Why Vedanta shareholders may gain from poor earnings

The sharp drop in net profit reported by Vedanta on Tuesday evening, primarily due to low earnings from its oil business, will improve the chances of the Vedanta-Cairn merger deal going through. Since the proposed merger was announced in June, Vedanta stock has fallen by 70% while Cairn shares are down 20%. If Vedanta’s earnings from oil stay low, Cairn shares could further come under pressure. This could compel the Vedanta group management to revise the 1:1.1 swap ratio in favour of Cairn shareholders.

The merger, which gives debt-laden Vedanta access to Cairn’s cash pile, could emerge as a key trigger for the out performance of Vedanta shares in the long term. (While the Anil Agarwal-led group’s oil business is housed in Cairn, Vedanta runs the metal mining and power divisions.) Amid weak commodity prices, Vedanta’s poor earnings numbers for the September quarter were expected by the Street.

What surprised most analysts was the worsethan-expected performance of the oil business, which pulled down consolidated profits. While Vedanta’s overall operating profit was the same as that in the June quarter, operating profit of the oil business (under its subsidiary Cairn India) was down 40%.

This, strangely, could benefit shareholders of Vedanta which is in desperate need of the cash that’s lying with Cairn. While Vedanta has a standalone debt of around Rs 35,000 crore, transferring Rs 17,000 crore cash from Cairn to Vedanta through dividends would be tax inefficient.

Under the circumstances, a merger of Cairn with Vedanta emerged as the obvious plan. But the deal was perceived by most as unfavourable for Cairn shareholders. “It is important that the merger with Cairn India goes through. The current stock prices and resistance by Cairn shareholders suggest that the deal might have to be sweetened,” said Sumangal Nevatia, analyst with Macquire Capital Securities.

Now, chances are lower earnings of the oil business could keep the Cairn India stock under pressure while a slow rise in the price of zinc (which contributes 50% of the operating profit) could have a positive rub-off on Vedanta shares.