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Divestures
Case: L&T: Restructuring theCement Business
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Chronology of Major Events
Grasim files an appeal against SEBI directive in SAT 22 Nov 02
SEBI advises Grasim not to acquire any further shares of L&T in the open market or through negotiations or otherwise until further advice
18 Dec 02 SEBI decides to take legal opinion on L&T plans of de merger to ascertain whether it amounts of violation of takeover code
29 Nov 02
Grasim proposes vertical de merger plan for L&T cement
business and offers Rs.130 per share for the de merged entity 27 Jan 03
SEBI clears Grasim on charges of management control of L&T. Asks to come up with revised open offer
14 Mar 03
Grasim announces 7 May 2003, as its date of open offer. Keeps the offer price unchanged at Rs.190 per share
24 Apr 03
Grasims open offer for L&T shareholders opens 7 May 03
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Share Price Movement of L&T and Grasim
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L&Ts Business Segments
L&TEngineering and Construction (ECC)
Electrical Business Group (EBG)
Cement
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Location of Cement Plants of L&T and Grasim (Including Subsidiaries)
L&T was a major force in cement business in the western part of India and to some extent in the southern part of the country as well
Cement business accounted for around 27% during the year 20022003
By 2002, Grasim had become the third largest player in the Indian cement industry with an installed capacity of 13 million tons per annum (MTPA)
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Market Share
(%)
of
Major
Players
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Impact if L&Ts Cement Business Gets Acquired by Grasim
Top 6 players would control ~57% of the installed capacity of the whole industry
Market leader in cement in India 1/4
th Market Share
22% of Installed
Capacity
Worlds 7th largest
producer of
cement
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L&Ts Shareholding Pattern
Stateowned
Life
Insurance
Corporation
(LIC),
the
largest
shareholder
in
L&T
with
a
18.6%
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Grasims Shareholding Pattern at the End of March, 2003
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Current offer price of Rs. 190
per share
Grasim paid in
2001 to Reliance: Rs. 306
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L&Ts Reaction to Grasims Open OfferApproached nancial
institutions that held about 44% of stake in L&T to oppose the
open offer
Intrinsic value of the
stock was at least 40% higher than Grasims offer price of Rs. 190 a
share
Under the various valuation methods, the
L&T scrip would be valued at close to Rs.
300 a share
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Grasims Reply
Rs. 190 per share is a fair valuation of L&T
Any increase in price is not in the interest of Grasim
shareholders
Grasim shareholders paid a premium initially to enter the company and the offer price was intended to bring down their average holding
cost of
L&T
shares
Open offer for Larsen & Toubro is not a mandatory
offer, and hence L&T shareholders are free to
decide whether they want
to accept
the
offer
price
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Grasims ReplyPrice of Rs. 306.60 per share paid
to Reliance Industries was to a large lot of shares through a single transaction, where the seller had
agreed to of oad its entire stockholding in L&T and withdrew
its nominees
from
the
L&T
board
Grasim was of the opinion that the 10% premium in open offer price
was more than the expected value of synergy per share
Grasim was unwilling to put any value on non quanti able
synergies
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What will be the Status of Combined Entity?
Considerable presence
in the western and southern markets and
thus enjoy greater pricing power
Deal will give a boost to industry consolidation
Better logistics and inventory management
Reduce transportation costs
Clusters that consume 42% of the total cement in the country
Will be number one Gaining scale advantages Operating cost reduction
Relatively new plant Cross branding Reduction in freight cost Enhanced financial flexibility
In pricing terms, the combined entity was expected to grow at a rate of 2% per annum due to the
increasing power they would have in determining the prices in the cement market, as against the current price growth of 1%
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Grasim's Suggestion of Demerger of Cement Business
May dilute Grasims holding in the cement subsidiary
Birlas preferred a vertical
split giving existing L&T shareholders a share in the new company in proportion
to their current holdings
Birlas served legal notices
on L&T
against
proceeding
with the proposed de
merger
Birlas maintained that de
merger of
the
cement
business amounted to asset
stripping
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Grasim vertically split the cement business, it was willing to make another open offer for the new
cement company
Second offer would not only match CDCs valuation of about $75/ton, but
also seek to buy about 20% of the new company instead of the 6.8%
nally proposed by CDC
Birlas stressed the fact that their second offer would enhance the
return FIs would receive, as they would be buying a higher quantity of
shares than CDC
Grasims nal proposal to L&T board on 27 Jan 2003 envisaged a vertical
de merger of L&Ts cement business
into a separate company and an open offer for acquiring control over the
proposed new cement company (New Cemco) at a price of Rs. 130 per share
Grasim's Suggestion of Demerger of Cement Business
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Comparison of Major Cement Industry Acquisitions Since 1997
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Corporate Restructuring
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DemergerSegregation of business verticals into independent entities
ROCE, RONW separately captured for each business
Market / regulator perception friendlyAutomatic listing of Transferee CompanyDemerger to be tax neutral provided prescribed conditions are fulfilled
Pros
Limited leveraging capacity on demerger of listed entities
Twin listed
entitiesClassical demerger requires transferee to
reflect assets at book valueCons
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Shareholders Position
Ultra Tech Cement L&T EPC Division
L&T20% Ultra Tech Cement
100% in EPC
L&T Shareholders 100%
80%
20%
100%
100%
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L&T Cement Acquired by GrasimPercentage of
Acquisition From Whom?
No. of Share
Aqcuired
Face
Value Price How?Acquisition of L&T Stocks by Grasim18th Nov 2001 10.05% Reliance 250,00,000 10 306 OTCJune Oct 2002 4.80% Open Market 119,40,000 10 184.5 Market20Oct02 20% Open Market 497.51 10 190 Open OfferAcquisition of UTC Stock by Grasim4Feb04 11.88% L&T 147.79 10 Restructuring Process4Feb04 4.50% L&T 55.98 10 342.6 Swap4Feb04 4% L&T 49.76 10 342.6 Swap
15Mar
04 30% Market 373.2 10 342.6 Open
Offer50.38%
Open offer failed fetching 0.38% stake
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Effects of DemergerShareholders get an Option to stay with the company
Cement business as separate entity can create more value to shareholder by attracting good acquisitions
D/E may look better due to distribution of debt
EPS likely to increase
Retained earnings may turn negative
Ensured survival of the existing management
Fetching higher price at right time
It is desirable to attract Industry specific investors
Better valuation & liquidityThere was no tax implication in the hands of the companiesinvolved or the shareholders
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Modes of Demerger
Spinoff
Splitup
Equity Carve out
Divestitures
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Need for
Demerger
Corporate attempt to adjust to
changing economic
and
political
environmentof the country
Strategy to enable others to exploit opportunity effectively
to optimizereturns when
the
parent company is unable to do
so
To correct the previous investment decisions where the
company moved intotheoperational field having no
expertise or experience to run the show on a profitable basis
To help finance an acquisition
To realize capital gains from the assets acquired at the time
when they wereunderperforming and now no better performance, capital gain can
berealized
To make financial and managerial resources available
for developing other more profitable opportunities
Selling unwanted and surplus or unconnected parts in the business as arestructuring
strategy to get rid of sick part of the company
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Tax Benefits on Demerger
Dividend No dividend income shall arise in the hands of shareholders of demerged
company on demerger
Capital gains no capital gains shall arise to shareholders of the demerged company on account of receipt of any shares from the resulting
company
Expenses incurred for the purpose of amalgamation or demerger shall be allowed
@20% every year from the year in which the demerger takes
place
Depreciation shall be apportioned between the
demerged company and the resulting company in the ratio
of number of days for which the assets were used by them
The accumulated losses and unabsorbed depreciation in a demerger shall be allowed to
be carried forward by the resulting company
Benefits available for demerger are also extended to
authorities or boards setup by
Centralor State Govt
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Conditions for
Tax
Neutral
Demerger
All properties and liabilities of undertaking being
transferred, should be
transferred to the resulting company and transfer should
be at book value
Liabilities to include Liabilities which arise out of
activities or operations of the undertaking
Liabilities to include Specific loans or borrowings
(including debentures) raised,
incurred and utilized solely for activities or operations of
the undertaking; and
Liabilities to include Consideration for de merger
should be met by issue of resulting company shares
At least 3/4th of de merging company shareholders
should become shareholders of resulting company
Shares to
be
issued
as
consideration to shareholders
on a proportionate basis
Undertaking should be transferred on a going
concern basis
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Demerger
Division of a Company with twoor more identifiable businessunits into two or more separatecompanies
The Company to obtain in-principle approval for listingfrom the exchanges havingnationwide trading terminalswhere it is listed, before issuing
shares or other securities to theshareholders of TransferorCompany
Types
Listed Company demerging into two
companies (both could be listed)
Listed Company is demerged into two
companies and
another unlisted
entity is merging
with the one of the demerged entity.
Distribution of shareholding in a
Wholly owned
Subsidiary among
shareholders
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Recapitalization
Writing off losses and fictitious assets
Correction of over capitalziation
Distribution of accumulated profits by
Payment toshareholders a part of
share capital.
Clean up balance sheet Revival of a Company
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85
Buyback and Earnings
Year 1 Year 2 Year 3 Year 4Earnings 100 100 100 100
Shares outstandi ngMonths 0-6 100 100 50 50Months-6-12 100 50 50 50
Average shares outstanding 100 75 50 50
EPS 1.00 1.33 2.00 2.00Change in EPS 33.33% 50.00% 0.00%
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86
Buyback and Earnings
Year 1 Year 2 Year 3 Year 4Earnings @ 20% growth rate 100 120 144 172.8Shares outstandi ng
Months 0-6 100 100 50 50Months-6-12 100 50 50 50
Average shares outstanding 100 75 50 50EPS 1.00 1.60 2.88 3.46
Change in EPS 60.00% 80.00% 20.00%EPS if no buyback 1 1.2 1.44 1.728Change in EPS 20.00% 20.00% 20.00%
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87
Buyback Need not to Increase EPS Always
Year 1 Year 2 Year 3 Year 4No. of Shares 1000 @ 1Operating profit 100 100 100 100Interest Income on Excess Cash@10% interest 30 30 30 30Earnings 130 130 130 130EPS 0.13 0.13 0.13 0.13
After Buyback of 100 share s for 3 per shareOperating profit 100 100 100 100Interest Income on Excess Cash@10% interest 0 0 0 0Earnings 100 100 100 100EPS 0.11 0.11 0.11 0.11
After Buyback of 300 share s for 1 per shareOperating profit 100 100 100 100Interest Income on Excess Cash@10% interest 0 0 0 0Earnings 100 100 100 100EPS 0.14 0.14 0.14 0.14
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Buyback of SharesMay increase EPS but may not
affect PE ratio
Price increase will be to the extent
of increase in EPS
Treasury stock don t enter into EPS
calculation
Opportunity cost associated with buy back..,Interest income lost on net cash after saving on dividend
payments and Interest incurred on debt obtained to fund the
purchase
Positive impact of buybacks on EPS and ROE is greater in the year
following buyback
because
Average weighted by time are
used to make EPS calculation and Reacquired shares are measuring
stock for full year
If a company s earning are growing, buy back can give a added boost to the earnings
growth rate for a longer period than in the case of stable earnings
company
Positive impact of buyback on earnings growth occurs for a finite
period of time
During the initial years of buyback each year s ROE and implied
growth rate will be misleading indicator of the future
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Buyback of Shares
Management trying to squeeze out a few more
EPS in deteriorating situation to meet the
market s forecast
May not be a meaningfull restructuring of the
company
May not be a genuine change in management
attitude towards maximizing stockholders
value
Simply a cyclical attempt to retain control over the
stockholders investment
DE ratio increases leading to running off with debt
capacity may be only at
book value
May be the change in DE ratio overstates the change
in company s level of financial risk and reduction
of borrowing capacity
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Excess Cash Interest on cash balance is taxed.., Once at the corporate level Second when its distributed to
shareholders Double taxation on dividend Makes equity a costly form of new
finance
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Excess CashOption 1
Hold an extra dollar of Treasury bonds and distribute it with interest at latter date Mean time corporate tax rate has to be
paid on the return After tax value = (1td)(1+r(1 tc))
td = tax on distribution (either as dividend or capital gain) r = return earned tc = corporate tax rate
Option 2
Distribute an extra dollar right away After tax value = (1td)(1+r(1 tp)) td = tax on distribution (either as dividend
or capital gain) r = return earned tp = personal tax rate Assumed: type of investment constant
inside and outside the firm
91
If the distribution tax is not expected to change; distribution now or after depends on difference between t c and t pDistribute now if t c > t p
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92
Theories of
Dividends(Effect of $1 Dividend on Share Price)
Announcement DayPrice Change
Ex-day price change
MM Theory 0 -1Taxes - -(1-t d)Signaling + -1
Agency + -1
Clientele effectsDepends on clientele
demandPossibly less than -1
Market conditions Depends on sentiment -1
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ESOP
Paying dividend reduces value of ESOPs
ESOPs are not dividend protected
Paying out cash balance leads to large value losses