Reliance Industries: Buy

Investors with a long-term perspective can consider buying the stock of out-of-favour market behemoth Reliance Industries (RIL). After the recent sharp correction, the stock’s current market price (Rs 761) discounts the company’s trailing twelve-month earnings by a relatively cheap 12 times. This is lower than RIL’s historic valuations (average price-to-earnings of around 18 times) and also lower than the current Sensex multiple of around 19 times.

Notwithstanding the ongoing travails in RIL’s exploration business which have proved a major drag on the stock, a few factors lend support to the company’s long-term prospects. Among these are a vote of confidence by global exploration giant BP in RIL’s faltering exploration business, the company’s solid financial muscle which should see it comfortably negotiate ongoing economic uncertainties, and the company’s ambitious expansion plans which should drive growth.

In market dog-house

Reliance Industries’ over-promise (80 mmscmd) and under-delivery (less than 50 mmscmd) on its KG-D6 gas production has relegated the erstwhile market favourite to the stock market dog-house for a long time now. After the recent 12 per cent fall over the past two weeks, the RIL stock has been a significant under-performer on the bourses declining almost 23 per cent over the past two years, while there was a 12 per cent rise in the Sensex. RIL’s recent run-ins with the government on issues relating to drilling of wells and the CAG’s report castigating the company on alleged over-spending in the KG-D6 block have also not helped, with reports suggesting a go-slow in decision-making in the corridors of power.

That said, the market reaction seems to be excessive. It appears that at present, disenchantment with the stock is so deep that any positive news about the company is being shrugged off. This includes the recent government nod for BP’s acquisition in the company’s oil and gas business, the company’s consistently strong results which reflect the benefits of a hedged business model, and its ongoing big-ticket expansion plans both in existing and new segments.

Cash may be king again

Also, some of the negatives attributed to the company’s poor showing may be overdone. There are apprehensions that RIL may not be able to optimally deploy its huge cash balance (Rs 45,775 crore as of June end), which in turn could depress profitability and return matrices. While there is some merit in this argument given the company’s enviable cash flows, RIL’s problem of plenty may not be such a bad thing after all, in the present economic scenario of high inflation and rising interest rates in India, and increasing global economic uncertainty. With the cost of funds moving up, cash may well revert to its status of king, and favour companies such as Reliance Industries.

The company’s cash chest and comfortable leverage position (net gearing of 11.4 per cent) should enable it to easily pursue its ambitious expansion plans, and avail funding on favourable terms. While, given the long gestation nature of most of the company’s projects, return matrices may not be inspiring in the short-term, a patient long-term investor could expect to reap good benefits. Meanwhile, on the back of a healthy cash position and buoyant interest rates, the company should continue to benefit from its savvy treasury operations, which saw ‘other income’ grow by 49 per cent to Rs 1,078 crore and contribute strongly to the latest June quarter profits.

Gas flows – when, not if

On the gas front, while RIL has indicated that it would take at least 2 - 3 years to increase production, it has expressed confidence that the collaboration with BP, a global oil behemoth with expertise in deep-water drilling, should result in good tidings. There seems to be substance in this argument. For, it seems somewhat inconceivable that a company such as BP would commit top dollar ($7.2 billion) for a 30 per cent stake in RIL’s oil and gas business, if it did not see potential for handsome returns over a reasonable time-frame. With the deal being approved by the government, RIL’s already healthy cash coffer is set to further increase.

Also, at present, while liquefied natural gas is being imported into the country at spot rates of around $10 - $12 per mmbtu, the gas produced domestically in RIL’s KG-D6 fields is priced at $4.2 per mmbtu. The company has been indicating that the current price is not viable for developing smaller fields. This price will be due for revision in 2014. While the present dip in production is attributed by the company to technical reasons , it is likely that an increased price may provide an added incentive to the company to ramp-up its production by then.

Hedged business model

Notwithstanding the declining fortunes of its oil and gas segment in the recent quarters, RIL’s sales and profits has been improving on a sequential basis, thanks to a business model which seems hedged to a good extent. Stanadlone net sales and profits in the June 2011 quarter stood at an all-time high of Rs 81,018 crore and Rs 5,661 crore respectively, driven a strong show in the refining and petrochemicals segments. Nevertheless, with the contribution from the high-margin oil and gas segment on the wane, overall margins which have been declining may continue to be under pressure.

The increasing differentials in the market between light and heavy grades of crude oil and the company’s high-complexity refineries which process cheaper, heavier crude helped it make the most of a strong refining environment and, enabled RIL post a robust gross refining margin of $10.3 per barrel in the latest June quarter. With the refining environment continuing to be strong, the company is expected to do well in this segment. Likewise, the petrochemicals segment which has been putting up a good show, thanks to favourable industry dynamics, is expected to do well in the coming quarters too. RIL has embarked on an expansion drive across its polyester chain, which should strengthen its global leadership position as an integrated polyester producer.

Pending the ongoing global economic uncertainties, a decline in the price of crude oil, even if it leads to a dip in the company’s Gross Refining Margins(GRMs), should aid the petrochemicals segment.

RIL’s foray into shale gas in the US has started yielding dividends with the joint ventures with Chevron and Pioneer under production, and the Carrizo JV expected to commence production later this calendar. As and when shale gas exploration commences in India, RIL by virtue of the technical expertise gained, may have a headstart.

The company has also entered into partnerships and is in the process of big-ticket roll outs in capital intensive businesses such as insurance, financial services and telecom. These ventures, however, may take some time to become profit-accretive.

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