What the Vedanta demerger really means

Vedanta plans out a mega demerger

Just a few years after Anil Agarwal consolidated his business interests to create value, he plans to do the opposite. As per the latest plan announced, Vedanta Ltd will split into 6 distinct companies representing 6 different business verticals. The problem today, as Agarwal outlines, is that the cycles and the financial challenges of any one line of business tend to impact the company overall. That could be avoided by demerging them into separate entities so that each business is treated on its own merit. The big challenge would be how to allocate the debt between the companies, but we have to await more details from the company. We know now that Vedanta Ltd shareholders will get 1 share in each of the 6 demerged companies for one share of Vedanta Ltd held pre-merger. Here are the 6 demerged entities in terms of business composition.

• Vedanta aluminium, which includes BALCO and other aluminium interests of Vedanta. It will be the largest company with revenues of over Rs50,000 crore.
   
• Vedanta Oil & gas, which will comprise of the upstream business of Cairn Energy and Cairn India.
   
• Vedanta Base Metals, which will include the other non-ferrous metals of the group, principally the Sterlite Copper business.
   
• Vedanta Steel, which will include the Electrosteel business and the iron ore mines which it had got as part of the acquisition of Sesa Goa.
   
• Vedanta Power, which will consolidate most of the captive power capacities of the group and also the pure power plays owned by them. 
   
• Finally, it will retain Vedanta Ltd which will now hold the 69.4% stake in Hindustan Zinc Ltd and also incubate fresh businesses like semiconductors.

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Ironic financials make a case for the demerger

In a sense, the financials of Vedanta Ltd are quite an irony. For example, the market cap of Vedanta Ltd is around Rs85,000 crore. However, the 64.9% stake that Vedanta Ltd owns in Hindustan Zinc, itself is worth Rs88,000 crore. That means, an investor acquiring Vedatna at the current market cap recovers cost through the HZL stake and all the other businesses come absolutely free of cost. For FY23, these businesses generated revenues of Rs150,000 crore, but the market cap is just about half of the revenues generated. Effectively, the EBITDA generated by Vedanta Ltd is nearly 40% of the market cap. 

If you look at it the other way. Vedanta can just sell its entire stake in Hindustan Zinc Ltd and make the company debt-free. In the process, they will lose a cash cow, but that is a choice that the company has to make. More than a decade ago, Anil Agarwal argued that a consolidated commodity megalith would solve the problems of commodity cyclicality. Nothing of that kind happened and the stock is now trading close to its yearly lows. Whether, in the ultimate analysis, the demerger leads to better value creation remains to be seen. For that, we need to understand what is holding up the valuations of Vedanta Ltd, as the stock quotes at a P/E ratio of less than 2.8X earnings. But, more on that later!

How the demerged businesses of Vedanta will look?

Here is a quick look at how the FY23 numbers for the demerged entity will look like for the various business groups.

Data Source: Vedanta Ltd

A quick glance at the above numbers shows that the company is still immensely profitable at a group level, but the dichotomies are huge. There are businesses like HZL and the oil & gas business where the EBITDA margins are above 50%, but there are also businesses like base metals and steel, where EBITDA margins are in single digits. The big bet is that (depending on how the debt is allocated), this demerger should result in a value explosion of the high-margin businesses while the low margin businesses may maintain current valuations. That would still be value accretive overall. However, there are challenges in most verticals.

On the aluminium front, it has to compete with two very powerful and profitable names in India viz. Hindalco and NALCO. The HZL stake has stayed at the same level for nearly 2 decades and the government is non-committal about the sale of the remaining stake. On base metals, it is still predominantly Sterlite Copper and that business still predicates on the reopening of the Tuticorin plant. It has been shut since 2018. On the Steel and ferrous space, Vedanta wants to exit the steel business of Electrosteel but wants to retain the iron ore mines it acquired from Sesa Goa. Oil is stuck in its own royalty and license challenges. Most verticals, even post-merger, would have a series of challenges.

What exactly is holding up valuations?

While the business challenges are still there, it does not explain the traditionally low valuations that the company has commanded. That is, probably an outcome of 3 factors; short-term solvency, global debt, and corporate governance.

1. What is the issue on the short-term solvency front? The company has about $2 billion of debt payouts coming up in January and August 2024, which is less than a year away. Markets have been concerned about how the debt payments would be funded. The shareholdings of the holding company are almost 100% pledged, so funding remains a big issue as short-term solvency remains a question mark.
    
2. Its global parent also has a debt and liquidity issue and S&P Global had recently downgraded the global parent, Vedanta Resources, due to a likely loan extension. The global holding company has been relying heavily on the cash flows generated from Vedanta dividends and that has not gone down well with investors.
    
3. There have also been corporate governance issues. In 2019, the stock was downgraded by most brokers after red flags over related party transactions in the Anglo-American PLC deal. Then in 2020, Vedanta made an abortive attempt to delist the stock at a very low price, which was blocked by LIC. These have not done good to valuations.

The demerger, by itself, may not add much value, unless the real challenges of liquidity, solvency and corporate governance are addressed.