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The $8.5 billion gamble?

By Devangshu Datta
August 16, 2010 11:15 IST
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Given it is in a completely different business, it's a question if Vedanta can seamlessly implement the optimal strategy for Cairn, argues Devangshu Datta.

Diversify or focus on core competency? Management theorists have often changed their answers to that question . There are case-studies to support either hypothesis. Some theorists say that a company focussed on one core business has a better chance to dominate its peer group.

Others point out that eventually, competitive advantages is eroded in any free market. Then a business must seek new avenues of expansion to maintain return on capital.

Asian entrepreneurs ignore the theoretical debate and focus on that one key factor - return on capital employed. In essence, they are prepared to develop competencies in any business that meets their RoCE criteria.

In India, the historical debate was settled by the License Raj: Possession of a licence, any license, meant guaranteed profits. So promoters took whatever was going. This meant massive conglomerates, which did all sorts of unrelated things.

The License Raj is no longer all-pervasive. But the mindset and legacies remain. However, some changes have been imposed by a free stock market. Once the Controller of Capital Issues was abolished, entrepreneurs could tap the primary market at whatever price investors would willingly pay.

Quite a few 'smart' promoters cashed in with a string of shady IPOs. The really smart promoters didn't try this. They worked out that a rupee of credible earnings translated into many rupees of valuations in a market no longer constrained by absurdities like CCI. So it paid in the long run to run honest businesses since that helped promoter wealth to multiply more sustainably.

Another thing smart promoters figured out was that the spin-offs of unrelated businesses paid off in terms of unlocked value. Conglomerates with several unrelated businesses held under one corporate structure are almost always valued lower than the fair sum of their parts.

If one company has, for example, a textile unit and a cement unit, it will almost always be valued lower than two separate companies, each focussed on one of these two businesses.

Part of the spinning off was accidental and forced. Feuding families had to spin off divisions into separate companies, since various members wanted to go down separate paths.

The most high-profile was the division of reliance group by the Ambani brothers. The two groups that resulted, RIL and ADAG, promptly saw surging valuations. But other groups that did spin-offs also saw valuations rising in newly-separated businesses.

It has gotten to the point where even related businesses are split up. For example, the telecom industry has seen telecom service providers selling off their tower units and outsourcing key operational functions like network rollout and maintenance. The telecom service provider now wants to focus purely on marketing and brand-building.

Part of the reason why spin-offs usually unlock value is that single businesses are easier to understand. But sometimes there is so much chopping and changing that analysis is difficult. Reliance Power and Reliance Energy for instance, saw a complex restructuring after the RPower IPO, into RPower and RInfra.

That was followed by the ongoing merger of RNRL into RPower. RIL has de-merged, listed, and re-merged Reliance Petroleum. In each case, investors had to rely on recast financials and make judgement calls about the permanence of new arrangements.

That background makes the current Vedanta-Cairns situation difficult to understand or comment on. The core competencies of the two are very different since E&P and mining of oil and gas are quite dissimilar to mining non-ferrous metals. The valuing of energy assets is also a very complex, uncertain exercise and government policy in this area isn't stable either.

Traders have initiated a classic paired strategy of buying the target (Cairn India) and selling the acquiring company (Sterlite in India). That's driven up Cairn's price and forced Sterlite's price down. If the deal doesn't happen, there would be a reversal in the trading pattern with Sterlite's price rebounding and Cairn's price dropping.

If the deal does come through, there's still some upside to Cairn with the prospect of open offers.

Is it a good long-term move for Vedanta? Cairn will ramp up production by next year. It also has other potential assets. India's exploration policy may change to an open acreage regime that leaves Cairn well-placed.

Energy prices are unlikely to fall in the long run. But Vedanta could be stretched finding $8.5 billion or more for a buyout. Also it's an open question whether it can seamlessly implement the optimal strategy for Cairn.

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Devangshu Datta
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