Reliance Industries Ltd, or RIL, recently declared its quarterly earnings. Our analyst Piyush Jain comments.
1) Quarterly results
The September quarter's net profit of Rs 59.7 billion was slightly below our analyst’s expectations due to other income falling Rs 2 billion short of his estimates. Though quarterly net profit was up 1.7% versus the same quarter last year, the result was largely immaterial.
Strong ethylene spreads kept petrochemical margins stable at 8.9% versus 8.8% last year, while higher fuel oil spread and wider crude oil differentials helped in refining margin expansion to 3.7% from 2.9% versus last year. Our long-term assumptions of 4.5% refining operating margins and 9% petrochemical margins are tied to our view of limited upside to margins, as Asian petrochemical and refining industry will remain well supplied over our 5-year forecast period.
The ongoing gasification and cracker projects are going to help Reliance sustain margins midst increasing industry competition.
RIL continues to deploy cash in large new businesses. We're looking at RIL entering defence manufacturing, with a greater excitement compared to the highly competitive telecom business where we are cautious on network deployment, extent of subsidies on instruments and price disruption as that will determine the returns on $11 billion investment in 4G telecom.
2) Fair Value Estimate
At the current price of Rs 961, our analyst believes that RIL's shares are fairly valued and his FV estimate stays at Rs 950 per share.
3) Risk
Even though RIL is integrated across the energy value chain, the company derives more than 70% of its revenue and 55% of its operating margin from the refining and petrochemicals businesses. Our valuation is highly dependent on our refining margin and crude oil assumptions, because crude oil forms the primary feedstock for refining operations. A significant improvement or deterioration in crack spreads could result in significant upside or downside to our valuation. Rapidly rising oil prices can crush margins.
RIL's petrochemical operations are exposed to feedstock price and availability volatility. Additionally, inability to meet shifting demand for various petrochemical products could crimp returns. In exploration and production, RIL's difficulty in replacing used/depleted reserves in time could lead to reduced profitability. Low oil and gas prices could hurt cash flows and have a negative impact on margins. Prolonged periods of low energy prices would weaken returns on capital and hurt the economics of new oil and gas projects.
Owing to high competitive nature of the Indian telecom and retail sector, Reliance could end up overspending on the spectrum and infrastructure, thereby end up deriving lower returns on invested capital. Also, we recognise regulatory and political risks as government-imposed duties and regulations have a direct impact on the business. RIL is engaged in arbitration with the government over allegations of gas hoarding. The company faces a potential loss of about $1.2 billion.
More than three fourths of revenue is dollar-denominated, which exposes the company to the local currency appreciation risk.
4) Economic Moat
Our analyst is of the opinion that RIL lacks an economic moat.
The company derives more than 70% of its operating revenue and about 50% of its operating profit from its refining and marketing segment, the lowest-margin business in its entire portfolio.
RIL's gross refining margins, or GRMs, have outperformed the Singapore benchmark GRMs by an average of $3 per barrel for the past seven years. The GRM is one of Asia's best due to its low operating costs and highly complex refining ability. However, this capability comes at the cost of greater capital intensity. The superior refiner margin has not resulted in excess returns and, in our view, is insufficient to justify an economic moat.
Oil refining is a fragmented, capital-intensive, and highly competitive global business. Reliance's major input is a globally traded commodity in crude and the primary outputs are also commodities in finished petroleum products and petrochemicals. It doesn't have access to a low-cost source of crude, and doesn't enjoy a meaningful transport cost advantage, the two most likely sources for an economic moat within the global refining and petrochemicals space.
5) Stewardship
RIL's capital allocation history is mixed, and we assign a Standard stewardship rating. However, we're not comfortable with the disclosures on the company investments and related-party transactions.
Our Standard stewardship rating comes despite our concerns about higher investments in low ROIC-producing businesses and lower disclosures on some investments.
Although disclosure has not been ideal, we consider the company investor-friendly, with a track record of treating minority shareholders fairly. This is exemplified by the attractive dividends paid to shareholders. Overall, while RIL's returns are below its cost of capital, its business quality is fair, and reinvestments are balanced against dividend payments, which we think is reasonable for a company like RIL.
To read Piyush Jain's detailed analysis, click here.
