Demerging Reliance

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The implications of the multiple demergers of the Reliance Group will keep analysts busy for years. There are two schools of thought about demergers.

Most management theorists like demergers because it's easier to value separate lines of business. The pro-merger school also babbles about demerged companies concentrating on "core competency".

The case for mergers, or holding a group together in this case, is usually based on synergies in the value-chain.

By eliminating duplication of effort in terms of management, marketing and back-office structures and ensuring a close integration of value-chains, staying together can help add value to a comglomerate or group.

In the Reliance case however, there is no way to simplistically apply either of the above. The companies in question were already separate entities with clearly demarcated businesses.

With the exception of Reliance Infocomm, most of the big companies were listed and traded at excellent valuations. Moreover, the companies already had separate management, back-office and marketing structures.

The group has always pursued a strategy of integrating the value-chain. It has moved upstream into exploration and downstream into retail in its petrochemical business. Where it doesn't have core competency, as in gas pipelines, it develops them.

The demergers thus mean that every separate company will have to reconsider its plans. Thus, for example, Reliance Energy will have to figure out where it sources gas for its new power plants and Reliance Industries will have to review its client list for the gas-finds in the Krishna-Godavari basin.

What is most problematic is the impact of the demerger on sourcing capital. All the Reliance companies have ambitious expansion plans. None possess the shelter of consolidated revenues anymore. Lenders are always more concerned about free cash flows than profits as such "" if you have positive cash flows, you can service a debt.

When it came to free cash-flow, RIL was the major cash-cow, which made lenders comfortable about proferring vast sums to the group.

On the basis of the terms of its external borrowings, Reliance Group's credit rating is perhaps higher than the GoI. That situation no longer holds and every company will presumably see a review of its credit rating.

The new Anil Dhirubhai Ambani Enterprises (ADAE) is likely to be scrambling to find new capital. Reliance Energy (REL) and Infocomm are both in need of cash to fund expansion plans. Hence the Rs 3,000 crore commitment from Anil Ambani.

In the given competitive environment, without further network rollouts, the telecom initiative from Infocomm could turn into a white elephant despite the apparent improvement in financials.

REL may have to source gas on commercial terms for the 3,750 MW Dadri project and reschedule its 12,000 MW expansion plans in Orissa. The ADAE companies also have bids out for the privatisation of the Mumbai and Delhi airports and the Mumbai-Nava Sheva link "" those would be mega-billion contracts.

The need for cash also means that an Infocomm IPO must be just around the corner. We have listed entities in the same domain, we will also have a benchmark valuation once the entire Infocomm stake is transferred to ADAE.

That IPO could be interesting for the investor. As to the currently listed entities, the euphoria of the last week means that valuations are already back to fully-priced levels. If you buy at current prices, don't expect super-normal returns.