Reliance Industries stock rated 'Overweight', says JP Morgan

Updated: Oct 21 2013, 19:09pm hrs
Reliance Industries (RIL) reported quarterly (Q2) profit of Rs 54.9 bn (+3% q-o-q, +1% y-o-y), in line with consensus, but with better petchem/refining, and lower other income. GRMs (gross refining margins) moderated from Q1 levels, but remained more resilient than regional benchmarks. We remain positive on Reliance Industries core business expansion strategy, and we expect resultant organic earnings growth to drive stock performance. While E&P (exploration and production) continues to dominate headlines, we see Reliance Industries as attractively priced for the long term. Upgrade to OW (overweight), with a Mar-15 price target of Rs 1,000.

GRMs fell sequentially to $7.7/bbl (vs. $8.4/bbl in Q1), with weak demand post-US driving season, and pre-Ramadan Asian buying. However, Reliance Industriess margins were more resilient than Singapore benchmarks due to a widening in light-heavy crude differentials. Petchems contribution was up 33% q-o-q with improving polymer margins, volumes and a weak currency. PX (paraxylene) margins remain robust, while yarn/fibre margins were pressured. Domestic demand remains robust and overall polyester chain spreads are being cushioned by Chinese cotton prices.

E&P news flow continues: D6 output continued to fall (to 14mmscmd in line with expectations). News flow on the pricing front continues to influence stock performancewe factor in a price increase for RIL, as we expect the government to prioritise increasing hydrocarbon output.

Refining margins fell to $7.7/bbl with a fall in regional benchmarks due to a fall in demand post-US driving season. Throughput rose to 17.7 MMT (million metric tonne). Petchems contribution was 33% higher q-o-q, with better spreads (polymers) and volumes. Gas production continued to decline (14mmscmd vs. 15mmscmd in Q1FY14 and down 51% y-o-y). RIL has begun work on arresting this decline with workovers and sidetracks underway in D1-D3, while an additional well will be drilled in the MA area. Retail continues to growa mix of strong same stores sales growth and new stores opening helped increase turnover by 31% y-o-y basis. RIL now operates over 1,550 stores across 136 cities in India.

Petchems saw operating margins rise while O&G (oil and gas) Ebit margins were flat on a q-o-q basis. Refining and others margins fell sequentially. With O&G remaining weak, Refining and Petchems accounted for 93% of Pbit (profit before interest and taxes) during the quarter. At the end of Q2 Reliance Industries had cash and cash equivalent of $14.5bn.

Organic growth to drive earnings: We remain positive on Reliance Industriess core business expansion strategy-regionally, we prefer stocks with a strong exposure to organic growth, high level of integration and earnings resiliency. With polyester expansions moving towards completion, we expect focus to shift towards the earnings growth generated. We expect Reliance Industriess expansions to drive petchem Ebitda (earnings before interest, taxes, depreciation, and amortisation) growth of 21% over FY13-17, with strong earnings growth visibility FY15 onwards. We expect EPS (earnings per share) to rise 18% over the same period.

While the overall polyester chain could continue to see some pressure, Reliance Industriess integrated operations allow earnings to remain more resilient. We expect refining margins to recover from current low levels as we head into the winter, and expect a full year margin of $8/bbl. We think near-term share price performance could be range-bound, with continuing news flow over the applicability of the gas price hike to Reliance Industries we however build in a price hike into our estimateswe expect raising domestic hydrocarbon production to remain a priority for the government. We think RILs valuations remain undemanding, trading toward the lower end of its historical range. While this de-rating is linked to disappointments on E&P production, we expect strong organic growth to help drive an expansion.

Refining lower, but premium to Singapore widens: Reliance Industries GRMs for Q2 stood at $7.7/bbl, falling less than regional benchmarks (Singapore GRMs fell from $6.6/bbl to $5/bbl). Overall margins came off during the quarter as demand was weak across light and middle distillates. However, with light-heavy crude differentials widening during the quarter (Arab Light- Arab Heavy widened by c.$0.3/bbl; Brent Dubai by c.$1.9/bbl). The company believes the market is fairly well balanced with new capacities being offset somewhat by shutdowns. The company expects middle distillate demand to be robust, driving margins.

Petrochemicals: better-than-expected quarter: Petrochemicals Ebit was higher 33% q-o-q, as a pick-up in polymer deltas and volumes, while PX margins remained robust. Ethylene chain margins improved, with restocking, and tight supplies aiding PE (polyethylene) margins. Demand remains robust, with domestic demand rising 8%, led by a 5% growth in PP (polypropylene), 6% growth in PE and 16% growth in PVC on the back of higher domestic consumption across all major end-use sectors. Polyester markets were affected by the weak economic sentiments across many major consuming centres.

Upstreamproduction decline continues

Domestic operations: Output at the D6 field continued to decline, averaging 14mmscmd (million metric standard cubic metre per day) for Q2 (vs. 15mmscmd for Q1). Reliance Industries has initiated steps to arrest this decline and augment production. Approvals for the satellite fields are in place, while approvals for the R-series cluster have been received from the MC (management committee). In addition, appraisal of the new D-55 discovery is also slated to begin. E&P remains a key stock driver, with the gas price hike dominating headlines. However, with development of new projects likely to take two-three years more, output will remain muted in the near term.

We upgrade Reliance Industries to Overweight: We remain positive on RILs expansions in its core businesses. We do concede that near-term performance could be choppy. We have a new Mar-15 price target of Rs 1,000. Key downside risks are project delays, weaker refining/PX margins and stronger Rupee, and adverse E&P regulations.

JP Morgan