Sell Reliance Industries Ltd.

Target price Rs815.00
CM Price Rs982.00

Tempering E&P expectations
We reduce our expectations on volumes and profitability of KG-D6 oil/gas and, thus, marginally lower our net profit estimates for RIL despite some upside to its refining and petrochemical margins. Net debt has also remained well above our estimates despite lower capex. We maintain Sell, with a Rs815 target price.

KG-D6’s lower profitability leads to earnings cut We have reduced our KG-D6 gas volume assumptions over FY10-11 by 10%, and our oil volume assumptions by a sharper 30-50%. We expected full cost accounting in E&P to lead to higher depletion rates, but the actual rates have been even higher than we estimated. The effective interest rate in 3QFY10 was just 3.7%, which we expect to rise to 6.3% by FY12 as global interest rates normalize. Given RIL’s rising net debt, its recent sale of treasury stocks seems a logical move to reduce gearing, even without considering any potential acquisitions.

Overall, we have reduced our FY10-12 EPS estimates by 2-7%. Caution on margin cycles Singapore Complex gross refining margins (GRMs) have strengthened in 4QFY10 to date, to US$5/bbl, from US$1.92/bbl in 3QFY10, and most of the upside has been driven by petrol.

We maintain that the current uptick is unsustainable, given the low levels of global capacity utilization. Petrochemical margins have also been stronger than we anticipated, but we expect them to weaken post 1QFY11 as new capacity comes online. We maintain Sell, with a target price of Rs815

We maintain our Sell rating on RIL with a sum-of-the-parts target price of Rs815 (up from Rs812.50). Our FY11-12 EPS estimates are 20% below Bloomberg consensus, and we see a drop in refining and petrochemical margins as the key trigger to achieve our target price.

Positive exploration news may provide upside, but our valuation already factors in significant exploration upside.

Tempering E&P expectations
RIL’s stock underperformance over the last 12 months (-12% vs the Sensex) reflects the disappointment over its E&P profitability and rising net debt. The stock price now seems to assume the current refining and petrochemical margins are sustainable (we see downside). KG-D6’s lower profitability leads to earnings cut

Slower ramp-up of KG-D6 volumes
We had earlier assumed that the KG-D6 block would achieve peak production of 89mmscmd of gas and 40kbd of oil from 1 April 2010.

We now cut our estimates on both counts.
In the case of oil, production during 9MFY10 averaged 8-10kbd and RIL is providing no guidance on how soon this would be ramped up to peak capacity (and also what the peak capacity level would be). Production in 3QFY10 was from three producing wells, while an additional two are due to come online by end-February 2010. RIL’s partner in the block, Niko Resources, has reduced its peak oil production guidance from 40kbd to 35kbd.

Consequently, we lower our peak oil production estimate from 40kbd to 35kbd and expect this to be achieved only from FY12. We reduce our FY10 and FY11 estimates, from 14kbd to 10kbd and from 40kbd to 20kbd, respectively.

In relation to gas, RIL achieved a production of 46mmscmd in 3QFY10 and is currently producing at the rate of 60mmscmd. The Indian government (GOI) has allocated gas to customers to the extent of 60mmcmd on a firm basis with additional fallback allocation of 30mmscmd. Following this allocation, RIL has current gas sales contracts for 61mmscmd. RIL now believes that additional gas demand is mainly along GAIL’s HVJ pipeline, where there is a capacity constraint. All customers who have pipeline connections with RIL gas (other than those on HVJ) are drawing their maximum quantity. In fact, RIL’s own plants are consuming 9mmscmd as against a GOI allocation of 4mmscmd. So, peak production capacity is unlikely to be achieved until the HVJ pipeline is fully expanded (which GAIL has estimated by October 2010).

We now assume that 4QFY10 production will average 65mmscmd, resulting in an FY10 average of 41mmscmd (earlier estimate: 45mmscmd). We reduce our FY11 estimate from 89mmscmd to 80mmscmd, while maintaining our FY12 estimate at 89mmscmd.

Higher depletion rates depressing bottom-line numbers
RIL follows the full-cost method of accounting, under which all costs incurred in E&P (including the cost of seismic surveys and dry wells) are capitalised, considering the country as a cost centre. These are then charged to the P&L via a depletion charge (included in depreciation costs), which is based on the ratio of oil/gas production to total proved reserves at beginning of the year. Other larger E&P players like ONGC/OIL/Cairn follow the successful-efforts method under which the cost of seismic surveys and dry wells is charged to the P&L in the year when they are incurred (or when the results of well drilling are known). The full-cost method has allowed RIL to capitalise the cost of all its E&P spending. Since the KGD6 reserves had been added to total proved reserves category, but were not producing, the depletion charge till FY09 was relatively low.

With the commencement of production from KG-D6, the depletion charge will now rise sharply. So what is now getting included in the depletion charge is not just the cost of developing the entire KG-D6 block, but also the spending on other E&P blocks in the country.

The impact in simplistic terms can be gauged by looking at the production to reserve numbers (see table below). Historical numbers show that RIL’s oil/gas production to opening proved reserve ratio was in the 1-1.2% range in the last five years. Based on our estimates of production, this ratio will rise to 7% in FY10 and 13.6% in FY11, causing a sharp rise in depletion rates as production increases.

The depletion rate in 9MFY10 appears to be in line with the 7% rate projected for FY10. For FY11, we have assumed a lower rate of 9% (compared to the 13.6% indicated above), by assuming additions to proved reserves by end-FY10. So, while in the petrochemical and refining business the depreciation charge kicks in upfront as the plant starts commercial operations (providing operational gearing as capacity utilisation increases), in RIL’s E&P business, the absolute depletion charge will keep moving up in line with the rise in production.

The financial impact of the depletion rates has been evident in quarterly results, as rising depreciation charges have reduced the EBIT contribution of the E&P segment. 3QFY10 depreciation charge of Rs27.95bn would call for an annual figure of Rs112bn, assuming gas production at the 3QFY10 level of 46mmscmd. With production forecast to rise, depreciation charges will also rise in tandem, unless there is a substantial addition to the proved reserves number. We have accordingly raised our total depreciation estimates by 7-10%.

Even after considering the enhanced depletion rate, the lifting costs for the KG-D6 block appear unusually high. RIL’s management has not disclosed specific lifting cost numbers and we assume these costs will fall in FY11 and beyond, as plateau production numbers are achieved.

Rising net debt despite commissioning of projects
As shown in the above table, net debt has been rising in the last three quarters, from Rs488bn as on 31 March 2009 to Rs540bn as on 31 December 2009. This rise is despite commissioning of all major projects (RPET refinery, KG-D6 gas production), sale of treasury shares of Rs31.9bn and after positive adjustment of forex gains of Rs37bn.

In the current quarter, RIL has sold additional treasury shares raising Rs61bn, and there is market expectation that this fund-raising is in view of possible acquisition opportunities around the globe (note that RIL has officially made a non-binding bid for LyondellBasell). However, given the point of rising net debt, we believe that sale of treasury shares is a logical move to reduce gearing, even without considering potential acquisitions.

Based on RIL’s press release, capex in 3QFY10 would work out to just Rs0.26bn (based on capex for 9M less 1H). RIL has clarified that till FY09 the capex numbers disclosed reflected actual cash spending on fixed assets. From FY10 onwards, the capex figures will be based on the balance sheet figures and would include adjustments for interest capitalisation and forex gains/losses. Note that RIL follows Indian GAAP, which allows forex differences on loans taken for purchase of fixed assets to be adjusted against the cost of the asset. We have obtained full details from management on quarterly numbers. During 9MFY10, the cash spending on assets was Rs107.7bn. The disclosed capex figure was Rs78.6bn, which was the balance sheet figure after adjusting for interest capitalised of Rs8.6bn and forex gain of Rs37.7bn. In addition to this asset spending, RIL has paid Rs53.75bn to creditors for capex, reducing their balance from Rs167.9bn at end-FY09 to Rs114bn at end-December 2009. These creditors (who are not part of the normal working capital cycle creditors) would need to be paid over the next few quarters, reducing the ability to cut net debt levels sharply.

The cash spending on assets has been below our estimates, but appears logical given the slower ramp-up of KG-D6 gas production.

Management estimates total KG-D6 gas capex for D1/D3 fields at US$8.9bn, out of which first phase to reach 80mmscmd was estimated at US$5.2bn and another US$3.7bn was estimated in phase 2 to maintain plateau levels. Given the delayed rampup, we now estimate phase 2 capex will start only from FY11 (FY10 assumed earlier).

Using the above figures on cash spending, we have attempted a cash flow reconciliation. The cash flow from operations works out to Rs186.7bn for 9MFY10. After considering cash outflow on creditors and fixed assets and sale of treasury shares (no dividend was payable during 9MFY10), net debt before working capital should have reduced by Rs57bn. Since actual net debt has risen by Rs52bn over this period, we estimate that working capital would have increased Rs109bn. Our estimate of working capital as at end-FY09 is Rs57bn (note that this excludes creditors for capex and the loans given to subsidiaries, which we classify as investments).

Interest rates expected to rise
We estimate that, after considering the figures on interest capitalised, the average interest cost on RIL debt has shrunk dramatically from over 10% in 3QFY09 to just 3.7% in 3QFY10. This is partly in line with the reduction in Libor, as nearly 80% of RIL’s debt is in foreign currency. Going forward, we expect a partial reversion to mean as interest rates move up. We forecast the average interest cost will go up to 6.3% in FY12, from 4.2% in FY10F. This would result in a sharp 50% rise in interest costs, as the interest capitalised figures would also come down substantially.
EPS estimates cut by 2-7% The decline in E&P profitability arising from lower oil/gas volumes and the higher depletion rate has more than offset the upside from the delayed downtrend in petrochemical margins that we were anticipating. Our earnings assumptions at the EBITDA level have hardly changed over FY10-12.

Note that we calculate our EPS and target price based on net shares outstanding (excluding treasury stock). Hence, we have increased our shares outstanding to consider the three tranches of the treasury stock sale. Bloomberg consensus EPS estimates, on the other hand, are based on gross shares outstanding, so we adjust our EPS numbers for gross shares when comparing with consensus estimates.

Caution on margin cycles

Recent GRM uptick not sustainable
Regional GRMs have improved substantially in the current quarter, after a sharp dip in 3QFY10. While we were expecting some bounce on a qoq basis, most of the upside has come from gasoline where margins have been very strong. Improvements in middle distillate (diesel/jet fuel) margins and in crude differentials have not been very significant (see table below). We believe margins will weaken going forward, and remain at around US$4/bbl (Singapore Complex) over the next four quarters, given continued overcapacity in the industry.

There has been a significant divergence in oil demand trends. The International Energy Agency (IEA) estimates that, over CY08-09, oil demand fell 3.7m b/d in OECD countries whereas it grew 2.12m b/d in non-OECD countries, with India and China recording robust growth rates. Demand appears to have peaked in OECD, and hence refineries are facing structural over-capacity and several closures have already been announced. However, the IEA estimates that OECD refinery utilisation rates averaged 77.6% in November 2009. Hence, we believe refinery closures need to be far more significant to cause any sustainable uptick in GRMs.

In non-OECD countries, there have been no refinery closures; in fact, bulk of capacity growth is concentrated here. We estimate that over CY09-11, India and China alone will add nearly 2.3m b/d of new refining capacity.

We expect RIL’s GRMs to improve, averaging US$7.2/bbl in FY11F and US$8.7/bbl in FY12F, compared to US$6.7/bbl in FY10F. Consensus expectations are much higher, at around US$9/bbl in FY11 already. We believe that for these higher margins to be achieved there have to be further improvements in middle distillate margins and crude differentials.

We maintain Sell, target price Rs815
We have marginally adjusted our target price from Rs812.50 to Rs815. Note that this valuation is for end-FY11 and hence considers net debt as on that date. We continue to value the refining, petrochemical and the old oil businesses at 7x FY12F EV/EBITDA. As explained earlier, we assume that KG-D6’s phase II capex has been pushed back by a year, which reduces the valuation of the block slightly (since it is based on the net present value as on end-FY11F).

Report card

Attribute	Value	Date
PE ratio	9.85	22/02/10
EPS (Rs)	99.35	Mar, 09
Sales (Rs crore)	56,856.00	Dec, 09
Face Value (Rs)	10
Net profit margin (%)	10.65	Mar, 09
Last bonus	1:1	07/10/09
Last dividend (%)	130	07/10/09
Return on average equity	13.36	Mar, 09

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