17 September 2011

RELIANCE INDUSTRIES - Mild rebuke; Final CAG report implies limited fair-value impact. Maintain BUY.:: Credit Suisse,

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The Comptroller and Auditor General’s final report on Reliance’s KG-D6
block, though milder than the draft report, retains assertions related to the
non-relinquishments of parts of the block. It still highlights contractual
inconsistencies but has dropped several objections. The recommendations
remain an irritant, but the value at risk from their implementation is less
than 2%. With the stock trading at a 19-20% PE discount to the Sensex
and peers, we remain BUYers.
Key issues raised by CAG. The draft report by the Comptroller and Auditor
General (CAG) on Reliance’s (RIL IB - Rs853.5 - BUY) KG-D6 block had
raised several issues. The key ones related to non-relinquishment of parts of
the block as mandated in the contract, the inadequately explained rise in
development costs and inconsistent contractual processes that may have
contributed to this rise. Reliance and upstream regulator Director General of
Hydrocarbons (DGH) had replied earlier refuting these allegations.
The final report.  The final report released yesterday appears less
trenchant but the CAG has held on its key assertions. On the contentious
issue of non-relinquishment of parts of KG-D6, for example, it comes down
on DGH for a mid-course change in stance in favour of Reliance and
recommends that the Ministry of Petroleum (MOPNG) should define the
discovery area based on the strict contract definition of successful
exploratory drilling. If implemented, this may require Reliance to relinquish
large parts of KG-D6.
Less harsh on rise in capex. The CAG also appears to have toned down
its criticism of the increase in D1-D3 development capex from US$2.5bn to
US$8.8bn, noting that acceptance of costs can only be certified after
future audits. Instead it focuses more on contractual inconsistencies. Here
too, we find that many of the instances cited in the draft report have been
dropped, leading to a cut in the aggregate alleged unproductive capex in
D1-D3 from US$620m to US$350m. Nonetheless, the report advises the
MOPNG to carefully evaluate these contracts, especially ones with Aker
Group (including the US$1.1bn FPSO for MA) to ensure that government
interest is protected.    
Limited impact.  The US$350m capex at risk is about 5% of D1-D3
spend so far. Therefore, any disallowance will have limited impact.
Similarly, we value the smaller discoveries in KG-D6 at just Rs11/share
and Rs4/share, as future exploration upside in the block limits the
downside from a forced relinquishment of the entire block outside of D1-
D3 and MA to just Rs15/share. Further, with the MOPNG and DGH
appearing to have sided with Reliance on these issues earlier while
replying to the CAG, we view this as a low-probability event, especially
as retrospective implementation is difficult.
Maintain BUY. Nonetheless, the recommendations will remain an irritant
until the government decides on the feasibility of their implementation as
well as its own willingness to do so. The CAG’s insinuation of undue
closeness between DGH and Reliance in prior years is especially tricky.
Nevertheless, with the stock trading at a 19% discount to the Sensex and
20% to global peers on FY12CL PE, we remain BUYers.

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