Buy Reliance Industries - Depreciated INR and lower GRMs offset each other; Edelweiss,

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Reliance Industries (RIL IN, INR 778, Buy)

Refining spreads continue to correct sharply led by gasoline and naphtha. Indian complex GRMs have averaged USD8.1/bbl last week. We believe that current low margins are unsustainable especially for new refiners with high capital costs. RIL is relatively better-off as its refinery is diesel-heavy where spreads have remained fairly stable. To account for current low GRMs, we have cut our FY12/13 GRM estimates to USD9.25/bbl and USD10/bbl, respectively. We have built-in lower gas output as well as a weakening INR, taking our FY12 EPS lower by 3.3%. Maintain ‘BUY’ rating with a revised target price of INR 1,134.

Refining margins on downtrend

Refining margins have corrected sharply with Indian complex GRMs dipping to USD8.1/bbl last week from USD13.5/bbl in Q2. The crack in margins is primarily led by gasoline and naphtha. Restart of refineries of Formosa and Shell and weak Asian gasoline demand has resulted in fall in refining margins. Diesel spreads, however, held firm led by rising dieselization and soaring Japanese demand post nuclear shutdown.

Current margins not sustainable

Given the escalating costs of new refineries, we believe that current low margins are not sustainable, therefore expect refiners to adjust their capacities and production slates accordingly. GRMs of USD8/bbl imply an IRR of 8% for new refineries, which we believe is unsustainable.

Adjusting for INR depreciation, lower GRMs & gas production

RIL will be better off given higher share of diesel. However, we do see downside to its GRMs led by Naphtha where spreads are the lowest in 3 years. We now estimate GRMs of USD 9.25/bbl and USD 10/bbl in FY12 and FY13. We have also incorporated lower gas output to account for a faster fall in production and estimate output of 44/39 mmscmd in FY12/13. However, INR depreciation should help, with FY13 EPS going up by 1.5% for a 1% fall in INR. Our revised FY12 EPS now stands at INR69.3, down 3.3%. We maintain our ‘BUY’ rating on the stock with a target price of INR 1,134. At CMP of INR778, the stock is trading at 11.2x FY12 and 10.2x FY13 EPS.