The proposal to merge Indian Petrochemicals Corporation Ltd (IPCL) with Reliance Industries, now that it has been announced, appears a natural and obvious move, given that both operate in the same industry. More so, if you consider the Reliance track record of merging group companies with the flagship.
The Reliance Industries that we know today is an amalgam of Reliance Petrochemicals Ltd (which implemented a part of the Hazira complex), Reliance Polyethylene Ltd, Reliance Polypropylene Ltd (these two were floated to implement another part of the Hazira complex) and Reliance Petroleum Ltd (the original entity that was floated to implement the Jamnagar refinery).
Yet, the proposal seems to have caught the market by surprise for two reasons. First, the Reliance Industries and IPCL Chairman, Mr Mukesh Ambani, while speaking at the IPCL AGM barely 20 months ago in June 2005, had ruled out any move to merge the two companies.
Second, the IPCL-Reliance merger is unlike any of the other instances quoted above in that it is not something that will bring in significant synergies more than what has already been achieved by the two in their independent avatars.
Operational synergies achieved
The core function of marketing and sales was combined within a year of the acquisition of IPCL by Reliance in 2002, with agents selling both brands of polymers and fibre/fibre intermediates. Synergies have also been achieved in product exchanges between the two — Reliance supplies naphtha for the Vadodara cracker of IPCL and also minor quantities of ethylene to the Gandhar complex.
What the merger will help achieve is to rationalise the other functions of finance, secretarial and HR where there could be some synergies to be achieved. But the cost-savings and efficiency improvement here cannot be significant enough to justify a merger of the two companies.
The combined entity will produce more of the same products such as polypropylene and polyethylene and a couple of new products in polybutadiene rubber and acrylic fibre, products that Reliance does not produce now.
The merger will also diversify the feedstock profile of Reliance, which now runs its cracker — the mother unit of a petrochemical complex — on naphtha. IPCL's crackers at Nagothane (Maharashtra) and Gandhar (Gujarat) use natural gas as feedstock.
There are other aspects being discussed as providing the rationale for the merger such as the use of Krishna-Godavari Basin gas in IPCL's crackers and the fact that the merger would add Rs 11,000 crore to Reliance's balance-sheet helping it to raise further resources.
Nothing prevented Reliance from supplying K-G Basin gas to IPCL when it remained an independent entity and, again, the character of the K-G Basin gas is not known yet. For use in a petrochemical cracker, the gas has to have molecules of ethane and propane apart from methane itself.
The swell on the Reliance balance-sheet, post-merger, will be nothing noticeable, given that it is already about Rs 1,00,000 crore in size; adding Rs 11,000 crore to it will make but a marginal difference.
Again, Reliance has traditionally taken the equity route to growth which is why it has a very low debt-equity ratio. There is enough elbowroom for Reliance to borrow more and adding IPCL's balance-sheet is not really going to make an impact there.
So what is the rationale for the merger now? One factor motivating the merger could be the losses accumulated by Gujarat Chemical Port Terminal Company Ltd (GCPTCL), a company where IPCL is a joint promoter with a few other Gujarat government-owned companies. GCPTCL operates a chemical port terminal with a jetty at Dahej and is deeply in the red. A merger of GCPTCL with IPCL, before the latter's merger with Reliance, could bring in a significant tax shelter for Reliance.
But, again, this is still in the speculative domain and requires the consent of the joint venture partners of IPCL. Reliance could also be seeking to capitalise on the run-up in its stock value in recent times which will enable a relatively more favourable share exchange ratio.
Petrochem monolith
Speculation on the rationale for the merger aside, what it will achieve is in creating a monolith petrochemical company that will hold approximately half the polymer market in the country; in some specific products such as polypropylene, the Reliance-IPCL entity will hold more than three-quarters share of the market. Some rationalisation of capacity and product lines will probably materialise to unlock value from the merger.
There is the question of what to do with the Vadodara complex of IPCL, which is about four decades old with capacities that do not help in deriving scale economies.
Scaling up the capacity is a problem because, with the city expanding around the complex, questions of environmental pollution and safety arise.
The cracker now runs on naphtha supplied by Reliance from its Jamnagar refinery. Capacities of the other two crackers of IPCL at Nagothane and Gandhar may also have to be scaled up, but the critical factor here will be availability of the feedstock — natural gas rich in ethane and propane.
Reliance has already announced plans for a new two-million tonnes per annum mother cracker with downstream units at Jamnagar and it remains to be seen how IPCL's expansion plans are married to this.
Valuation issues
Between the shareholders of Reliance Industries and IPCL, the merger appears more favourable to the latter. IPCL is a pure petrochem play with its revenue and earnings subject to commodity price cycles. Reliance, though still largely a commodity play, is better balanced between oil refining and petrochemicals.
About two-thirds of its revenues comes from oil refining and the restfrom petrochemicals, but when it comes to earnings, both businesses contribute in almost equal measure.
The presence in businesses such as retail, oil exploration and production (E&P), and life-sciences also lends better balance to the revenue and earnings streams. Of course, this picture could change if the company were to hive off its E&P and/or retail businesses.
For Reliance shareholders, the merger does not bring in anything extraordinary, even as it dilutes the equity capital by about 4 per cent from Rs 1,393 crore now to Rs 1453 crore, post-merger.
The merger would add about 12 per cent each to Reliance's revenues and earnings this fiscal (extrapolated latest nine-month earnings).
The stock price movement in the two days of trading since the first announcement of the merger reflects this clearly.
While the IPCL stock is up 16 per cent from Rs 231.65 to Rs 268.6, the Reliance stock is up by just 2.2 per cent in the same period. The share exchange ratio of one Reliance share for every five IPCL shares appears balanced in relation to the prevailing market prices of the two stocks, though from a book-value perspective it appears weighted heavily in favour of Reliance.
As of March 31, 2006, the book value of a Reliance share is Rs 324 and Rs 198 per share of IPCL.
An interesting aspect to take note is that the government holds 10.40 lakh shares accounting for 0.35 per cent of IPCL's equity capital as per the filing to the stock exchanges in January 2006.
Assuming that the government has already not sold this stake, it would become a shareholder in Reliance as a consequence of the merger, holding 2.08 lakh shares!