Standard & Poor’s Ratings Services yesterday said that a proposed merger between the two Vedanta group companies will improve cash fungibility within the group. The merger is a step in Vedanta’s group simplification process. The proposed merger between Vedanta Ltd and Cairn India Ltd is expected to be completed by the end of the first quarter of 2016 at the earliest.

Cairn India is an oil and gas company, majority owned by Vedanta Ltd, which is an intermediate holding company,  majority owned by Vedanta Resources PLC (Vedanta Resources: foreign currency BB-/Negative/--).

“In our view, the financial performance of Vedanta Resources PLC would gradually strengthen because of greater cash fungibility and improving cash flow adequacy and leverage after the merger,” said Standard & Poor’s Credit Analyst Mehul Sukkawala.

“We expect the improvement in financial performance to lower the downside rating pressure on the company. But for now, the operating performance of Vedanta Resources’ key businesses will remain the most important factor for the company’s credit profile.”

Vedanta Resources will benefit from access to the free cash flows that Cairn India will likely generate annually. This should help improve the debt servicing capabilities and deleveraging efforts of Vedanta Resources and its Indian subsidiary Vedanta Ltd. The free cash flows are expected to be about US $ 500 million in fiscal 2016 (year ending March 31, 2016) and increase to more than US $ 800 million by fiscal 2018, given the base-case expectation of an increase in oil prices.

It is expected Vedanta Resources’ ratio of funds from operations (FFO) to debt to improve to 11.5 percent-12.0 percent in fiscal 2016 and more than 25 percent by fiscal 2018 after factoring in the merger. Without the merger, the ratio is estimated to be about 10 percent in fiscal 2016 and 20.0 percent-22.0 percent in fiscal 2018, still better than about 7 percent in fiscal 2015.

“We also expect the company’s debt-to-EBITDA ratio to improve to 4.5x-4.7x by fiscal 2016 and to less than 2.5x by fiscal 2018 considering the merger. We estimate the ratio to be about 5x in fiscal 2016 and 2.8x-3.0x in fiscal 2018 without the merger. The debt-to-EBITDA ratio was 5.9x in fiscal 2015.”
Vedanta Resources continues to consider various options to refinance its US $ 2 billion maturities due mid-2016 by the end of 2015 alongside the merger process.

“In our view, a more significant improvement in Vedanta Resources’ credit profile continues to hinge on the operating performance of its individual businesses. Our base case considers a sizable improvement in aluminum production to result in better financial and operating performances.”

The proposed merger involves an equity swap and will result in Vedanta Resources’ shareholding in Vedanta Ltd reducing to 50.1 percent from 62.5 percent. The merger is subject to shareholder, legal, regulatory and government approvals.

Key among them are approvals from Cairn Energy PLC and Life Insurance Corp., which are Cairn India’s largest shareholders after Vedanta Ltd and India’s income tax authorities.