Reliance Industries stock rated Underpeform by Jefferies, says 2017 surge makes it unfavourable

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Published: December 18, 2017 1:39:04 AM

Reliance's EBITDA may double to $20 bn by FY22/23e but at $123 bn in EV, much of that appears baked in.

Reliance, EBITDAReliance’s EBITDA may double to bn by FY22/23e but at 3 bn in EV, much of that appears baked in.

Reliance’s EBITDA may double to $20 bn by FY22/23e but at $123 bn in EV, much of that appears baked in. Indeed, even with rising EPS, return ratios stay modest while FCF may lag expectations as working capital normalises. Earnings may falter too; the IGCC (integrated gasification combined cycle) is yet to start, downstream margins may soften and the telecom ramp-up may not be as smooth as what the $46 bn already priced in as telecom EV presumes. We assume at Underperform with a bottom-of-street Rs 790 PT.

Expectations: Reliance’s share price started to do well into modest expectations in 2015 but sentiment has swung dramatically in 2017. Street forecasts for telecom only vary in their degree of optimism while the financial outcomes from the energy projects is rarely disputed.

Belief: We do not disagree with the core premise. The new projects may lift energy Ebitda to $10 bn by FY20e with telecom/retail boosting consolidated Ebitda to $20 bn by FY22/23E.

EV: The 71% share price rise in 2017 has lifted EV to $123 bn already, though, baking this optimism in. Refining/petchems rarely trade over 6-7x EV/Ebitda; neither do mature telcos.

Hurdle: In fact, the share price already presumes $46 bn in telecom EV that would need to rise to ~$75 bn in three years if Reliance’s shares have to compound at 15% in this period.

Telecom: In turn, this may require  $12 bn in telecom Ebitda — 50% more than our top-of-consensus $8 bn in FY22E. ARPU would need to more than just double as we assume (`228) or subs rise more than the 2.5x rise we model (310 m) or margins settle higher (63%).

Patience: It is not impossible; there are monetisation options in addition to mobile but that ramp-up itself may be bumpy testing investor patience. Raising the sub base and ARPU together may be a challenge. Tariffs rose in Oct, e.g., but were soon diluted with incentives.

FCF: Patience may be tested on FCF too which may lag Street estimates. Telecom capex will remain high, E&P capex will pick up, vendor and spectrum dues need to be cleared while core working capital which helped cashflow by $10 bn in FY13-17  may normalise.

EPS: Earnings may falter too. Refining/olefin margins may soften; the IGCC may take longer to stabilise, as could telecom. Valuations are complacent at 12.7x FY18E EV/Ebitda.

We assume at Underperform. Our Rs 790 price target builds a 15% discount to SOTP (energy: 7.7x EV/E, telecom/retail: $50 bn) to reflect capital allocation uncertainties that accompany periods of pot’l FCF for Reliance. Upside risks: higher refining margin; telecom revenue.

Executive Summary

We were constructive on Reliance when we felt that investors underappreciated its energy projects and dismissed telecom out of hand. The stock did well in 2015-16, therefore, into modest expectations but the 71% rise in 2017 (Sensex: +22%) has turned that on its head. Our core premise remains —the new projects may lift energy Ebitda by 50% and Jio is a transformational idea but at $123bn EV for ~$20 bn in consol. Ebitda in FY22/23e, risk/reward is unfavourable. Indeed, we believe ROE will only modestly rise and ROCE will still be in single digits in the next five years with headline net debt trending higher as FCF lags expectations unless the generous core working capital terms that helped cash flow by $10 bn in FY13-17 persist. We assume at Underperform (from Hold) with SOTP-based Rs 790 12M PT that values telecom/retail at $50 bn EV and energy at 7.7x Ebitda.

A surge in 2017 has left EV at an all-time high of $123 bn: For seven years since the GFC, Reliance underperformed the broader Indian markets as softer margins weighed on earnings and capex rose as it started to spend on its new energy projects while also taking a large risky bet on telecom. By late 2014, though, when the start-up of the energy projects was imminent and the telecom strategy was better crystallised, risk/reward had turned favourable. Reliance started to do well into such modest expectations, therefore, outperforming the market in 2015 (by 19ppt) and 2016 (by 5ppt). In 2017, though, its share price has risen 71% outperforming the indices by 49ppt. EV, adjusted (down) for its 6.5% treasury shares and (up) for its $18 bn in vendor and spectrum liabilities, has risen $40 bn in 2017 to near all-time highs of $123 bn. The markets clearly expect a surge in earnings.

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