleum with RIL.

The classic strategy of the group has been to execute and commission large, capital-intensive projects on the balance-sheet of new companies and, once the project is implemented or operations stabilise, merge them with RIL. The advantage in this is that RIL is protected from the risks of project execution while its balance-sheet is insulated from taking on large equity or debt burden.

Similar track

Call it coincidence or design, the merger announcements of both the original RPL and the re-born one, were made on a Friday of the last weekend of February and the board meetings to finalise the merger were both scheduled within the first three days of March. The merger announcement of the original RPL was made on Friday, March 1, 2002 while the board meeting was held on Sunday, March 3.

In the present instance, the announcement has been made on Friday, February 27 while the board meeting to finalise the merger is scheduled for Monday, March 2. This is, of course, only a symbolic similarity. There are larger, more serious similarities between the two mergers.

First, the merger in 2002 came on the back of a difficult period for RIL in its (then) main business of petrochemicals. The company had seen a fall in sustainable earnings growth in two of the three quarters ending December 31, 2001. Petrochemical prices were soft and the economy was down, leading to demand contraction.

The last couple of quarters of this fiscal have similarly been difficult ones for RIL; earnings actually declined in the third quarter ended December 2008 — the first such decline in 12 quarters. There are also murmurs in the market — unsubstantiated, of course — about potential losses facing the company in crude futures market positions, currency exposure and in the foray into retailing. We may never know how correct these murmurs are. Yet, the fact is that the company is facing a tough time on the earnings front.

Back in 2002, the merger of the original RPL was backdated to be effective from April 1, 2001 and speculation then was that this was done to mask the under-performance of RIL by combining the cash-rich RPL business with itself. Going by this logic, chances are high that the current merger will also be with retrospective effect from April 1, 2008.

Second, the merger of the original RPL in 2002 benefited RIL in terms of a large depreciation cover along with other tax benefits as RPL supplied a couple of products to RIL. In the present instance, the merged RIL will benefit tremendously from the tax benefits that the new RPL enjoys by virtue of its location in a special economic zone (SEZ).

Such benefits include income-tax exemption for 100 per cent of profits derived from exports in the first five years of operations of the RPL refinery and 50 per cent of profits for the next five years. Besides, the new refinery will not have to pay excise duty and service tax for products and services, respectively, sourced from within India. It will also be exempt from stamp duties on land transactions and loan agreements.

The third similarity is likely to be in the share exchange ratio. If past mergers are any indication, the ratio could be skewed in favour of RIL shareholders.

The merger of the original RPL where each share of RIL was exchanged for 11 of RPL favoured RIL’s shareholders. Speculation on the exchange ratio for the present merger ranges between 1:16 and 1:19 based on the market prices of the two shares.

No synergies

There was at least a façade of business synergies in the merger of the original RPL with RIL. The original RPL was supplying naphtha and a couple of other refinery by-products to RIL’s petrochemical complexes. Such synergy is not evident between the new RPL and RIL. Except for RPL’s refinery being technologically more advanced, there is no difference between it and RIL’s existing Jamnagar refinery.

Crude oil sourcing benefits are touted as an advantage from the merger but nothing prevents joint sourcing of crude in the international market by the two companies jointly. Indeed, the group was setting up trading desks in international centres to source crude for the two companies.

Why the merger?

Given this context, the prime motivating factors for this merger appear to be to gain “dinosaur”-like size which will strengthen RIL’s balance sheet. In the short term, it may also help the company play down the expected under-performance in the current fiscal.

The way to look at the merger though is that it was always waiting to happen. There seem to be two main reasons why RPL was floated.

First, to get SEZ benefits, the refinery project had to be housed in a separate company. The refinery would not have been eligible for the tremendous benefits from its SEZ status had it been just a project on RIL’s balance-sheet.

It is not clear now though whether the merger will impact the SEZ benefits but statements by government officials seem to imply that there will be no issues on this score. Second, RIL will now be able to add a new, state-of-the-art refinery asset to its balance-sheet with just a tiny equity expansion. RIL holds 70.38 per cent of RPL’s equity now; Chevron holds 5 per cent with the balance 24.62 per cent with the public.

When the original RPL was merged in 2002, RIL shares accruing to itself by virtue of its direct 28 per cent holding in RPL were extinguished; only those held by group and associate companies, which were a small percentage, were transferred to a treasury trust.

Assuming that similarly, the 70.38 per cent shares held by RIL in RPL are extinguished; that Chevron’s holdings are bought back by RIL and extinguished; and assuming a share exchange ratio of 1:16 (based on Friday’s closing price of Rs 1,265 for RIL and Rs 76 for RPL), RIL will have to issue 6.92 crore fresh shares that will see its equity increasing from Rs 1,454 crore to all of Rs 1,522 crore!

The correctness of this figure is based on several assumptions listed above and will change based on what is decided in the board meeting on Monday.

While the number of shares issued could be marginally higher based on the exchange ratio, the fact remains that the addition to RILs equity will be nothing compared to what it might have been had the Rs 27,000-crore refinery project been executed on its books.

And that will be the biggest benefit of the merger and is the fundamental reason why it is being considered now.

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