Holcim’s Ambuja-ACC deal: have investors got it all wrong?

The stock market verdict on Holcim’s restructuring of its India is an unequivocal thumbs-down. Both Ambuja Cements and ACC are down on Thursday, a day after the merger was announced. Ambuja Cements took a bigger hit and fell by 10.5% while ACC was down by 3%.

But when one analyses the transaction, after looking at the math of the transaction then it does not appear to be as bad as perceived by investors. The deal may actually lead to a higher growth in Ambuja’s earnings per share (EPS)* post-acquisition of ACC, when compared to its EPS post-merger with ACC.

A full-fledged dilution would have resulted in an equity dilution of 78% compared to the current equity dilution of 28%. Second, a merger would have seen the combined entity’s EPS at Rs 10.8, compared to Rs 10.2 for Ambuja Cements. That indicates there were no immediate gains available from a merger to shareholders. If we add the synergy gains of Rs 900 crore, after deducting tax, then the EPS jumps to Rs 13.2. That’s a significant improvement.

In the current transaction, the post-merger EPS works out to Rs 11.5 which is higher than what a merger would have led to. What’s more, after adding the synergy gains, the EPS works out to Rs 14 a share. Thus, the transaction does not lead to Ambuja Cements’ shareholders being in a worse position as compared to a merger.

One sore point can be the consideration of Rs 3500 crore payable to Holcim, for the acquisition of the 24% stake in Holcim India. The valuation is fair. The previous article on this issue, in indiabusinessview.com had said (link): “At present, Holcim owns 100% of Holcim India. It will sell 24% of its stake in this company to Ambuja Cements for Rs 3,500 crore. Is that a fair deal? Holcim’s stake in Ambuja Cements and ACC is valued at Rs 14,457 crore at current market prices and a 24% share of that amounts to Rs 3470 crore.” And, Holcim has its own shareholders to answer to, so an arms-length price for the stake can be called a fair deal too.

Also, both companies together generate ample cash from operations—Rs 3,400 crore in 2012—that should be adequate to fund their capital expenditure plans and even service debt if needed. If there is one big mistake that Holcim can be accused of, then that is not communicating, in a very clear manner, its intentions behind the deal and working out the math for investors–for both lay and institutional investors. It may have helped them understand why a deal—that appears so complex on the outside—was charted out, why shareholders may not only benefit from this deal but their gains may be more than if the two companies had been merged.

Here is a complete analysis of the deal. A word of caution: what lies ahead is lengthy and may appear complicated too—just like the deal it seeks to analyse.

The outcome that shareholders were looking for: a clean merger of ACC and Ambuja Cements
A key reason for shareholder disappointment, on learning of this development, is that they did not get what they wanted—a formal merger. They were contemplating a joint future after a share swap between ACC and Ambuja Cements.

For considering the impact of a notional merger, prices prevailing before the announcement was known to the market are used. That would be July 24, since the deal was announced post-market hours. At these prices, ACC’s shareholders would have got 1 share of Ambuja in exchange for 6.4 shares of ACC. That would have meant an equity dilution of 78.3% in Ambuja’s equity capital. That is a sizeable dilution. Also, a popular metric to gauge the impact of a merger is the notional EPS of the combined entity, as if it existed as of December 31, 2012.

The combined revenues of the two companies would have been Rs 21,088 crore, with an operating profit margin of 22.1%, and an EPS of Rs 10.8. That compares with the existing EPS of Rs 10.2 for Ambuja and Rs 73.8 for ACC. Ambuja has a share with a face value of Rs 2 while ACC’s share has a face value of Rs 10. Since ACC’s equity capital is on the higher side, the merger would have seen Ambuja’s EPS go from a pre-merger level of Rs 10.2 a share to Rs 10.8 a share. That gain is not something worth chasing for, by doing a merger.

Of course, there will still be the post-merger synergies, stated at about Rs 900 crore. If we add that right away just to get a picture of what benefits can accrue, it will result in an EPS of Rs 13.2 and if we take a P/E ratio of 18 times, that works out to a price of Rs 237 or a 24% increase in Ambuja’s valuation. That is a significant jump that could have been achieved, assuming the post-merger synergies were realised.

But how would a merger have affected Holcim and its stake in its India units?
There are some unknowns in this transaction that also need to be factored. One is whether a merger poses some disadvantage to Holcim in terms of the tax treatment on such transactions. Another is whether the cement industry’s concerns on the anti-trust action taken by the Competition Commission of India had any role to play. A full-fledged merger between the two companies would have required approval from the CCI, involving a detailed investigation into anti-competitive impacts that this merger could have, and could have resulted in delays. Maybe, the current transaction may jump through the CCI hoops more easily, since the two entities remain separate as such, and ultimate ownership remains with Holcim.

A merger, as contemplated above, would have seen Holcim end up with a 50.01% stake in the combined entity. Leaving these unknowns aside, Holcim would have ended up with a stake similar to what it already had in Ambuja. But the combined entity would become a formidable player with a sizeable common balance-sheet. If its valuations improved as a result, and Holcim was more comfortable with a stake at 60% instead of 50%, it would have to spend significant sums in acquiring that stake.

In the current deal, Holcim is getting a 60.1% stake in Ambuja Cements without paying a single cent for it. If we take the above example, Holcim would have required cash of Rs 5725 crore to complete the transaction, assuming a notional price of Rs 209 for the merged entity.

Holcim’s balance-sheet as of March 31, 2013 shows that the company has CHF3 billion in cash, but it also has CHF 9.3billion in long term financial liabilities and CHF4.5 billion in current financial liabilities. With a total of CHF 13.8bllion in debt, or Rs 87,226 crore at current rates, it would not have preferred taking on more debt to fund a stake hike.

The actual transaction
Therefore, it may have come up with this convoluted structure that has been greeted with dismay by investors. It is first selling a 24% stake in Holcim India to Ambuja Cements for Rs 3,500 crore in cash. Subsequently, it will merge Holcim India with Ambuja Cements in an all-share transaction. Note that Holcim India’s pre-existing 9.76% stake in Ambuja Cements will get cancelled.

In addition, Ambuja Cements will also own 24% of Holcim India, so it will have to issue its own shares, to the parent company Holcim, only to the extent of 76% of Holcim India’s equity capital.
Therefore, it is issuing 58.4 crore new shares leading to post-transaction increase in Ambuja Cements’ equity capital by 28% to 197.7 crore. A merger would have seen a 78% increase in its equity capital. Thus, equity dilution is far less than what it could have otherwise been.

In return for this equity dilution, Ambuja Cements gets a 50.01% stake in ACC. Ambuja Cements’ consolidated financials will now include that of ACC. Based on their 2012 financials, the proforma consolidated EPS works out to Rs 11.5 a share, after taking half of ACC’s profit since the rest will be attributed to minority interests. That is still higher than Ambuja Cements’ present EPS of Rs 10.2.

What’s more, if we take the promised cost-savings of Rs 900 as a given, and we apportion three-fourths of it to Ambuja Cements (taking half as Ambuja’s share of cost savings, and half of the remaining half attributable to ACC), then the EPS actually goes up to Rs 14 a share. That is an even better outcome than what a merger could have achieved.

Does that mean that Ambuja Cements’ shareholders have it all wrong?

Not really. They are right to be indignant at nearly all the cash being taken out of the company, even if Holcim plans to reinvest it in its Indian cement business itself. Also, Ambuja Cements may have to spend another Rs 3,000 crore over the next two years, to increase its stake in ACC to 60%. With money required for capital expenditure, the money could have been used better by Ambuja Cements.

But also consider this: ACC and Ambuja Cements together generated about Rs 3,400 crore as net cash generated from operations in calendar 2012. Both companies have very low debt levels, with combined debt of Rs 120 crore as of December 2012. Therefore, they can borrow money to fund expansion and the creeping acquisition—some level of debt can be considered desirable too for a joint stock company—and use internal resources too. Thus, even after an Rs 3,500 crore payout and an Rs 3,000 crore commitment, finding resources should not be a problem.

In sum, the structure proposed by Holcim does not appear to be as unfavourable to shareholders of Ambuja Cements, as the share decline indicates, except for that part where the cash exits the company.

Lack of communication
If there is one aspect that Holcim can be clearly faulted for, it is not communicating the transaction in more detail and with the implications laid out clearly for investors. The company could have made it clear that it did consider a merger (the assumption is that this option must have been there on the table) but decided against it, and given reasons for it. It could have explained why it needed the Rs 3,500 crore payout and, if it had reason to believe so, why this would not affect Ambuja Cements’ capex plans or balance-sheet health.

It could have made it clear that selling a 24% stake in Holcim may give it a windfall, but is also limiting equity dilution and by how much. What impact does that have on the proforma EPS could have also been communicated. It has been done in the past, when big M&A transactions have been announced. By making clear that this is a notional calculation, they will not be violating any disclosure norms either or be accused of giving forward guidance. Holcim should have also clarified why it wants Ambuja Cements to increase its stake in ACC to 60%.

Some of these messages are there, but they are scattered across—some in the press release and some in the presentation. But most importantly, Holcim should have done the math and told Ambuja Cements’ investors that valuations are not getting affected because of this transaction. It may have avoided all the bad publicity that this transaction has got. While investors may still not have welcomed it with open arms, they would have at least stopped to analyse the message a little more carefully before shooting the messenger.

Update: (*) Note that the EPS calculation in this article does not consider a one-time charge on account of change in depreciation in both Ambuja Cements and ACC, that takes into account additional depreciation for previous years. That impact would have been spread over a number of years. While it is prudent to deduct it from profits, instead of adjusting it in the balance-sheet, it has been excluded for the sake of this analysis.

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