Cairn India — Open Offer: Sell in open market

Shareholders without a stomach for high risk can consider selling their holdings in Cairn India. Also, they may be better off selling their shares in the open market (through stock exchanges) at the current levels (Rs 346), rather than tendering in the ongoing open offer at Rs 355 by Sesa Goa, a Vedanta Group company.

Two key reasons underpin our recommendations. The continuing uncertainty about the proposed sale of a majority stake in Cairn India by its parent, Cairn Energy, to mining major, Vedanta, and the issues raised therein could possibly end up in protracted litigation. This could create operational uncertainties for the company and dampen valuations. The high capital gains tax liability on shares tendered through an open offer suggests that selling in the market may be a better exit route.

Headed for litigation

Given the stakes involved, there is a likelihood that either or both partners in the prolific Rajasthan block — Cairn India (70 per cent share) and ONGC (30 per cent share) — would resort to legal recourse to address their various points of contention (in particular, the much-talked about royalty issue). Litigation about the royalty issue cannot be ruled out, even if the Vedanta deal receives government approval.

ONGC, emboldened by the government's stand that royalty paid for the output from the Rajasthan block is cost-recoverable, is likely to push its case.

An adverse outcome in this matter could see Cairn India's revenues and valuation take a big hit. An unfavourable turn of dice in the royalty dispute could see Cairn India take a revenue hit of $1.8 billion (around Rs 8,000 crore) over the field's life. This translates into a per share impact of around Rs 40. Assuming that the deal does not secure the government nod, there is the possibility of Cairn Energy/Cairn India going to Court questioning the government's decision. This could cause a lot of uncertainty given that the co-operation of ONGC along with that of the government is a pre-requisite for key decisions impacting Cairn India's prospects, including ambitious output ramp-up plans, and indeed for smooth operational performance. In this context, litigation may prove to be a drag.

Solid Franchise

Shorn of the above issues though, Cairn India's core business is an attractive one, especially in a scenario of firm oil prices. Since commencing production in the Rajasthan block in 2009, Cairn India has ramped up output to 125,000 barrels of oil per day (bopd). It has indicated immediate output increase possibility to 150,000 bopd, for which it has sought and awaits approval from ONGC and the government. Cairn India estimates that if production plans go as per schedule, the output from the Rajasthan fields can be increased to 175,000 bopd by the end of the calendar, and further to 240,000 bopd, going forward.

The company's strong operational track record, sales tie-ups with private and public sector refiners, processing facilities (Train 4 expected to be operational by end-CY-2011) and transportation infrastructure (pipeline extension from Salaya to Bhogat expected to be completed by end-CY-12) justify its positive market reputation.

Besides, Cairn India is sitting on some other high-potential blocks in India, and one in Sri Lanka. Healthy profitability (net margins around 60 per cent) and a strong balance-sheet (debt-to-equity at a low 0.10 times, as on March 2010) are added positives.

The company's strong operational performance is reflected in its profits for the nine month period ended December 2010 expanding by almost five times year-on-year to Rs 3,877 crore. As a result, the stock's trailing 12-month price-to-earnings ratio, has declined from 67 times in May 2010 to a reasonable 16 times now. This, despite a 19 per cent increase in the stock price since then.

The strong run in the price of crude oil in recent times also bodes well for Cairn India which is a strong proxy play on the commodity and is not affected by the subsidy regime in the country.

Cairn's Rajasthan crude oil is priced at a discount of 10-15 per cent to the price of Brent, which currently hovers around $125 a barrel, up 31 per cent over the past four months.

Why sell than tender

Shareholders who tender to the acquirer in an open offer do not enjoy tax concessions on gains. Short-term capital gains in such cases are taxed at 10 per cent to 30 per cent, depending on the tax slab applicable to the investor, while long-term capital gains (on shares held more than one year) are taxed at 20 per cent without indexation benefit or at 10 per cent with indexation benefit. On the other hand, gains on shares sold in the open market through recognised stock exchanges are eligible for tax advantages (no tax on long-term capital gains, and 15 per cent tax on short-term capital gains).

With the prevalent share price of Cairn India (Rs 346) just Rs 9 short of the open offer price of Rs 355, shareholders who have held shares for more than a year and fall in the higher tax slabs are likely to gain more on an after-tax basis, if they sell in the open market.

Shareholders should, however, compute their tax implications and effective gains, based on market price, cost of acquisition, period of holding and tax slabs, before taking a call on whether to sell in the market or to tender.

Also, sale in the market allows shareholders to fully exit their holding, whereas the number of shares accepted in an open offer would depend on the acceptance ratio — number of shares accepted as a proportion of shares tendered. For example, if public shareholding in a company is 40 per cent, and the open offer is for 20 per cent, only five out of 10 shares tendered will be accepted, if all public shareholders tender shares.

Earlier this week, Petronas, which held 14.9 per cent in Cairn India, sold its entire stake in the open market. Of this, Sesa Goa acquired 10.4 per cent, due to which the likely acceptance ratio in the open offer has improved from around 53 per cent to around 73 per cent. That is, shareholders are likely to have seven out of ten shares accepted, if the shareholding remains as it stands.

Given the prevalent uncertainties over the deal, shareholders of Cairn India who tender in the open offer may run the risk of payments on accepted shares/return of unaccepted shares getting delayed beyond the stipulated date of May 15. Also, if the deal does not finally go through, the tendered shares would be locked in till such time they are returned, resulting in loss of liquidity and marketability.

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