Refiner’s cash flows, tax sops will come in very handy in these tough times

Legend has it that during a routine lunch with his sons in the winter of 2001, the late Dhirubhai Ambani, who was 69 years old then, first sounded out the idea of a merger between Reliance Industries (RIL) and Reliance Petroleum Ltd.

RIL was then into petrochemicals business, while RPL was refining crude oil.

The motive was clear: a merger engendered sales tax benefits, depreciation benefits and a much stronger balance sheet.

A couple of months later, on April 8, 2002, the merger sailed through with 99.5% of shareholders giving their approval.

With that, RIL, the textiles turned petrochemicals giant metamorphosed into a formidable force in petroleum.

The first refinery at Jamnagar, which processed 660,000 barrels of crude per day, was soon fused into the parent.

RIL then decided to set up a second refinery in Jamnagar, also calling it Reliance Petroleum Ltd (it holds 70% stake in this entity), with a capacity to refine 580,000 barrels per day.

Now, with the second refinery up and running, it was time for a 2002 redux, for the same reasons as then, then some.

On Friday evening, RIL said its board will consider on Monday whether to merge RPL with itself, in an effort to draw financial and taxation-related synergies.

Back-of-the-envelope swap-ratio calculations show that according to current market price, one RIL share will be equal to 16.4 shares of RPL.

Mukesh Ambani, the promoter of RIL, holds around 49% in RIL, but controls 52% of the voting rights.

While RIL itself holds 70% of RPL, another 5% in the latter is with Chevron Inc, the San Ramon, California-based US petroleum giant.

Analysts said the move will have an immediate beneficial impact on the cash position of RIL, which is known to be strained.

An industry official said RPL, which went public in April 2006, is starting to generate cash at a time when RIL needs it very badly.

“The first advantage is that as a shareholder, RIL would have had to wait for a year to get its hands on the cash, which would have come as dividend. With the merger, the cash will be available as soon as it flows in to RPL,” he said.

Another big advantage is in accounting for depreciation. A new project like RPL, set up at a cost of more than Rs 25,000 crore, will generate huge amounts of depreciation in its initial years.

However, RPL, being an export-oriented unit in a special economic zone, already enjoys 100% tax exemption on its profits.

So the huge depreciation cannot be used to lessen the tax burden.

“Once the company is merged, the depreciation of RPL becomes the depreciation of the combined entity. Depreciation amount is kept separately in another account and is not passed on to the bottomline, reducing the profit and the tax,” an analyst said.

The swap ratio seven years ago was one RIL share for every 11 RPL shares.

Also, this being a the acquisition of a subsidiary, the standard valuation guidelines of the Securities and Exchange Board of India will not be applicable.

Thus if history is anything to go by, RIL is likely to be valued at a premium over the start-up which is yet to make its first money, said analysts, pointing to a possible sell-off in RPL shares on Monday.

A swap ratio less than 17:1 would mean investors in RPL would be better off selling their stock and buying RIL shares instead, an analyst said.

There is also speculation about Reliance working out a deal with the new government to sell its products in the local market.

RPL, being in a special economic zone, cannot sell its produce in the local market. But most of the Saarc countries, which are major consumers of Reliance products, are in bad shape themselves.

The cash flow from RPL can also be used for RIL’s retail venture.

“Given that many retail chains are in a disarray and are in desperate need for cash, they could sell out to RIL. This is the similar route they followed when bringing up their petro business. And when the market turns for the better, you might see a Reliance Retail IPO,” said an analyst who did not wish to be named.

N Sundaresha Subramanian, Sreejiraj Eluvangal & Promit Mukherjee/ DNA-Daily News & Analysis Source: 3D Syndication