Reliance Industries stock rating: ‘Buy’

Reliance Industries (RIL) and BP Plc (BP) recently announced that BP will take 30% interest in RIL?s 23 oil & gas blocks in India, including the producing KG D6 block. The implied value of RIL?s E&P (exploration & production) assets, based on the consideration BP is paying for the 30% stake, is in line with our valuation of RIL?s E&P. However, RIL?s share price factors a much lower valuation. This deal should help re-rate RIL?s E&P valuation.

BP will acquire a 30% stake in 23 oil & gas blocks, including 19 in India?s eastern offshore region. BP will pay $7.2 bn for the 30% interest in the 23 blocks. BP may also pay another $1.8bn as future performance payments based on exploration success that results in development of commercial discoveries.

BP would pay $7.2-9.0 bn for the 30% stake, implying a value of $27-30 bn for the 100% stake and $23.4-29.3 bn for RIL?s 97.6% stake in these blocks. However, most of the consideration of $7.2 bn that BP will pay is likely to be for KG D6, in which RIL has a 90% stake. On that basis, implied value works out to $21.8- 27.2 bn. We are valuing these assets at $25.7 bn (total E&P value $32.9 bn).

Problems with KG D6 ramp up and KG D9 dry wells meant RIL’s E&P valuation was de-rated. RIL therefore did not participate in the refining and petrochemical rally in the last six months. RIL?s share price (Rs 956) is closer to our bear case fair value of Rs 923 (lower E&P) rather than the base case (Rs 1,193). We believe this deal will bring in a lot of benefits and also help re-rate RIL?s E&P valuation.

We expect strong earnings growth for RIL in FY11- FY12e, driven by refining margin recovery and a surge in oil & gas volumes. RIL has 4.7 bn boe 2P (barrel of oil equivalent, proven and probable) reserves from the exploration of 5% of its Indian acreage. It has large unexplored prospective acreage and, thus, large reserve-accretion potential. RIL also has a lot of cash and treasury shares, and should generate strong free cash flow. This may be used to make value-accretive acquisitions.

BP will take stake in 23 blocks of RIL, including:19 blocks (18 deepwater and 1 shallow water) in the eastern offshore; 2 deep-water Kerala-Konkan blocks; 2 onland blocks, including the Cambay block in which RIL has made several oil discoveries. BP already is RIL?s partner with a 50% interest in one KG deepwater block allotted to them in NELP-VII.

RIL also has a 30% interest in the producing pre-NELP blocks Panna, Mukta and Tapti (PMT). It also has 5 CBM (coal bed methane) blocks in India, including two, with gas resource of 3.5 tcf. (trillion cubic feet) RIL has also recently formed three US Shale gas JVs. BP will not take an interest in any of these E&P assets of RIL.

Most of the consideration of $7.2 bn that BP will pay RIL is likely to be for the producing KG D6 block. RIL has a 90% stake in KG D6 and 98% average stake in the other 22 blocks.

We are valuing RIL?s 90% stake in KG D6 at $19 bn, including $16.9 bn for discoveries already made and $2.2 bn for exploration upside in the block. Assuming BP is valuing KG D6 on a similar basis, $6.35 bn of its $7.2 bn consideration may be for 30% in KG D6. It may thus be paying $850m for the 30% interest in the other 22 blocks, in which RIL has a 98% stake. Thus, the implied value of the 100% stake in these blocks is $2.85 bn and the implied value of RIL?s 98% stake is $2.8 bn.

Thus, the implied value of RIL?s 90% in KG D6 ($19bn) and 98% in other 22 blocks ($2.8bn) works out to $21.8 bn. If the exploration upside option of $1.8bn, which BP may pay RIL is considered, the implied value of RIL?s stake in these blocks would rise to $27.2bn.

We are valuing RIL?s stake in E&P assets, in which BP is taking a stake, at $25.7 bn. We are also valuing PMT, CBM and US Shale gas at $7.2 bn and RIL?s total E&P assets at $32.9 bn.

Thus, the implied value of RIL?s E&P assets, in which BP is taking a stake, is $22-29 bn. We are valuing RIL?s stake in these assets at $25.7 bn. Thus, our valuation is in the middle of the implied valuation range.

However, RIL?s current share price factors a much lower valuation for RIL?s E&P business in our view. RIL?s share price is closer to our bear case fair value than the base case fair value. The main difference in our base and bear case fair value is the bear case E&P value of Rs 279/share vis-?-vis Rs 508/share in the base case.

Our PO (price objective) of Rs 1,193 ($50.41) is based on a sum-of-the-parts valuation. The value of the refining and petrochemical business, oil and gas reserves and resources, as well as its retail business, is calculated on DCF (discounted cash flow) basis, using a WACC (weighted average cost of capital) of 11.8%. Refining and marketing (Rs 431) is 33% of our PO, E&P valuation (Rs 508) 39%, petrochemicals (Rs 333) 26% and organised retail (Rs 19) 1%.

?Bank of America Merrill Lynch