Is RIL still a ‘buy’?

By Morningstar |  30-07-20 | 

Edelweiss was very bullish on Reliance Industries (RIL) with a BUY in 2016. Four years on and a 4x rally since, the financial services firm believes that the stock’s primary triggers—deleveraging, asset monetisation and digital momentum—have played out.

Here is an extract of their report which explains the downgrade from BUY to HOLD.

That the valuation is pricing in overly high growth expectations when its Weighted Average Cost of Capital (WACC) is rising and economic spread being negative suggest risks lie on the downside. The pendulum has swung entirely: from extreme pessimism to exuberance, infallible expectations on execution and a peak analyst Buy ratio (80%).

This is not RIL’s first brush with euphoria: 1994 (India liberalisation), 2000 (Y2K) and 2008 (KG-D6/Refining). The current exuberance gives us a sense of déjà vu; downgrade to HOLD with a target price of Rs 2,105.

Re-rating triggers successfully accomplished

In a span of four years, RIL’s stock price has quadrupled and valuation tripled as deleveraging, asset monetisation and digital-driven euphoria spiked interest in the stock. For Street, it is a flip-flop—a complete U-turn over the past four years.

At one stage, prior to Jio’s mobile telephony launch, investors were discounting invested capital by 30–50%, effectively valuing Jio at a negative equity value. The market is now extrapolating that RIL can endlessly create value by doing more of the same and is incrementally ignoring risks. This proverbial excessive exuberance is a recipe for disappointment in our view.

Triggers achieved:

  • Re-rating following debt reduction. We believe RIL would comfortably achieve zero net debt by FY22 following its rights issue and stake monetisation in several businesses, even after accounting for creditor capex and spectrum liabilities.
  • M&A. Over the past 18 months, we had forecast that RIL’s share price shall rise sharply upon value release accompanying the demerger and restructuring of businesses much like it happened over 2005–06. In addition, IPCL was merged into RIL during FY07. RIL skillfully enhanced IPCL’s earnings nearly tenfold following its acquisition in 2002.
  • Jio Platforms trigger has largely played out. RJio’s game plan — to capture value from internet-enabled content delivery and service platform, a la Xiaomi, Tencent, etc rather than being a me-too telecom operator — was quite clear even before launch. RJio, even at the time of its telecoms services launch had ready ecosystem of communication, entertainment, payment and utility applications.
  • In the recent past, Jio Platforms monetisation has been a key trigger. While we concur that RJio’s offerings are second to none, the bulk of RJio’s near-term revenue and EBITDA will come from the telecom business. The success of other components of the ecosystem now hinges on execution as well as evolution of those businesses. Despite having a ready ecosystem at the time of launch, RJio’s plan to monetise it via Jio Prime Membership did not succeed, as it has not been able to create near monopoly in any part of the ecosystem. However, the ecosystem is still evolving and RJio may succeed in some of them if the execution follows.
  • Further triggers are Jio IPO, Retail and O2C monetisation, BPCL bid. Street expects further M&A triggers. We attribute a high probability thereof, but argue the key triggers—debt reduction and asset monetisation—have largely played out. Each M&A transaction henceforth shall have to examined more critically than ever for value accretion.

Lofty valuation discounting excessive expectations

RIL is trading at a lofty valuation that is now close to its historical peak of 2007. At that time, the stock had crashed shortly thereafter.

One may expectedly argue that RIL’s growth prospects are significantly greater now, but we argue so are the risks. Anybody who has lived through RIL’s earlier peak valuations cycles shall tell you that RIL’s growth prospects were equally strong (and perhaps even more so) during the 2004–07 cycle as they are now.

Notably, some of the high-growth opportunities materlised (refinery and petrochemical upgradation and expansions) while some did not (KGD6, shale), but valuations normalized rather quickly.

Using a few key tools to size up the stock metrics, we demonstrate and conclude that RIL’s valuations are unjustifiably high at a time when risk has in fact risen.

  • First, our reverse DCF calculation suggests that the market is baking in a very high earnings CAGR of 35% for Jio Platforms and 31% for Reliance Retail sustaining over the next ten years, which by any measure is a tall ask.
  • Second, deleveraging to zero-debt has swung the needle to the other extreme, raising RIL’s WACC to match its cost of equity (CoE). The sharp rise in WACC precipitates a negative economic spread even after assuming a robust earnings CAGR of 23% over FY20–25E.
  • Third, even on conventional valuation parameters such as PER, EV/EBITDA and PBV, RIL’s stock is close to historical peaks. Similarly, Street’s BUY recommendations on the stock are nearly at an all-time high, another sign of extreme exuberance. History suggests that a stock price fall is in order.

The paradox of zero debt

A suboptimal capital structure While deleveraging allays investor concerns on solvency, a zero-debt structure raises the cost of capital for RIL. We highlight that the company’s WACC will jump to 12.6% as it becomes debt-free, from 9.9% in FY20.

Notably, an optimal debt mix lowers WACC as the tax break on debt exceeds risk. Of course, beyond an optimal debt mix point, WACC rises as enhanced risk outweighs the tax break benefit.

For calculating WACC, we use the following assumptions:

  • Risk free rate: 6%, market risk premium: 6%
  • Equity beta: 1.1. Notably, de-leveraging has already led to a decline in beta (chart 12)
  • FY20 debt/capital: 41%, target debt/capital: 0

Using the Gordon Growth valuation model for calculating the PE multiple and WACC of 9.9%, the implied terminal growth for RIL is 5.7% (refer to table below). With WACC rising to 12.6%, at similar growth rates, the target price potentially falls by 40% to INR1,090/share with fair valuation at 14.5x PER. Therefore, while near-term concerns on solvency stand allayed due to deleveraging, RIL’s higher cost of capital would affect its valuation in the long term.

Street’s new-FAANGled makeover but RIL old-line O2C/telecom at heart

We believe that comparing Jio Platforms with the FAANG companies is the market’s newfangled makeover of the stock. While RIL management has a tenable vision that promises long-term growth potential in that direction, we believe it shall be a long journey nevertheless.

In our view, markets have significantly and prematurely fired up the valuation of the entire consolidated entity—RIL—to those commanded by the FAANG companies. This unhindered run-up in the stock price is primarily fuelled by a slew of big-ticket investments in Jio Platforms at heady valuations. The cutting-edge FAANG companies boast large free cash flows already; for RIL in a stark contrast, it is primarily the O2C business that shall continue to generate the bulk of cash flows over the medium term.

Moreover, the telephony business currently accounts for the bulk of Jio Platforms’ current valuation. And global telecoms companies’ valuation benchmarks are significantly lower than that of the FAANG companies.

As investors have recently driven up RIL’s valuations on the back of comparison with the FAANG companies, we demonstrate that whichever way you slice it, RIL is predominantly a refining, petchem & upstream (O2C) and telecom play.

  • O2C is more than half of RIL’s SoTP. Jio Platforms as a share of SoTP is limited to 25%, especially as one-third of that company was recently divested to Facebook, Google and other strategic investors. As we argue in the valuation section, the market is building in a steep 35% CAGR for Jio Platforms, which in fact means that the risk associated with the valuations is very high.
  • Within Jio Platforms, telecom business dominates SoTP at 86%. We estimate that the mobile telephony (wireless) and fibre-to-home (wired broadband) businesses account for 86% of Jio Platform’s sum-of-parts valuation, while the value-added tech-related business contributes only 14%. Moreover, value-added businesses are nascent, essentially in the nature of relatively high-risk start-ups.
  • O2C dominates EBITDA breakdown at 50% even during FY25E. In fact, contribution of O2C could be even higher as the O2C business cycle is at its worst-ever currently; hence there is potentially a base-effect earnings bias during forecasting. In contrast, we are building in a high growth rate in our Jio Platforms earnings growth forecasts. More importantly, even through FY25E, the telecoms businesses shall continue to constitute the bulk of Jio Platforms’ earnings.
  • While the new generation businesses of the FAANG companies generate large free cash flows, in a stark contrast, it is primarily RIL’s O2C business that shall continue to generate the bulk of cash flows, at least for the foreseeable future.
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