The company should generate strong FCF over the next five years, averaging $5 bn (~11% yield) in current weak oil prices. 2016 execution in both downstream and telcos is likely to fuel a 50% profit leap by F18e
Reliance Industries is set to generate strong free cash flow (FCF) after almost a decade as its capex cycle is nearing an end; earnings delivery should start from downstream expansion. In the last 16 years it has outperformed during periods of positive FCF generation and vice-versa. Its average FCF yield of 11% stands out compared to global peers. We are raising F17/18e EPS by ~3%/8% to reflect higher GRMs (gross refining margins), and our price target goes to Rs 1,329, implying 37% upside. Downstream projects will increase RIL’s refinery edge as it saves on energy costs by replacing LNG with petcoke. Off-gas cracker will change its feedstock mix to gas at 67%, up from 40%. Hence it would be a key gainer if oil prices move up. We expect these projects to add ~$2.5 bn in Ebitda by F18, leading to lumpy 65% growth in standalone earnings and ~50% on a consolidated basis assuming telecom losses.
Chalking out a potential roadmap for doubling of market cap to $100 bn—turnaround of telecom losses and a rebound in oil prices (to $60/bbl) are the keys: RIL’s F16e capital employed in telecoms (~$18.6 bn) is currently a drag, being ROCE-dilutive. However, RIL has taken steps to improve its network by focusing on: (i) high-quality pan-India 800MHz spectrum; (ii) highest fibre coverage (250K rKms) amongst operators; and (iii) infra sharing tie-ups with RCOM, which should yield lower network costs . Based on our F20 estimates of ~$7 bn of revenues and 132m subscribers, we project Ebitda of $2.9 bn. This could lead investors to value telco at 1x EV/IC vs. the current zero implied at CMP. Further, if oil prices were to increase to $60bbl, it could add another $1 bn of Ebitda, or about 14% to earnings.
Key risks to our thesis include: (i) reduction in global product demand; (ii) longer gestation of telecom business; (iii) with additional FCF generation and key projects behind and low dividend payout, investors are already looking to hear from RIL on its plans to utilise its FCF.
We are getting more bullish on RIL: The stock has outperformed the Sensex by >35% in the last 12 months, largely driven by higher GRMs. We believe this is just the start—RIL is nearing the completion of its largest ever capex programme of ~$46 bn over F14-17e, paving the way for a multi-year cycle of strong FCF generation averaging $5 bn, implying >11% FCF yield. This is one of the highest amongst large cap global oil & gas peers under Morgan Stanley coverage. This robust FCF is underpinned by strong core refining and petchem businesses, which is further aided by downstream expansion, helping RIL’s earnings to grow >50% by F18e, even in the current low oil price environment. Our analysis of the stock price history over the last 15 years suggests that RIL has outperformed once it starts generating FCF after its capex mode; a similar cycle is now likely to play out, in our view.
We chalk out a potential roadmap for the stock to double to reach market cap of $100 bn
Telecom (Jio) turnaround is the key: Jio has ingredients which can make its telecom venture profitable. Its spectrum portfolio and fibre reach is formidable compared to existing incumbents. Its infra sharing deals with RCOM, coupled with lower network costs, can help it deliver better margins of >40%. In addition, LTE is a superior technology and its consumer adoption could be much faster as both availability and affordability of 4G handset/ device is improving rapidly. This is key to watch for, as India is at an inflection point of growth in data usage and RIL with a pan-India sub 1GHz spectrum for 4G coverage is better placed than incumbents to take advantage of that.
Increase in oil prices to ~$60/bbl: RIL will benefit from its exposure to oil through downstream expansion projects. After the commissioning of projects, its profitability would also be linked to crude oil prices, with every $10/bbl change leading to ~8% change in EPS.
Strong FCF generation starting F17e to propel RIL’s stock price:
RIL is almost at the end of its largest ever capex cycle—$46 bn over F14-17e, a large part of which has gone into downstream expansion and its new venture in telecom (Jio), which is nearing its launch. Due to this, RIL’s FCF was negative for past four years and its ROCE fell below its cost of capital. This led to RIL underperforming the market by >65% in the last five years.
RIL is now geared up for recovery in its cash generation as well as ROCE, in our view: We are more bullish on RIL’s core refining and petchem business where margin trends continue to remain robust as supply growth is slowing down compared to demand, which continues to remain strong. RIL will also benefit from the start of earnings delivery from downstream which we expect will add ~$2.5 bn in Ebitda by F18e even assuming oil prices were to remain low at $41/bbl.
Strong core business of Refining and Petchem coupled with start of earnings delivery from downstream expansion drives our confidence for FCF to remain strong
In the weak oil environment currently, RIL is gaining from strong elasticity to product demand and hence higher GRMs. In the event of an oil price rebound, it will benefit from its exposure to oil through downstream expansion projects. After the commissioning of projects, its profitability would also be linked to crude oil prices with every $10/bbl change leading to ~8% change in EPS.
Why do we think core GRMs will remain strong? Overall we see a strong 2016 for Asian refiners as capacity additions slow down and demand growth remains healthy, supporting GRMs. Widening crude discounts should further help Asian refiners.
(i) The existing Jamnagar refining and petchem complex is one of the best assets to maximise downstream margins in the current oil price environment: RIL’s Jamnagar refining complex is far superior to its peers in terms of scale, design, flexibility, level of automation and degree of integration, in our view. It is also differentiated from other global refineries in terms of its ability to take advantage of the light/heavy crude price differential and alter the product slate/adapt to changing market dynamics.
Consistently superior GRMs compared to its peers: RIL has consistently achieved superior GRMs versus Singapore complex margins, owing to higher complexity and efficient crude processing. RIL’s refinery configuration is also characterised by superior product slate versus other refineries. We forecast RIL’s core GRMs to average ~10.9/bbl in F16 and expect similar margins of $10.75/bbl in F17e and $10.25/bbl in F18e.
(ii) Downstream expansion will further improve margins by enabling RIL to: (i) lower its energy costs by replacing LNG with low value petcoke; and (ii) improve its feedstock cost competitiveness and hence improve the long-term returns for its petrochemical business.
RIL is executing four key downstream projects in its core Refining and Petchem business with estimated capex of ~$17 bn
(i) Petcoke gasification plant at its refinery—to lower its energy costs and improve GRMs.
(ii) Refinery off-gas cracker in Petrochemicals—to lower its feedstock costs by increasing exposure to gas vs. Naphta.
(iii) Polyester/aromatics capacity expansion—to benefit from demand growth in India.
(iv) Import of ethane from US—to give feedstock security. We estimate these projects will add ~$2.5 bn in incremental Ebitda in the first full year of operations even in a low $41/bbl oil price environment–implying project ROCE of 10%. Our stress test suggests that at a $30/bbl oil price, incremental Ebitda could be ~$2 bn, implying project ROCE of 7%. In a higher oil price environment, we estimate that Ebitda could be as high as $4.3 bn. RIL has already spent >$15 bn (85%) on these projects and as the first gasifier based on our discussion with management, we expect commissioning of these projects during CY C1Q16.
— Morgan Stanley