>RELAINCE INDUSTRIES (FIRST GLOBAL)

Reinitiating Coverage.....

• Economic slowdown and increase in global refining & petroleum capacities to continue pressurising margins…

• D6 gas production to drive earnings over next few years…but interest charges set to rise significantly following commencement of gas production

• Hard to feel overtly bullish about the stock, given its very un-commodity like valuations of 15-17x FY10 Earnings, and EV/EBITDA of 11x

The story......
The global downturn in commodities has severely impacted companies exposed to the commodities sector and Reliance Industries Ltd. (RIL.IN) (RELI.BO) has been no exception. Over the last five years, RIL’s gross refining margin (GRM) witnessed a rising trend and improved from $5 per barrel in FY03 to $15 in FY08. Moreover, the differential between Singapore GRM and RIL’s GRM widened from $2.8 per barrel in FY03 to $7.6 per barrel in Q1 FY09. RIL also benefited from its capabilities to process cheap heavy and sour crude, as a result of the modernization scheme implemented by the company. However, both the petroleum as well as petrochemical cycles peaked in July 2008, following which, the prices of petroleum and petroleum products declined sharply, resulting in severe erosion in the margins of refiners and petrochemical producers. As a result, RIL’s GRM declined to $9.9 per barrel in Q4 FY09, while the difference between Singapore GRM and the company’s GRM narrowed to $4.2 per barrel in the quarter. The recent up-cycle in petrochemicals had lasted for over five years and it will be only prudent to assume that the current downturn will last for at least 2-3 years. We believe that the economic slowdown, coupled with an increase in refining and petroleum capacities across the world, will continue to exert pressure on the margins of refiners for a prolonged period and expect the difference between the benchmark refining margin and RIL’s refining margin to remain at the lower end.

In fact, the going will be much tougher for RIL this time around, as the company had earlier benefited from high import duties (10%) on ethylene polymers and petrochemical products, which have now been reduced to 5%, thus offering very little protection. Moreover, Reliance Petroleum Limited’s (RPL) new refinery has commenced production at a time when the growth in demand for petroleum products is declining globally. Also, there exists a huge threat from Middle East and Chinese companies who have the ability to flood the Indian market with their competitively priced products. We believe that the EBIT margin of RIL’s petrochemical business, which improved from 10.1% in FY02 to 13% in FY09 (and that too on high petrochemical prices), will witness a contraction due to increase in new capacities and demand destruction. The KG D6 gas & oil production will drive the growth in RIL’s revenues and profit over the next few years, particularly in the capital recovery phase, when the profit earned on petroleum will be low. However, there will also be an increase in the company’s finance costs on account of loans taken for its oil exploration business, the interest on which was being capitalized until the start of its commercial production and will now be expensed out. The company’s ongoing litigation with NTPC and RNRL could also act as a dampener and if the court verdict does not come in RIL’s favour, then the valuation of the company’s gas business could take a significant beating. RIL’s other segments, such as Retail and Special Economic Zone (SEZ) development are becoming a drag on the company’s overall performance. On the positive side, RIL’s amalgamation with RPL will result in the unlocking of operational synergies, in the form of cost optimisation and better negotiation abilities for purchasing crude, product placement, freight optimisation, and logistics. Based on our sum of parts valuation, RIL’s value per share works out to Rs.1602, which means that the stock is trading at a 20% premium approximately to its SOTP value. It is hard to justify RIL’s rich valuation, be it on a P/E or EV/EBITDA basis, given the intrinsic commodity nature of its business. We therefore, reinitiate coverage on RIL with a rating of Market Perform with Underperform bias.


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