How negative is the merger of JSWISPAT? ::Nomura research

News reports of merger of JSW Steel and JSW ISPAT; the company
has denied the news
There have been news reports suggesting that JSW ISPAT (JSWI IN,
not rated) might be merged into JSW Steel in next few weeks (Source:
business today, August 29, 2012). Earlier, management had guided that
the merger would happen once JSWI turns profitable. The company has
said that these are media rumours and asked us to ignore it. However,
we present below our view on the merger, if it happens.

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A negative development if the merger takes place…
We believe this merger at current levels would be negative for JSW Steel
given JSWISPAT shares would ideally get a negative value owing to low
profitability and high debt. Though JSW Steel already holds close to a
49.3% stake in JSWISPAT, it didn’t get a negative value on account of
this stake given JSW ISPAT was a listed company.
Impact on valuation: we expect -INR45/share impact on JSW Steel
Post merger, JSW Steel would have total consolidated EBITDA of
INR75bn in FY13F and INR82bn in FY14F. At 5x FY14F EV/EBITDA,
the merged entity will have EV of INR408bn and equity value of
INR158bn.
However, JSW Steel would benefit from JSWI’s deferred tax assets of
INR20.9bn. We estimate JSW Steel can use this over next six years and
hence ascribe an NPV of INR12.9bn to the deferred tax assets. As a
result, we estimate JSW Steel on a consolidated basis would have value
of INR721/share, compared with our current target price of INR766.


Limited equity dilution for JSW Steel…
We would expect equity dilution of 7.5-8.1% for JSW Steel on account of
the merger. JSW Steel already holds a 49.3% stake in JSWI. So to

acquire the remaining shares, JSW Steel would have to issue 16.9-
18.2mn shares, which be 7.5-8.1% dilution.
As per news reports, the merger ratio would be in the range of 1 share of
JSW Steel per 70-75 shares of JSW ISPAT. JSW Steel currently has
223mn shares, which would go up to 241.2mn shares (assuming merger
at a ratio of 1:70).


Leverage to increase significantly for the consolidate entity
More than impact on the P&L account, JSW Steel’s balance sheet would
see major deterioration on account of this merger, in our view. We
estimate that JSW Steel’s total consolidated net debt would go up to
INR250bn (from current INR175bn) and D/E ratio would also increase
from 1.03 currently to 1.4.
Please note that we have treated preferential capital of INR6.4bn (which
JSWI reports under shareholder’s capital) as debt in the below
calculations.

There could be some synergy benefits from lower interest costs
We believe this merger could result in lower interest cost for JSW ISPAT
debt. Currently average cost of debt for JSW ISPAT is close to 15%,
while the same for JSW Steel is close to 7.5%. This could result in
savings of close to INR3.5bn and an increase in net profit of INR2.5bn,
assuming interest cost on debt of JSW ISPAT comes down to 10%.