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Reliance Industries (RELI.BO)
Buy: Valns Factor E&P Downside, Not Petchem/Refining Recovery
Reiterate Buy; E&P disappointment in the price — On top of a 20% YTD underperformance, RIL has continued to lag the Sensex recently (by 3% in the last
month) despite a robust petchem and refining recovery, as –ve newsflow on KG
gas ramp-up has continued to affect stock sentiment. However, we believe that
while E&P disappointment is now fully priced in, strength in its cyclical businesses
offsets most of the –ves, making risk/reward compelling. Reiterate Buy (1L) with a
TP of Rs1,184 (Rs1,140 earlier) as we roll forward to Mar-12E from Sep-11E.
Earnings cut limited to 2-5% — Our assumptions of slower KG gas ramp-up
(57/64/80 mmscmd for FY11/12/13E) and stronger rupee are largely offset by a
robust petchem outlook, limiting our EPS cut to 2-5%. For KG gas, while timelines
on a price hike remain uncertain, recent data points reaffirm our view that prices
are set to rise for RIL. Accordingly, we assume higher price of US$5.2 for vols over
80 mmscmd in FY14E and for entire vols beyond FY15E. While our E&P value
increases only marginally (Rs464 to Rs471) as a result of this due to our reduced
vol forecasts, this could witness further upside if a price hike leads to expectations
of reserve value enhancements and an advancement of ramp-up timelines.
Stronger petchem, improving refining outlook — RIL should continue to benefit
from strong margins across the polyester chain due to cotton tightness, which is
unlikely to ease until 2HCY11. We also see stronger ethylene margins over CY12-
14 as supply growth comes off, though CY11 margins could remain capped.
Overall, the changes lead to our petchem EBITDA forecasts staying flat over FY11-
12E and up 8-9% over FY10 (7-9% yoy declines earlier), despite appreciating
rupee. For refining, we see gradual improvement of product demand/supply
balance into CY11-12, which should support RIL’s GRMs of US$8.3/9.4/10.0.
Potential for gas price upside improving — Recent discussions with mgmt suggest
that RIL is in dialogue with the gov’t for higher gas prices for new prodn. Also, the
gov’t has recently allowed ONGC to charge a price of US$5.25 for non-priority
customers, further indicating its willingness to raise prices. While timelines remain
uncertain, we continue to believe that higher prices would drive E&P value for RIL.
Valuations Factoring in E&P Downside, Not Petchem/Refining Recovery
RIL’s underperformance vis-à-vis the broader market has continued in recent times with the
disappointment on KG gas ramp-up determining stock sentiment. However, with the stock trading
at <13x FY12E P/E, we believe that current valuations are not pricing in the significantly improved
petchem outlook and a gradual improvement in refining, making risk/reward attractive at current
levels. Our new target price of Rs1,184 (previously Rs1,140) incorporates a slower-than-earlieranticipated ramp-up in KG gas production (volumes of 57/64/80 mmscmd over FY11/12/13E) and a
stronger rupee (45/44/43 over FY11/12/13E), which is largely offset by robust petchem (FY11-12E
EBITDA up 8-9% over FY10 levels) and gradually improving refining (GRMs of US$8.3/9.4/10.0 over
FY11/12/13E). Recent data points reaffirm our view that prices for RIL’s incremental gas
production are set to rise, and while they may not have an immediate impact on current production
volumes, this could be a key driver of E&P value as well as sentiment on the stock.
Target price of Rs1,184; maintain Buy
We continue to base our Rs1,184 target price on an average of a sum-of-theparts value (Rs1,117/share) and P/E value (Rs1,192/share) and explicitly addsNPV of the shale gas JVs of Rs30/share. We have, however, rolled-forward our
multiples basis from Sep-11E earlier to Mar-12E.
Estimates revisions
We have revised down our EPS estimates by 3/2/5% over FY11E/12/E13Edriven by adjustments to our forecasts across businesses as well as the
assumption of a stronger rupee, as discussed in detail in the following sections.
Segmental breakdown
(i) E&P – volume downside priced in; price upside not
– We value RIL’s E&P business at Rs471/share (Rs464/share earlier) in our
SOTP based on 10x Mar-12E (8x earlier) EV/EBITDA; the implied premium
of our SOTP valuation to NAV of known reserves (D6+NEC+CBM) remains
largely the same at 42% (43% earlier). We continue to base the E&P
valuation on an EV/EBITDA-based methodology in our SOTP to remove the
impact of high DD&A. The reason for the higher multiple we now attribute
to the E&P business is our lower production estimate of 64 mmscmd for
FY12 as well as the higher price of US$5.2 we take beyond production of
80 mmscmd. The impact of the higher gas price as well as the production
ramp up will only be felt in FY14 and beyond, which cannot be adequately
captured using near-term multiples.
– Based on latest updates suggesting a slower ramp-up of KG gas
production, we tone down our gas production forecasts to 57/64/80
mmscmd over FY11/12/13E (63/80/110 mmscmd earlier). While
management has not guided towards any firm timeline to get to the 80
mmscmd plateau, we believe that RIL should be able to ramp-up to this
level by FY13E.
– Given recent management commentary and our thesis of a structural
increase in gas prices, we now assume higher prices for KG gas going
forward:
• US$5.2/mmbtu for production over 80 mmscmd in FY14E, and
• US$5.2/mmbtu for the entire production FY15E onwards.
While a formal revision of KG gas price could still be some time away (the
price of US$4.2/mmbtu is fixed till Mar-14), we believe that skewed gas
demand/supply in India and favorable economics for domestic gas would
eventually lead to higher gas prices for RIL. Recent higher gas prices for
ONGC also point towards the government’s willingness to increase prices
Inching closer to a gas price hike
After our upgrade report titled, ‘Upgrade to Buy: Cyclical Risks Priced In;
Structural Gas Rewards Not’ dated 23 August 2010, which had discussed the
likelihood of domestic gas prices moving up with RIL being a key beneficiary
1
,
there have been certain other events/indications which support our viewpoint:
As per press articles (Economic Times), the government has allowed ONGC
and OIL to charge up to US$5.25/mmbtu for gas sold to non-priority (nonpower and non-fertilizer) consumers, which were earlier paying
US$4.75/mmbtu. While this is applicable only for 7-8 mmscmd of gas, this is
again indicative of the government’s intent to: (1) provide a level playing
field to the public sector oil companies, and (2) incentivize these companies
to invest in new fields by pricing their gas higher.
As per recent press articles (Economic Times), the government has asked
the Planning Commission to appoint a high-level committee to suggest a
mechanism for uniform gas price for all consumers in order to minimize gas
price volatility, to make gas price across consumers more uniform, as well as
protect the interests of sensitive sectors such as power and fertilizer. The
government expects the committee to come out with this mechanism within
one year. RIL could be an indirect beneficiary of this, as in the event of an
increase in price of incremental KG gas production by US$1/mmbtu (24%),
the impact on the price paid by a consumer in FY13 if pooling is fully
implemented could be much lower at just US$0.2-0.3 (6%) in our view, a
fairly manageable increase. Even if the price of entire KG gas production is
increased by US$1/mmbtu (unlikely, however, before FY14 as the price for
existing volumes is fixed at US$4.2 for a period of five years ending FY14),
the impact on the consumer would be just US$0.4-0.5.
Recent discussions with management
We recently met RIL management wherein they mentioned that the company
was in dialogue with the government for higher gas prices, stating that they
needed an assurance of higher gas prices before committing capex and
going ahead with the development of the D-6 satellite fields, NEC-25, and
the CBM blocks. Management also mentioned that a price of cUS$6/mmbtu
would be a win-win situation for everybody: for RIL as it would encourage
quicker development of new fields, for the government as it would benefit by
way of higher profit share, and for gas consumers as it would still be much
cheaper than imported LNG. They reiterated that RIL has been approached
by customers willing to pay a price higher than the existing US$4.2/mmbtu
for KG gas (see our report titled ‘Buy: Potential Gas Price Surprise in the
Offing?’ dated 15 Sep 2010).
2
Edward Sampson, Chairman of Niko Resources (RIL’s partner in KG-D6,
MN-D4), recently in an energy conference indicated that they were trying to
get a higher price for KG gas. He said that while they were getting US$4.2
for their KG gas production, there were other producers in Western India
which were getting ~US$6/mmbtu. In an earlier presentation, he had
mentioned that they were looking for a 25-50% gas price increase, which
would incentivize development and advance production in D6 and NEC-25.
Based on recent developments and management commentary, we believe that
while gas prices for the current D6 production (upto 80 mmscmd) may not be
revised in the near future (we assume a price hike only beginning FY14E), any
newsflow and/or concrete action on implementation of higher prices for
production from new fields (KG-D6 Satellite, NEC-25, and CBM) will enhance
value of reserves (i.e., premium to NAV) and act as a key stock trigger.
(ii) Refining – gradual improvement of demand/supply
balance
– We do not expect the refining cycle to return to the peak in 2004-07.However, we see a gradual improvement of refining demand/supply
balance into 2011-12 and Singapore GRM benchmark is likely to rise to
mid-cycle level (~US$5-5.5/bbl) in 2012 vs. US$4.3/bbl in 2010E and
US$3.7/bbl in 2009.
– Our blended GRM assumptions for RIL stand at US$8.3/9.4/10.0/bbl for
FY11/12/13E, implying reasonable premia of US$4-4.8 to our Singapore
GRM assumptions.
– We continue to value the refining business in our SOTP based on 7x
EV/EBITDA and roll forward to Mar-12E.
(iii) Petrochemicals – benefiting from cotton tightness
– Gradual ramp-up of new cracker start-ups in 2010 (Thailand, India,
Middle East) suggests effective supply growth would remain high at 6-7
MMT (4.5% pa) in 2011, capping near-term ethylene margins. We,
however, see a strong ethylene margin upswing over 2012-14 with supply
growth falling to 4 MMTPA (2.5-3%) during the period.
– Cotton tightness unlikely to ease until 2H11, which will support margins
across the polyester chain, benefiting RIL.
– Our estimates are now based on our new regional forecasts, which take
into account the stronger outlook for PX and the rest of the polyester
chain.
– We continue to value the petchem business in our SOTP based on 7x
EV/EBITDA and roll forward to Mar-12E.
Reliance Industries
Company description
Reliance Industries is a conglomerate with interests in upstream oil & gas
(E&P), refining, and petrochemicals. It has commissioned a super-size refinery
project through RPL (now integrated) and has commenced gas production at
its large gas find in the D6 block in KG basin. RIL is foraying into organized
retailing and has plans to undertake SEZ projects over the medium/long term.
Investment strategy
We rate RIL Buy/Low Risk (1L) with a Rs1,184 target price. We believe that
while the recent underperformance in the stock is pricing in the E&P
disappointment, it does not capture the stronger petchem and improving
refining outlook. We expect continued cotton tightness to drive margins across
the polyester chain, thus benefiting Reliance. We expect an uptick in the
refining margins as well with a stronger product demand/supply balance going
forward. A ~40% premium to NAV looks justified for the E&P business given
new discoveries and intensive exploration calendar. While KG gas production
ramp-up has disappointed, we believe gas prices are set to structurally rise in
India, as exemplified by higher prices approved by the government for ONGC's
production from new fields. Any willingness on the part of the government to
increase KG gas price (which, along with APM gas, is now the cheapest in the
country) would be a positive surprise and could lead to expectations of
acceleration in further development of Reliance's KG reserves and increase in
gas production, driving possible earnings upside and stock performance.
Valuation
Our Rs1,184 target price is based on an average of a sum-of-the-parts value
(Rs1,117/share) and P/E value (Rs1,192/share) and explicitly adds NPV of the
shale gas JVs of Rs30/share. Our SOTP is derived by: 1) Valuing RIL's core
petchem and downstream oil business on an EV/EBITDA of 7.0x FY12E, in line
with regional chemicals and refining peers; this also captures the expected
recovery in global refining; 2) Valuing total E&P assets including oil & gas
prospects and other blocks at Rs471/share based on 10x FY12E EV/EBITDA; 3)
Valuing investments in the organized retail business, SEZ, etc. at Rs37/share,
based on book value of investments so far; and 4) Valuing treasury stock (post
stock sale) at target price. For the P/E valuation, we ascribe a 15x FY12E
multiple, in line with the market multiple. We believe RPL and KG gas
commencement will lead to the market focusing on FY11/12 earnings (which
capture the impact of both), prompting us to give equal weightage to a
multiple-based methodology and an SOTP while deducing our target price.
Risks
We rate RIL Low Risk, in line with the rating suggested by our quantitative riskrating system, as diversified earnings and significant value contribution from
the emerging E&P business partly mitigate the impact of the global slowdown
on the cyclical components of its business, while commencement of the new
refinery and KG gas production limit execution risks. Downside risks that could
prevent the shares from reaching our target price include: RIL's margins are
exposed to the global petrochemical and refining cycles; further delays in the
ramp-up of production of KG-D6 gas; delays in the drilling programme and/or
negative news-flow for the new blocks (D9, D3, MN-D4).
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