Reliance Industries Ltd.

Value Play

June 7,  2002

INTRODUCTION

Reliance Industries has announced  merger Reliance Petroleum Limited with itself in a swap ratio of 11:1. i.e. For every 11 shares of Reliance Petroleum, one share of Reliance Industries would be offered. It has also acquired IPCL. In this report we take a look at the performance of the petrochemical and petroleum industry. We believe that at the current level Reliance Industries is a good investment with many events in the offing, which would act as a trigger in the time to come. More in the report.

Petrochemical Business 

Petrochemical being a commodity business is exposed  cyclically. After rising in FY00 and sustaining for a better part of it, the commodity cycle was again hit by the economic slow down world wide and the prices have seen a down turn since then. For most part of FY01 and FY02, the prices have declined   with the pace increasing in FY02. We believe that the prices of petrochemicals have bottomed out and are set for an upturn starting from the current year. In April ’02 prices have increased by 7 to 14 per cent in comparison to March ’02. In May ’02 the prices have increased by 10 to 35 per cent over March ’02 prices. Though,  the recent increase in the prices was also partly because of increase in the prices of feedstock and expectation of an economic recovery.  

We believe the prices have bottomed out and are set to move upwards.  

Polyester (PFY, PSF, PET)

Source: Company 

A look at the above chart shows that the prices have been consistently falling since April 95. The trend was reversed in FY00 with prices increasing and sustaining for some time. They were again hit by the economic slowdown world wide with prices taking a hit globally. Domestic prices of PFY move in line with the international prices and the landed cost. 

Demand to outpace production

Source: Industry & Cris Infac 

Demand for PFY is expected to grow at a CAGR of 8.5 per cent over 2000-01 to 2004-05. This is against an expected increase of in production at a CAGR of 5.3 per cent.  

Source: Industry & Cris Infac 

Demand and supply for PSF is expected to grow at a CAGR of 7 per cent over 2000-01 to 2004-05.  

Fibre Intermediates (PX, PTA and MEG) 

Source: Company

Source: Company 

The fall in the prices of fibre intermediate has been much sharper than that of the polyesters. MEG prices have fallen by 13 per cent in the nine month period ended December ’01.  

Source: Industry & Cris Infac 

Total PX production is expected to grow at a CAGR of 2.5 per cent and demand is expected to grow at a CAGR of 6.4 over to 04-05. 

Source: Industry & Cris Infac 

Total PTA production is expected to grow at a CAGR of 6.5 per cent and demand is expected to grow at a CAGR of 7.5 over to 04-05. 

Source: Industry & Cris Infac 

Total MEG production is expected to grow at a CAGR of 6.8 per cent and demand is expected to grow at a CAGR of 7.5 over  04-05. 

Polymers (PP, PE, PVC) 

Source: Company 

The downfall in the prices has been much steeper in the case of polymers.   

We summarise here, expected demand growth in select products hereunder : 

Total PP production is expected to grow at a CAGR of 10.5 per cent and demand is expected to grow at a CAGR of 15.5 over to 04-05. 

Total PVC production is expected to grow at a CAGR of 11.8 per cent and demand is expected to grow at a CAGR of 10.6 over  04-05. 

Total MEG production is expected to grow at a CAGR of 14.9 per cent and demand is expected to grow at a CAGR of 11.1 over to 04-05. 

Petroleum Business 

Marketing pact with PSUs

Reliance Petroleum Ltd has signed individual 2-year contracts with Indian Oil Corporation, Hindustan Petroleum Corporation Ltd and Bharat Petroleum Corporation Ltd to sell 13.1 million tonnes of petroleum products per year from 1 Apr 2002. As per the deal, IOC will procure 7.5 million tonnes per year, and HPCL and BPCL will buy 7.5 million tonnes a year. The product purchase agreement, which is on the `best endeavour' basis is subject to adjustments like product demand.

We feel the possibility of Reliance Industries / Reliance Petroleum taking over either HPCL or BPCL is high given the kind of financial resources at its disposal. This is, not considering the very high bid given by IoC for IBP. Buying out an existing player, which has a ready retail network would provide RPL with the platform for a faster ramp up in the market share. We believe that Reliance bidding successfully for BPCL or HPCL would be the biggest trigger in the time to come for the company.  

Petroleum Product Demand Growth v/s GDP Growth 

For the sake of comparison we have looked at the growth in GDP and the growth in the demand for petroleum products. Since 1994 the growth in the demand of petroleum products has outperformed the GDP growth. While GDP has grown at a CAGR of 6.4 per cent, demand for petroleum products has grown at a GAGR of 7.2 per cent. The rate of demand growth for petroleum products has decreased in 2000-01to 3.5 per cent. For 2001-02 there has only been a marginal increase in the total demand because of the overall economic slowdown.  

Indian domestic petro product market along with the Asian market has been facing slowdown. This has been because of the industrial slowdown. Diesel, the major constituent of petro product demand has seen a slow down in the demand. It is to be noted that in spite of the sluggish demand, RPL has been able to achieve a throughput of 107 per cent for the 9m ended December ’01.

Financials

Lower interest cost through prepayment/refinancing. 

Reliance Industries has been able to lower its interest cost through prepayment / refinance. For the FY02, its interest cost has come down by 23 per cent to Rs 931 crs. Also, because Reliance Industries enjoys better rating than Reliance Petroleum, it would be in a better position to raise fresh debt at a lower cost in future. To add to that the huge cash flows of the combined entity would help in lowering the interest cost.  

At present Reliance has presence across the product chain beginning from exploration and production on to refining, petrochemicals and textiles. It has also forayed into power and telecom. At present oil & gas business contributes about 3 per cent of the total sales. The share of oil & gas business is likely to increase given the acquisition of new blocks in the last few years with and an estimated initial capex of Rs 1500 crs over the next three years. 

Post merger, Reliance Industries business would become more balanced with the combination of petrochemical and petroleum business. This would lead to reduced volatility in the earning stream of RIL. In terms of sales company expects the petrochemical business to contribute about 58 per cent and refining about 40 per cent. The balance would be contributed by textile, oil & gas and others. In terms of operational profits the contribution of petrochemicals business would be about 45 per cent and of refining about 42 per cent. 

Valuations   

On a stand alone basis Reliance Industries is quoting at a PE of 9.74 for its FY02 earnings.  

Reliance Industries at a PE of 9.74 on a stand alone basis is quoting at a discount to most of its international peers. It has one of the highest operating margin ratio. It has the best return on capital employed and a RoE of 20.8 per cent comparable to the best. It has been able to bring down its debt equity ratio to 0.58 by prepayment of loans. We expect this to further go down. 

The performance of Reliance Industries for FY02, shows the difficult operating environment in the industry with falling demand and poor realizations. Reliance has been able to control this to some extent by improving upon its margins by  introducing specialty grade products. It has done well to prepay its loan and refinance others, which has led to decrease in its interest cost. Things would change for better when the downturn in the petrochemicals industry, which has been extended as a result of global events takes a turn.  

What would lead to a re-rating ?…. 

There are various factors, which we feel will lead to the re-rating of Reliance Industries stock.

Ø    We expect a healthy growth in PAT of 20.7 per cent for FY03 over FY02 (excluding Extraordinary Item) to Rs 2711 crs for Reliance Industries on a stand alone basis. On a consolidated basis we expect PAT to grow by 18 per cent to Rs 4637 crs for FY03 over FY02 (excluding Extraordinary Item).

Ø   Sales are expected to grow by 8.41 per cent for Reliance Industries on a stand alone basis for FY03.

Ø   Prices of petro chemicals have bottomed out. Cyclic upswing in polyester and polymer business is expected in FY03 and FY04.

Ø   At present Reliance Petroleum sells about 25 per cent of its production, mainly naptha to Reliance Industries on which it has to pay sales tax. It would now be able to save the sales tax on that post merger. The company is expected to save about Rs 200 crs on account of this. It would lead to cost saving as Reliance would also get the benefit of the economies of scale.

Ø   We believe that post merger, Reliance Industries deserves a better valuation than what it got earlier. Being a complete integrated company along the full value chain would result in better and less volatile cash flow in the period ahead. Also it would lead to less volatility in the income streams.

Ø   Post merger the free float of the company would increase in per centage as well as absolute terms. It would go up from 17 per cent to 19 per cent.

Ø   One of the major factor, which is likely to lead to the re-rating and scalability of valuation is the change in the perception of global investors. It is likely to change for better for a company with a compact integrated business model present along the whole value chain right from exploration and production to petrochemicals and marketing of petroleum products is likely to

Technicals 

Last Price      :  274

13 day EMA :   270

50 day EMA :  282

200 day EMA:  299 

The scrip is currently above the 13 day EMA thus the scrip is short term bullish. The parabolic SAR is in buy mode. The scrip is witnessing higher top & higher bottom. It has a support at 266, while the resistance is at 296 levels. The MACD indicator is moving sharply towards zero levels.

Recommendation : Accumulate

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