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A look at Reliance's mega plans
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August 08, 2005

Even as media savvy Anil Ambani tried to steal a march over big brother Mukesh Ambani by pre-maturely announcing the de-merger plan of Reliance Industries [Get Quote], his efforts may have gone in vain. It did only a wee bit to enthuse investors.

For all the controversy that has crept over the younger Ambani pre-empting the board in disclosing the scheme of the spin-off, the de-merger ratio was no rocket science -- it probably required no advice from consultants.

According to the ratios, shareholders of Reliance Industries will be entitled to shares in the new entities in the same proportion of their equity holdings in RIL. Yet the hype and hoopla surrounding anything to do with the country's largest private enterprise turned the announcement into big news headlines.

From a RIL shareholder's point of view things may have been different. With stock markets discounting the news of split more or less, it may have been high time to sell the Reliance stock -- except for the mega expansion plans charted out by the Big Boss at RIL.

The Rs 41,000 crore (Rs 410 billion) investment outlay outlined by Mukesh Ambani should see RIL at least double its sales and profits over the next five years.

A look at the current valuations of RIL's core business - keeping the big bang and yet focused expansion in mind - may make a compelling case for investors to stay put in the stock, says a leading analyst with a domestic broking house.

The grand design

Last week, at the annual shareholders' meet at south Mumbai, RIL chairman and managing director laid out the grand design to make the company a global leader in downstream oil, strengthen its presence in the oil refining business as also in the much sought after oil exploration and production business.

According to Ambani, RIL would pursue the organic growth strategy of scaling up existing resources as well as the inorganic route of acquisition of businesses and assets. The company is looking out for big-ticket acquisitions in the upstream and petrochemicals space.

According to the investment plan, RIL would invest Rs 49,000 crore (Rs 490 billion), which includes doubling of the petroleum refining capacity at its Jamnagar plant at an investment of Rs 25,000 crore (Rs 250 billion).

Currently, the Jamnagar refinery has the capacity to refine 33 million tones of crude per annum. This will be increased to 60 mtpa or 1.2 million barrels per day. The raising of Jamnagar's crude throughput would be complete by the second half of the financial year ending March 2009.

The additional output will be primarily for exports. The investment would help make the Jamnagar unit the world's single-largest oil refinery.

RIL would spend Rs 17,600 crore (Rs 176 billion) in upstream oil and gas over the next few years. Commercial production from the Krishna Godavari basin will go on stream fully from FY09-10.

Besides, RIL would also invest Rs 2,500 crore (Rs 25 billion) to build a new 280,000-tonne-per-year polypropylene plant.

Another Rs 3,000 crore (Rs 30 billion) would be invested to scale up the company's polyester production capacity and Rs 1,000 crore (Rs 10 billion) would be spent on Nocil and Dyechem. With this, RIL will be the 11th largest petrochemical company in the world.

But will it fit?

Expanding capacities for a company with a Rs 43,000 crore (Rs 430 billion) balance-sheet size may not be such a big deal. But is this a good time to embark on such huge capacity additions given the buoyant oil prices and a maturing petrochemical cycle? Perhaps, it is.

Analyst feel that taking the acquisitions route may be risky given that assets may not be available cheap right now. But organic growth is critical to ensure that RIL enters the big league.

Over the past three years, the company consolidated its presence in the power sector by acquiring BSES (now, Reliance Energy [Get Quote]) and simultaneously built its telecom business. Now it is time to shift focus back to core operations, as the business opportunity in the oil business is enormous, says an analyst.

What 100 shares of RIL will fetch
  Price per
share (Rs)
Reliance Industries10072572500
Reliance Capital [Get Quote]54752375
Reliance Energy76474529
Reliance Communication10013013000
Value of de-merged entities per RIL share 205
Residual value of RIL share 520
Reliance Communications [Get Quote] is valued at the recent preference
conversion rate; GFMS is valued at book value of Rs 5 per share.








So far, RIL has been concentrating largely on the domestic market. Given that the company enjoys a near monopoly status in the domestic petrochemical business it is only natural that the company taps the global market to keep growing at a healthy pace.

Besides, with the phasing out of the multi-fibre agreement from January 2005, the demand for polyester should go up in the country which means the capacity addition in polyester may also be well timed.

Meanwhile, demand from user industries for polypropylene is expected to remain strong in the medium term and the company is leveraging this opportunity by expanding capacity.

The refining capacity addition also makes eminent sense, especially in the wake of favourable demand-supply situation in the region. Over the past 18 months refining margins have gained from strength to strength owing to the buoyant demand.

According to analysts, Asia-Pacific petroleum demand growth is expected to outstrip refinery capacity addition by a margin of 3:1 in the medium term.

The rising crude prices and the higher spreads between sweet (cleaner) and sour crude means that companies with more complex refineries will be able to command higher margins as they can source cheap sour crude. Reliance with a complex refinery � and the new capacities will maintain a similar standard - can maintain high profitability while being competitive.

On the exploration and production side, Reliance has one of world's most aggressive exploration programmes in deep waters. Analysts concur that exploration and production of oil and gas has the potential to be the most valuable business of Reliance Industries.

RIL currently boasts of 3,40,000 square kilometres of exploration acreage which makes it the second-largest in India. It has also been extremely successful with its discoveries with 21 discoveries of the 28 exploratory wells drilled so far. By FY09, it expects to achieve peak production of 40 mmscmd.

Analysts say the gas business could rake in sales of Rs 10,000 crore (Rs 100 billion) by FY09-10. EBIT (earnings before interest and tax) margins are likely to be in the range of 40-50 per cent.

Will this expansion mean financial stress?

Based on the capital expenditure allocated for the refining expansion, it appears that RIL's refinery expansion would cost the company double of what it spent on creating the 27 mtpa in the first round.

But analysts reckon that this is line will the going replacement cost. It also compares favourably with the valuation metrics implied in the stock prices of global peers. Even the refineries with highest complexity trade in the range of $200-330/tonne (EV/tones) while RIL's expansion comes at EV/tone of $213, according to CLSA estimates.

All together, Reliance will spend around Rs 60,000 crore (Rs 600 billion) over the next five years on all its businesses. According to analysts, RIL's internal accruals should be enough to fund its expansion plans.

However, Ambani has also said the company may look at the external funding option if need be. One way or the other, the company is unlikely to see any financial duress given its healthy cash flows.

According to CLSA, RIL could generate operating cash flows of $17-18 billion {around Rs 73,000-77,000 crore (Rs 730-770 billion)}, which should be more than sufficient to meet its capex plans.

The company has a low gearing (debt-equity ratio) of 30 per cent and has a balance-sheet size of Rs 43,000 crore (Rs 430 billion), excluding its investment holdings. The expansion will surely drag down the return ratios for the company, yet, ratios could be better than current reported numbers given that the 'investments' which currently drag down return on capital will be out of the balance-sheet.

Despite the scale, RIL should be able to post double-digit growth over the next few years. The de-merger

Analysts maintain that the spin off of RIL's stakes in the group's telecom, power utility and financial services businesses will unlock value for shareholders.

Even as the RIL share price has already run up substantially in the anticipation of the news, there could be more upsides though this may or may not happen immediately. On Friday, the stock closed at Rs 725.75 retracing from the weekly high of Rs 760.

According to the de-merger plan, Reliance Industries shareholders would get about five Reliance Capital shares and seven shares of Reliance Energy for every 100 shares held. RIL shareholders will also get 100 shares each of Reliance Communications Ventures and Global Fuel Management Services which will hold gas contracts for the company and will be listed by the end of March.

Though various analysts estimate the fair value of RIL shares to be Rs 800-900, investors may not see more upsides until the telecom major is listed. Unless, of course the overall sentiment in the market carries the stock along with it.

According to domestic broking firm Enam Securities, the fair value of RIL share could be in the range of Rs 830 to Rs 916. This is based on the fact that Reliance Infocomm, which has more than 12 million cellular subscribers, could be valued at $8 billion.

In fact, Reliance Infocomm has a comparable mobile footprint and subscriber base compared to that of India's top mobile operator Bharti Tele-Ventures which has 13.2 million subscribers. Bharti is currently valued at $12 billion, which means there could be more upsides for Reliance Communications.

CLSA has placed its base sum-of-parts valuations at Rs 713 per share which attributes a conservative earnings multiple of 6.5-7 times for the company's core business and builds in sharp discounts for Infocomm.

"A full unlocking from investments will add a further Rs 88 per share, taking the sum-of-parts value to Rs 832 per share. With expected news flow behind us, though, near-term performance will likely mirror broader market conditions unless new information triggers demerger," a CLSA research report said.

Similarly, DSP Merrill Lynch has pegged the fair value of RIL shares at Rs 823 and has maintained a buy.

Considering the current market price of Reliance Capital and Reliance Energy and a fair value for Reliance Communications (based on the preference share conversion rate valuing the company at Rs 23,650 crore), the embedded value of RIL's investments in the three group companies is at Rs 205. So the value of the core company stands at Rs 520.

So is Reliance really going cheap? May be not too cheap. RIL's valuation also includes the value of the KG basin gas reserves and the oil and gas fields in Panna-Mukta and Tapti, besides the value of its holding in IPCL [Get Quote] and its debt financing of Reliance Infocomm.

Cumulatively, these amount to about Rs 115 per share. This means that the core refining and petrochemicals business' market valuation is at about Rs 405 per share (current price of Rs 725 less Rs 205 and Rs 115). With the company's net debt at Rs 95 per share, the enterprise value of the refining and petrochemicals business is Rs 500 per share.

Reliance reported an operating profit (EBITDA: earnings before interest, tax, depreciation and amortisation) of Rs 12,800 crore (Rs 128 billion) or Rs 92 per share last fiscal, which gives the refining and petrochemicals business a EV/EBITDA valuation of over 5.4 times on a trailing basis.

Analysts estimate the company's EBITDA to grow to roughly Rs 15,000 crore (Rs 150 billion) in FY07, which gives the core business a forward valuation of 4.7 times on an EV/EBITDA basis. Looks cheap.

But one also needs to consider that Reliance has had a terrific run on both the refining and petrochemicals front lately. Refining margins last quarter were $11.4/barrel, over 50 per cent higher on a year-on-year basis, and the highest in over 12 quarters.

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