On July 4, the boards of Reliance Power and Reliance Natural Resources Ltd (RNRL) approved a scheme of merging the companies in a four (RNRL) for 1 Reliance power share swap. Our initial thought is that this transaction is done out of necessity rather than value creation. The only real fundamental value that RNRL could bring to RPower shareholders, in our view, is the undeveloped gas assets. Again, it seems that RPower has paid an enterprise value of $1.4 bn for this more speculative upside. We retain our Underperform the stock is trading at approximately a 40% premium to our valuation. With financial closure achieved for only 17% of its project pipeline, we believe there is still a long way to go regarding project execution.
The lack of domestic gas supply is the main constraint for gas-fired power generation in India. As highlighted by a recent Infraline report, the total gas requirement for the proposed gas-fired power projects in the 12th (FY13-FY17) and 13th (FY18-FY22) Plan projects is 490 mmscmd. The report noted the overall shortage of gas for the 11th and 12th Plans likely to be around 168 mmscmd.
The recent Supreme Court decision over the RNRL-RIL case highlighted that the government has ultimate control of how gas supply in India is allocated. RNRL has no power projects: We believe RNRL itself has no power projects of its own?it?s essentially trading the gas?against the government?s desire to allocate gas to end-users and not traders. Therefore, to support an allocation of gas in a highly competitive environment, the merged entity will have a portfolio of gas-fired power capacity that could support such an allocation. Hence, we believe that an RNRL-RPower is more a merger of necessity than of value creation.
Stripping out cash-plus investments imply a PBV of 11.8x, highlighting the early stage of the execution cycle for the combined RPower/RNRL entity. On our numbers, pro forma earnings for the combined entity would have been Rs 7,804 m ($170 m) for FY10?slightly dilutionary for equity holders. Note that earnings are essentially driven by investment revenue, not operational earnings and are largely irrelevant. Practically, both groups still represent uninvested cash/investments.
The media release highlighted several positives:
* ?RPower to derive substantial benefit from RNRL?s gas supply master agreement (GSMA) with RIL?
Our view: Agreed, the gas supply may allow the construction of up to 8,000 mw of new gas-fired capacity. But much of the potential value of this gas supply has been reduced since the SC decision suggests a price of at least $4.20/mmbtu for the gas. In our view, this is adequately reflected in the price. Also, we still don?t know exactly where this gas capacity will be built?high risk to execution.
* ?Prospects for gas from RNRL?s coal bed methane (CBM) blocks, comprising 45% interest in four CBM blocks with an acreage of 3,251 sq km and estimated resources of about 193 billion cubic metres, and a 10% share in an oil & gas block in Mizoram, with an acreage of 3,619 sq km and reserve potential of up to 28 billion cubic metres.?
Our view: Admittedly, we have to do more work around these assets regarding valuation. But in our view, this is the only real fundamental upside for RPower shareholders from the transaction. Therefore, it seems that RPower has paid an enterprise value of around $1.4 bn for these assets.
* ?Enhanced reliability and cost efficiency for RPower through RNRL?s coal supply logistics and shipping business.?
Our view: We haven?t considered downside value from coal supply logistics and are already factoring in low costs of coal production at RPower?s blocks.
* ?RNRL shareholders to benefit from RPower?s diversified generation portfolio of 37,000 mw and substantial coal reserves.?
Our view: Of the 37,000 mw of power projects in the pipeline, only 600 mw are under operation. RPower has spent only 5% of the potential capex required to roll out its growth pipeline and that financial closure has been achieved for only 17% of its projects. We believe there is still a long way to go on execution.