Stock Recommendation:: Reliance Industries

RIL stock price has corrected by over 22% from its peak resulting in drop in expectation value. With atleast 9 discoveries under appraisal (two more discoveries over the last three weeks), highly competitive off-gas based petrochem complex on the anvil, we believe, risk-reward has turned favourable and presents a well diversified growth opportunity. We are upgrading the stock from Neutral to Outperform, with a base case target price of Rs3025/share, an upside of ~19% from current levels. RIL is now our top pick in the oil and gas / Petrochem space.

Key arguments:

1. Potential risk to refining margin is overstated. Margins remain robust.

We maintain that refining margins are headed down. However, we believe, the risk to refining margins is being overdone. Refining margins remain robust, with March month Singapore complex averaging US$8.5/bbl (our long term Singapore GRM average is USD 6/bbl and USD12.75/bbl for RIL). Though, this is seasonal (peaking in the month of May) and is not sustainable, we believe, a crash to below US$5/bbl on a sustained basis is highly unlikely. While weak global economic growth and its impact on OECD oil demand remains a concern, with a relatively weak demand elasticity and support from developing countries, global demand, is reasonably well placed. A relatively weak supply pipeline and upgradation to higher fuel norms across major consuming countries are set to provide downside support. Squeezed EPC resource base and escalating capex costs are delaying refinery commissioning over the next three years, especially in the Middle-East. While, scheduled capacity commissioning correspond to steady demand growth, we believe, slippages by few months, which are very common, would push it down further, keeping demand-supply fairly balanced, even if demand were to be impacted to global GDP growth.

In the case of RIL, gasification of coke and value addition to refinery off-gases (scheduled for FY11-12) along with ability to produce Euro IV & V fuels, are set to support the margins. We believe, RIL’s refining business deserves a valuation premium to global multiples on account this.

2. E&P related positive newsflow to be the key driver of stock performance

Appraisal of significant discoveries in Cauvery, KG and Mahanadi basins in India along with Yemen discoveries are likely to provide a steady flow of positive news, driving stock performance. Pronouncements by Niko and Hardy oil, minority stake holders in some of these blocks indicate very large reserve potential in the discoveries, comparable to KG-D6. GCA’s (Gaffney, Cline & Associates) report (Competent Person’s report) to Hardy oil indicate potential reserves running into several TCF in D9, while D3 is supposed to be more favourably sited with respect to existing discoveries in KG basin. Pronouncements by Niko too indicate large potential in D4. Atleast nine discoveries are under appraisal in KG-D6, Cauvery, KG D5 etc are likely to add to SOTP value. Further, a large CBM resource base and a mix of highly prospective acreage in prolific basins provide a good base for future upsides from E&P. With scheduled arrival of new rigs for deepsea drilling over the next 12-18 months, new discoveries are likely We have valued the reserves based on P/CF multiple, across three scenarios, base-bull-bear cases.

3. a. Petrochem – polyester could surprise

Petrochem downcycle from 1QCY09 is already in the price as it is the consensus view. No major suprises are likely, as we have already built in decline in margin in all through FY09. We believe, polyester margin recovery would cushion the impact of ethylene-propylene cycle downtrend over the next couple of years and could surprise the market. Buoyant cotton prices further provides scope for polyester price upside. Polyester delta over PTA and MEG is close to its cash cost and could only improve from here.

b. Gas based facilities – superior profitability, deserves valuation premium

With IPCL in its fold, RIL is best placed to leverage high petrochem product prices (primarily a function of high crude prices, though higher margins too contributed). Domestic gas prices have not risen much, leading to vastly superior margins for gas based petrochem producers in the country compared to naphtha based producers globally. Gas based cracker margins are about 30-50% higher than naphtha based ones. With crude prices unlikely to fall below US$60/bbl and gas prices unlikely to move up sharply, we believe, Indian gas based crackers would remain more profitable than naphtha based ones for some time to come. Hence, we believe, they have to be valued at a premium. Domestic C2 prices continue to be linked to natural gas prices, though C3 is linked to international propane price. Some debottlenecking is in the pipeline in IPCL’s gas cracker as well as PVC, which is set to add to value.

c. Off-gas based petrochem plant – vastly superior economics

Off-gas based petrochem plant (scheduled for FY11-12 commissioning) offers vastly superior economics vis-à-vis naphtha as well as domestic gas. The relative feedstock cost advantage is ~0.4x vis-à-vis 0.6x for gas based plant, with 1x being the benchmark based on naphtha based plant. These numbers correspond to a crude price range of about US$70-80/bbl and hence would be even more favourable at current crude prices. We believe this plant too would be also command valuation premium over global averages.

4. Large cashflow – set to fuel growth

With very large cashflows ranging between Rs250-300b from FY10 (not adjusted for capex in the pipeline), we believe, growth is likely to be accelerated. (RIL has traditionally been growth focused and has generated superior return ratios) Potential investment in a new refinery at Jamnagar, most likely under RPL could be a large value creator for RIL on account of the favourable tax benefits under the first RPL refinery. Investment opportunities in E&P, SEZ, City gas projects along with overseas inorganic growth opportunities exist. New investment avenues like semiconductor are opening up and appear highly attractive, especially with the Government providing favourable terms.

5. Robust earnings growth – E&P and RPL key contributors

We forecast standalone net profit growth of 15.4% (excluding RPL stake sale) and 24.6% over the next two years, on the back of gas business earnings, even as petrochem and refining earnings decline. Consolidated profit growth is expected to be stronger at 31% and 36% yoy respectively, driven by RPL refinery commissioning. 4QFY08 is likely to be another strong quarter, with 23.6% yoy growth in net profits, driven by a record high refining margin, thanks to record high diesel spread over crude. Our base case target price implies a P/E of 17.4x FY10E.