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Reliance Industries (RIL)
Energy
It’s a BUY. We upgrade the RIL stock to BUY from ADD (upgraded on July 25, 2011
from REDUCE) on valuations and 38% potential upside to our SOTP-based target price
of `1,045. Our reverse valuation exercise reflects that the market is not ascribing any
value to its E&P business. Our trough-case valuation is `890. However, a significant rerating
will depend on (1) improved corporate governance and (2) prudent use of cash;
we would suggest dividends/buy-backs in the absence of meaningful planned capex.
Upgrade to BUY given attractive valuations; concerns overdone
We upgrade the RIL stock to BUY from ADD previously given a favorable risk-reward balance post
the recent sharp correction in its stock price. We note that the stock has corrected 20% over the
past three months (see Exhibit 1) reflecting investor concerns about (1) likely tough operating
conditions for RIL’s refining and chemical businesses, (2) limited visibility on E&P business, (3)
potential negative implications from a CAG audit report and (4) lack of clarity over possible
utilization of cash. However, current valuations are discounting a rather pessimistic scenario. The
stock is currently trading at 11.2X FY2012E EPS and 10.1X FY2013E EPS.
Stock price is implying nil value to RIL’s E&P segment and lower multiples for key businesses
Exhibit 2 gives our SOTP-based fair valuation of RIL. We value the RIL stock without its E&P
segment at `856 with (1) the refining and petchem segments contributing `612/share and (2) cash
and investments (including loans and advances) at `244/share. This implies that the market is not
ascribing any value to RIL’s E&P business, which seems to be an overly pessimistic assumption. We
admit that the market may be ascribing lower multiples to RIL’s refining and chemical segments
given a bleak global economic outlook. However, we believe that cyclicality of a business should
not change its value over time and the multiples should be adjusted appropriately to reflect the
earnings cycle.
Reverse valuation implies 4.5X EV/EBITDA multiple to RIL’s refining and petchem segments
Our reverse valuation exercise (see Exhibit 3) shows that the stock price is implying 4.5X EV/EBITDA
to RIL’s refining and petchem businesses based on FY2012E estimates. We use DCF-based
valuation for RIL’s E&P segment which implies fair value of ~US$17 bn for its key E&P blocks
including KG D-6, KG D-3, KG D-9, NEC-25 and MN D-4. This is significantly lower than BP’s
implied valuation of US$24 bn assuming no performance payout from BP and negligible value
from RIL’s other blocks.
18% potential upside to our trough-case valuation of RIL at `890
We compute trough-case value of RIL at `890 (see Exhibit 4), assuming (1) lower multiples for
refining and petchem segments at 5.5X FY2013E EV/EBITDA, (2) peak production of KG D-6 block
at 50 mcm/d, (3) no tax exemption on gas production from KG D-6 block and (4) nil value from
the upstream blocks under development/appraisal.
Possible triggers in the short term
We discuss possible corporate actions that RIL can pursue in the short term (next 3-6
months) to improve investment sentiment for the stock. Most of these pertain to improved
corporate governance. RIL can do little about chemical and refining margins given the global
nature of these businesses and a generally weak global economic outlook. Also, the E&P
segment is unlikely to provide any positive triggers over this period given that RIL does not
have any deep-water drilling rigs currently. KG D-6 gas production will likely continue to
languish at around 45-47 mcm/d for the next 12-15 months.
�� Clarity on use of cash. We would suggest RIL actively look at increasing dividends and/or
buying back its shares as a way to shore up investment sentiment for the stock. RIL does
not have any meaningful planned capex for now and acquisitions are rarely inexpensive or
value-accretive. As we had discussed in our June 14, 2011 report titled The size and
success trap, use of cash would be critical for the RIL stock in the medium term. We had
discussed four options and the relative merits and de-merits of the options—(1) capex in
extant business, (2) capex in new areas, (3) acquisitions and (4) dividends/buy-backs. We
model RIL to generate `740 bn of free cash flow in FY2012-14E.
�� Cancel treasury shares. This would optically increase RIL’s EPS by 9.8% (3,273
outstanding shares versus 2,981 shares without treasury shares). More important, it
would remove a potential source of overhang (RIL did sell treasury shares in 2009 and
2010) and remove an unnecessary complexity. RIL does not need to raise shares in the
short term (or it would appear for a long time) given its likely large cash free flows.
�� Simplify company structure. In our view, RIL can simplify its structure by (1) merging
several investment subsidiaries with itself, (2) cancelling outstanding treasury shares
(discussed above), (3) merging entities of the major shareholder, which are in the same
line of business, with RIL and (4) reducing the number of subsidiaries in new segments.
We understand the need for subsidiaries in some cases, especially for overseas operations
and new businesses. However, several layers of subsidiaries and cross-holdings
unnecessarily create confusion in the minds of investors (see Exhibit 5). Also, RIL has
interactions with several companies of the major shareholder (see Exhibit 6). RIL does not
share the basis of transactions with these entities but discloses the transactions
(purchases, sales, investments, loans) as per standard reporting practice. In our view, it
would be best to merge these entities with RIL at book value.
�� Better and consistent disclosures. We have discussed this issue several times in the past
and our suggestions are not new.
�� Disclosures on sales volumes, realizations and margins. We believe the Street
would welcome additional disclosures on sales volumes, realizations and margins of
key products. RIL does not currently disclose sales volumes of key products; it has
never done so historically. It shares production volumes, which is useful, but not as
useful as sales volumes given inventory adjustments. Finally, breakdown of revenues
by key products (not just by segments, which it mandatorily discloses in line with
reporting standards in India) would be more useful in understanding trends and
assessing future earnings.
�� Consistent disclosures on capex. We do not find current information on capex
relevant or adequate and would welcome additional disclosures on capex in the
‘normal’ manner. We note that RIL has stopped disclosing quarterly breakdown of
capex since 4QFY08. Also, in the FY2011 annual report it has not given breakdown
of capex by various segments that it used to provide in the past. Finally, it has started
disclosing net capex from 1QFY09 as opposed to actual capex; this has little
significance since movement in foreign currency loans arising from fluctuations in
the currencies of foreign loans versus the reporting currency is adjusted against the
gross block. RIL has reported ‘negative’ capex in certain quarters (see Exhibit 7 that
shows volatility in reported quarterly capex).
�� More conservative accounting policies. We would advocate adoption of Successful
Efforts Method of Accounting for the E&P segment compared to the current Full Cost
Method of Accounting. Almost all global E&P companies follow the former. RIL does not
have an extensive drilling program currently. Thus, it would be the best time to switch
over to SEM, in our view, and align its accounting policies with the prevalent standard.
Also, RIL can adopt the standard IAS 21 versus its current practice of recognizing any
income or expense arising from exchange difference either on settlement or on
translation in the P&L except in the case of FC borrowings used for acquisition of fixed
assets, where the amount is adjusted in the carrying cost of such assets.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Reliance Industries (RIL)
Energy
It’s a BUY. We upgrade the RIL stock to BUY from ADD (upgraded on July 25, 2011
from REDUCE) on valuations and 38% potential upside to our SOTP-based target price
of `1,045. Our reverse valuation exercise reflects that the market is not ascribing any
value to its E&P business. Our trough-case valuation is `890. However, a significant rerating
will depend on (1) improved corporate governance and (2) prudent use of cash;
we would suggest dividends/buy-backs in the absence of meaningful planned capex.
Upgrade to BUY given attractive valuations; concerns overdone
We upgrade the RIL stock to BUY from ADD previously given a favorable risk-reward balance post
the recent sharp correction in its stock price. We note that the stock has corrected 20% over the
past three months (see Exhibit 1) reflecting investor concerns about (1) likely tough operating
conditions for RIL’s refining and chemical businesses, (2) limited visibility on E&P business, (3)
potential negative implications from a CAG audit report and (4) lack of clarity over possible
utilization of cash. However, current valuations are discounting a rather pessimistic scenario. The
stock is currently trading at 11.2X FY2012E EPS and 10.1X FY2013E EPS.
Stock price is implying nil value to RIL’s E&P segment and lower multiples for key businesses
Exhibit 2 gives our SOTP-based fair valuation of RIL. We value the RIL stock without its E&P
segment at `856 with (1) the refining and petchem segments contributing `612/share and (2) cash
and investments (including loans and advances) at `244/share. This implies that the market is not
ascribing any value to RIL’s E&P business, which seems to be an overly pessimistic assumption. We
admit that the market may be ascribing lower multiples to RIL’s refining and chemical segments
given a bleak global economic outlook. However, we believe that cyclicality of a business should
not change its value over time and the multiples should be adjusted appropriately to reflect the
earnings cycle.
Reverse valuation implies 4.5X EV/EBITDA multiple to RIL’s refining and petchem segments
Our reverse valuation exercise (see Exhibit 3) shows that the stock price is implying 4.5X EV/EBITDA
to RIL’s refining and petchem businesses based on FY2012E estimates. We use DCF-based
valuation for RIL’s E&P segment which implies fair value of ~US$17 bn for its key E&P blocks
including KG D-6, KG D-3, KG D-9, NEC-25 and MN D-4. This is significantly lower than BP’s
implied valuation of US$24 bn assuming no performance payout from BP and negligible value
from RIL’s other blocks.
18% potential upside to our trough-case valuation of RIL at `890
We compute trough-case value of RIL at `890 (see Exhibit 4), assuming (1) lower multiples for
refining and petchem segments at 5.5X FY2013E EV/EBITDA, (2) peak production of KG D-6 block
at 50 mcm/d, (3) no tax exemption on gas production from KG D-6 block and (4) nil value from
the upstream blocks under development/appraisal.
Possible triggers in the short term
We discuss possible corporate actions that RIL can pursue in the short term (next 3-6
months) to improve investment sentiment for the stock. Most of these pertain to improved
corporate governance. RIL can do little about chemical and refining margins given the global
nature of these businesses and a generally weak global economic outlook. Also, the E&P
segment is unlikely to provide any positive triggers over this period given that RIL does not
have any deep-water drilling rigs currently. KG D-6 gas production will likely continue to
languish at around 45-47 mcm/d for the next 12-15 months.
�� Clarity on use of cash. We would suggest RIL actively look at increasing dividends and/or
buying back its shares as a way to shore up investment sentiment for the stock. RIL does
not have any meaningful planned capex for now and acquisitions are rarely inexpensive or
value-accretive. As we had discussed in our June 14, 2011 report titled The size and
success trap, use of cash would be critical for the RIL stock in the medium term. We had
discussed four options and the relative merits and de-merits of the options—(1) capex in
extant business, (2) capex in new areas, (3) acquisitions and (4) dividends/buy-backs. We
model RIL to generate `740 bn of free cash flow in FY2012-14E.
�� Cancel treasury shares. This would optically increase RIL’s EPS by 9.8% (3,273
outstanding shares versus 2,981 shares without treasury shares). More important, it
would remove a potential source of overhang (RIL did sell treasury shares in 2009 and
2010) and remove an unnecessary complexity. RIL does not need to raise shares in the
short term (or it would appear for a long time) given its likely large cash free flows.
�� Simplify company structure. In our view, RIL can simplify its structure by (1) merging
several investment subsidiaries with itself, (2) cancelling outstanding treasury shares
(discussed above), (3) merging entities of the major shareholder, which are in the same
line of business, with RIL and (4) reducing the number of subsidiaries in new segments.
We understand the need for subsidiaries in some cases, especially for overseas operations
and new businesses. However, several layers of subsidiaries and cross-holdings
unnecessarily create confusion in the minds of investors (see Exhibit 5). Also, RIL has
interactions with several companies of the major shareholder (see Exhibit 6). RIL does not
share the basis of transactions with these entities but discloses the transactions
(purchases, sales, investments, loans) as per standard reporting practice. In our view, it
would be best to merge these entities with RIL at book value.
�� Better and consistent disclosures. We have discussed this issue several times in the past
and our suggestions are not new.
�� Disclosures on sales volumes, realizations and margins. We believe the Street
would welcome additional disclosures on sales volumes, realizations and margins of
key products. RIL does not currently disclose sales volumes of key products; it has
never done so historically. It shares production volumes, which is useful, but not as
useful as sales volumes given inventory adjustments. Finally, breakdown of revenues
by key products (not just by segments, which it mandatorily discloses in line with
reporting standards in India) would be more useful in understanding trends and
assessing future earnings.
�� Consistent disclosures on capex. We do not find current information on capex
relevant or adequate and would welcome additional disclosures on capex in the
‘normal’ manner. We note that RIL has stopped disclosing quarterly breakdown of
capex since 4QFY08. Also, in the FY2011 annual report it has not given breakdown
of capex by various segments that it used to provide in the past. Finally, it has started
disclosing net capex from 1QFY09 as opposed to actual capex; this has little
significance since movement in foreign currency loans arising from fluctuations in
the currencies of foreign loans versus the reporting currency is adjusted against the
gross block. RIL has reported ‘negative’ capex in certain quarters (see Exhibit 7 that
shows volatility in reported quarterly capex).
Efforts Method of Accounting for the E&P segment compared to the current Full Cost
Method of Accounting. Almost all global E&P companies follow the former. RIL does not
have an extensive drilling program currently. Thus, it would be the best time to switch
over to SEM, in our view, and align its accounting policies with the prevalent standard.
Also, RIL can adopt the standard IAS 21 versus its current practice of recognizing any
income or expense arising from exchange difference either on settlement or on
translation in the P&L except in the case of FC borrowings used for acquisition of fixed
assets, where the amount is adjusted in the carrying cost of such assets.
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