Reliance Industries (RIL IN) Downgrade to UW: HSBC Research

Reliance Industries (RIL IN)
Downgrade to UW: Fully valued
 2QFY13 results in line with our and consensus estimates;
refining business contributed 60% of operational profit
 We believe the recent run in refining margin is unlikely to
sustain given weak macro outlook and impending return of
several refineries from unplanned shutdown
 We retain TP of INR800 but downgrade RIL to UW (from N)
due to recent run up in the share price

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RIL reported 2QFY13 net profit of INR53.76bn ( +20%qoq, -5.7% yoy) in line with
our and consensus estimates. RIL reported gross refining margin (GRM) of USD9.5/bbl
for the quarter and USD8.5/bbl for 1HFY13. Refining business continues to dominate the
operational earning. Therefore, we increasingly believe the investors would view refining
margin as the main driver of RIL’s stock. A USD2/barrel change in refining margin
changes our EPS estimates by 22%.
Refining margins unlikely to sustain. We believe the sudden jump in refining margin
from its YTD low at USD3.2/bbl in June to a YTD high of USD12/bbl in August was due
to unplanned shutdown of several refineries globally. In the absence of demand support,
on-streaming of these closed refineries will start to impinge on margin in Q3FY13. A
strong 2QFY13 result therefore is a good opportunity to exit the stock.
Petrochem expansion unlikely to be significant value driver near term. RIL is
expanding its petrochemical throughput by c47% in stages by FY16-end. The addition to
the earning is only marginal till FY17. We expect the petrochemical sector EBIT to grow
at less than 2.5% CAGR over FY12-14e. These projects to add materially to net income
would require near perfect integration between petcoke gasification and off-gas cracker
(OFG), never attempted at the scale RIL is attempting. We therefore believe investors
would rather focus on the refining business as the primary driver of the stock.
Valuation and risk. Our cautious stand on the stock is despite increasing our GRM
assumption from USD7.25/bbl in FY13 and USD7.5/barrel in FY14 to USD8/bbl in
FY13-14 to factor improvement in gasoline spreads. We have lowered our USD-INR
exchange rate forecast for FY14 and FY15 based on the current spot rate of 53.12 (as per
Reserve Bank of India spot rate). Our FY13e EPS estimate increases by 4.2% while
FY14e/FY15e estimates remain largely unchanged. Our sum of parts based target price
remains unchanged but we downgrade the stock to Underweight on its recent run up. Key
risks to our rating are improvement in refining and petrochemical margin, increase in gas
output and deployment of cash in earning accretive businesses.


Investment view
RIL has been a story of backwards integration from its textile and petrochemical businesses into refining,
and then into upstream. The deepwater gas discovery in 2002 prompted investors to value RIL as a
company providing the growth of an emerging market player with the earnings stability of an integrated
oil company. However, a steep decline in D6 gas production has dampened the outlook forcing investors
to focus on the downstream business as the main driver of RIL’s share price.
Refining margins unlikely to sustain. We believe the sudden jump in refining margin was led by
unplanned shutdown of several refineries across eastern and western hemisphere. Demand on the other
hand continues to be under pressure with EIA in its latest forecast has lowered its estimate for growth in
oil demand in CY12, fourth time since January. In the absence of demand support, on-streaming of these
closed refineries will start to impinge on margin in Q3FY13. More than 5 mbpd (6% of global capacity)
had to undertake unplanned shutdown over last 4 months due to a combination of adverse weather
conditions and/or accidents.
Petrochem expansion unlikely to be significant value driver. RIL is expanding its petrochemical
product output by c47% in stages by FY17. Majority of the additional capacities will be on stream only
by FY16-end. The polyester capacities however are scheduled to commence operation starting FY14. The

addition to the earning is only marginal till FY17. We expect the petrochemical sector EBIT to increase
from present INR90.6bn (37% of the core business EBIT) by less than 2.5% CAGR over FY12-14e. The
EBIT from petrochemical business could increase by c45% by FY18 but this would require the new
projects like petcoke gasification and off-gas cracker to be operating as per or better than expectation.
Integration of these projects have not been attempted anywhere globally at a scale company has
envisaged. We therefore do not expect market to start ascribing meaningful valuation to these expansions
at this stage. Refining business therefore would remain the dominant business segment near term.
Market is still optimistic on E&P – we disagree. Market believes that with the increase in gas prices,
RIL will be able to produce more gas. However, out analysis of statements by RIL and its partner Niko
seems to suggest that gas production volumes will remain low even at higher capex.
Broadband business conundrum – continues. RIL procured a countrywide BWA license (4G) two
years ago in September 2010 after paying a license fee of cINR130 bn. The company has yet to roll out
its services though. Due to high frequency of the BWA license (2.3MHz), the coverage is an issue as also
confirmed by the pilot run by Bharti Airtel. This will clearly pose challenge for a countrywide rollout for
RIL’s LTE technology. We therefore believe that RIL will start with top 10-30 cities before gradually
rolling out in rest of the country. Clearly, the advantage of a pan-India license therefore is not
immediately exploitable as incumbents also have comparable spectrum in the major circles. We also
believe a pure data option has not succeeded anywhere globally and therefore RIL may have to dovetail a
voice option as well as part of its service bouquet. License conditions however do not allow RIL to
seamlessly transfer voice signals to other operators



Our valuation remains unchanged. We value the upstream business on a DCF basis (WACC 11.1%; RFR
8.0%; ERP 5.5%, Beta 1.0) for the producing blocks and on a reserve multiple basis for the discovered
blocks. We value RIL’s downstream businesses using a 6x EV/EBITDA multiple on FY14e earnings,
which is in line with the average multiples of its global peers. We also value the recent shale acquisitions,
Pioneer and Atlas Energy, on a DCF basis. Under our research model, for stocks without a volatility
indicator, the Neutral band is 5ppt above and below our 11% hurdle rate for Indian stocks, or 6-16%
above the current share price. Our target price implies a potential return of -2.8% which lies in
Underweight band; therefore, we downgrade the stock to Underweight. Potential return equals the
percentage difference between the current share price and the target price, including the forecast dividend
yield when indicated.
Sensitivity analysis and risks
Key upside and downside risks to our rating and estimates are gas production volume and gross refining margin or
petrochemical margin coming in ahead of, or below, our expectations.