Completion of ongoing projects, fuel retailing could restore investor confidence
The price is right; upgrade to Buy: We upgrade Reliance Industries Ltd (RIL) to Buy from Add with a revised TP (target price) of R1,040 (+4% from R1,000), as the CMP (current market price) adequately factors (i) erosion of earnings/valuation from its telecom foray and (ii) weaker economics of core-business projects in a lower crude-price environment. In the medium term, the following moves could help create value for shareholders—(i) commissioning of ongoing projects, (ii) foray in fuel retailing, (iii) listing of retail entity, and (iv) strategic divestment in its telecom business.
Recent correction offers Buy opportunity: We see the recent weakness in RIL’s stock price as an opportunity to Buy. We have largely factored in the potential negative impact from telecom business in our SOTP (sum of the parts) valuation by ascribing no equity value to it, assuming incremental equity infusion of $2 bn in addition to $3.5 bn invested until September 2014. We see weak crude prices recovering over the next 12-15 months, as a gradual reduction in non-Opec crude production and rising global demand will help absorb Opec crude supply and provide a balance to global oil markets.
Catalysts to create value in the medium term: We see two catalysts that could help restore investor confidence in RIL’s execution capabilities in its core businesses: (i) successful commissioning of the ongoing projects and (ii) its foray into fuel retailing. Two other measures that could help create value for shareholders in the medium term are: (i) listing the retail entity and (ii) strategic divestment in telecom business. We revise our FY15-17 EPS estimates (standalone) to R69.4 (+1.5%), R74.2 (+1.1%) and R85.6 (-2.1%) to reflect (i) our economics team’s revised exchange rate forecasts, (ii) lower crude price assumptions, and (iii) other minor changes. The stock is inexpensive (or ex-growth) at 10.2x FY16 adjusted standalone EPS (before commissioning of core-business projects) and is already discounting telecom losses to continue in perpetuity, which we believe is unlikely. Our reverse valuation exercise shows that the CMP is ascribing a low 4.8x FY17e EV/Ebitda (enterprise value/ earnings before interest taxes depreciation and amortisation) for the core businesses, factoring in nil equity value from non-core businesses.
Catalysts to allay investor concerns: RIL’s stock (-22%) under-performed the BSE-30 Index (+65%) by 87% in the last five years, after it reentered the telecom business by acquiring pan-India BWA (broadband wireless access) spectrum in June 2010; this, despite (i) reasonable strength in refining and petrochemical margins in the same period and (ii) beginning core-business capex projects in FY14 to address investor concerns about cash utilisation and steady earnings trajectory. A diversification (telecom) from the core businesses and disappointment on KG D-6 gas production led to the stock’s underperformance. We attempt to identify catalysts that could help allay investors’ concerns and create shareholder value in the medium term.
Successful commissioning of core-business projects. Timely completion of RIL’s ahead-of-the-league core-business projects (and steady margins) will help provide the necessary impetus to standalone earnings. RIL is on track to commission its petcoke gasification project, refinery off-gas cracker and downstream petchem expansion units by the end of FY16.
Aggressive foray in fuel retailing. In our view, aggressive participation in the fuel marketing business (given its attractive integration with RIL’s refining business) will gain RIL $5-7/bbl (barrel) of additional margins (refining +marketing) for every barrel of fuel sold in the domestic markets through its own retail network instead of exports. RIL’s petroleum sales to downstream PSU oil companies have been declining over the past few years and this is unlikely to improve given PSUs’ refining capacity expansion plans.There are challenges in expanding the fuel retail network given the dominant presence of PSUs, dealers’ erstwhile bitter experiences, and sharp increase in land prices; however, RIL, with its financial muscle, can provide initial funding and discounts to attract new retailers.
Listing of retail business. Listing its retail business separately will help unlock fair valuation that is otherwise hidden within RIL’s SOTP-based valuation. RIL’s retail business has grown significantly in terms of revenues and the company has become the largest brick-and-mortar retailer in India.
Strategic divestment in telecom business. RIL could create value for its shareholders from a potential M&A in the telecom business, if it enters into a strategic partnership with a global telecom player who is willing to pay a ‘premium’ price to gain a strategic entry into the Indian market.
Buyback and/or cancellation of treasury shares. We believe RIL could consider a buyback at CMP, given manageable leverage at the consolidated level even as a major capex cycle nears completion over the next 12 months. A meaningful buy-back programme will provide comfort to the investors and protect any further downside from continued concerns about its telecom business. If the company considers cancelling treasury shares, it would remove the unnecessary complexity and optically increase RIL’s EPS by 9.9% (3,235 outstanding shares versus 2,943 shares without treasury shares).
Telecom loss may offset standalone earnings growth: The potential loss from its telecom business is difficult to quantify at this stage given sketchy disclosures (on rollout plans) despite a rather significant allocation of capital—if RIL were to improve disclosures, it would help allay investors’ concerns about the telecom business. Our preliminary calculations, assuming country-wide rollout of telecom services, suggest (i) R40 bn Ebitda loss, (ii) R35-45 bn of depreciation and amortisation, and (iii) R20-25 bn interest costs, which can potentially taper consensus earnings growth that is expected from the commissioning of core-business projects in FY17.