Crop protection, chemicals and seeds company UPL Ltd is paying premium valuations to merge its group firm Advanta Ltd with itself. Upon merger, the company will issue one equity share for every share of Advanta. Over and above this, the resident (Indian) Advanta shareholders will receive three optionally convertible preference shares with an annual dividend of 5%.
Advanta shareholders can either convert or redeem the preference shares before 18 months from the issue date. Though UPL holds substantial stake in Advanta (48%), the terms of the merger are generous.
The companies are on different levels. UPL generates better margins. The company’s return ratios are also far superior. Compared with Advanta’s trailing 12-month return on capital employed and return on equity of 10% and 13.8%, respectively, UPL is estimated to generate 21% and 20%, respectively, in the current fiscal year, according to Emkay Global Financial Services Ltd’s calculations. Based on this, Advanta’s valuation (price-to-equity multiple) is estimated to be more than double that of UPL.
The UPL management expects Advanta’s profit to double toRs.240 crore by 2016-17 on margin expansion and restructuring benefits. The combined entity will benefit from synergies and an enhanced product portfolio. Annual cost savings on general administration, finance and tax benefits are pegged at around Rs.90 crore per year. In a conference call, the management expressed confidence that the merger will add positively to UPL earnings from 2016-17 onwards.
But as the selling in the share suggests, the Street is not fully convinced. The concerns emanate from the scepticism that Advanta’s profitability may take time to catch-up, weighing on UPL’s earnings. “In our view, this merger in the near term is earnings dilutive for UPL as the synergy benefit and improvement in Advanta’s profitability may take some time,” Emkay Global Financial Services said in a note.
Due to equity expansion of around 19%, the merger is expected to dilute UPL earnings by around 6-10%, analysts estimate. Sharekhan Ltd says the deal may take a “couple of years” for synergy benefits to emerge. Overall, the deal, though beneficial in the long run, effectively creates an overhang for the stock in the short term.
Thanks to its relatively better growth rates, UPL has been outperforming the broader markets—the stock is up 24% in the last one year. While the company’s prospects may remain intact, improvement in Advanta’s performance will play a crucial role in continuation of outperformance in UPL shares.
“We believe merger is likely to create near-term overhang on the stock, however, from a medium-term perspective, we continue to like UPL due to its diversified geographic mix, higher exposure to emerging markets, shift towards branded portfolio, improving FCFF (free cash flow) generation and reduction of debt,” B&K Securities India Pvt. Ltd said in a note.