Wednesday, November 23, 2011

>Recent correction offers opportunity to accumulate RIL stock

Weak Rupee versus weak cycles. We believe RIL stock offers a favorable reward-risk
balance post the 10% correction in its stock price in the past three weeks. The softness
likely reflects the market’s concerns about recent weakness in refining margins but
ignores the steep correction in the Rupee over the same period, which should partially
offset weaker margins. We have made a few changes to our earnings model but retain
our 12-month SOTP-based fair valuation of `1,000. We upgrade RIL stock to a BUY
rating from ADD noting 27% upside to our target price.

Recent correction offers opportunity to accumulate RIL stock
We see a favorable investment reward-risk balance at current levels. RIL stock has corrected by
10% in the past three weeks reflecting the market’s concerns on (1) sharp decline in global
refining margins (see Exhibit 1), (2) likely subdued chemical margins given a weak global macroenvironment and (3) continued decline in KG D-6 gas production. RIL stock is currently trading at 10.3X FY2012E EPS and 9.7X FY2013E EPS (adjusted for treasury shares).

Refining margins tumble led by contraction in gasoline cracks
Singapore margins have plunged in the recent weeks, led by sharp contraction in gasoline/naphtha cracks. We compute Singapore complex gross refining margins at -US$2.5/bbl in the latest week versus US$3.5/bbl in October 2011. We would not be unduly concerned about weekly movement in refining margins and expect a rebound from current very low levels. However, we maintain our subdued view on the refining cycle for the next 12 months due to (1) demand weakness and (2) refining capacity additions in CY2012E. We model RIL’s refining margins for FY2012-14E at US$9.8/bbl, US$10.1/bbl and US$10.4/bbl; US$10.2/bbl in 1HFY12. Exhibit 2 gives the sensitivity of RIL’s earnings to key variables—exchange rate assumption, refining margins and chemical prices.

Production from KG D-6 continues to decline; factored in our earnings estimates
We take cognizance of the continued disappointment in the gas production from RIL’s KG
D- block, which has declined to 41.7 mcm/d for the week ended October 30, 2011. (1) The
steady decline from the block and (2) lack of progress on other E&P blocks has resulted in
sharp contraction in the value being ascribed to RIL’s E&P business. Our reverse valuation
exercise reflects that the market is not ascribing any meaningful value to RIL’s prospective
E&P blocks.