Reliance Industries - Cyclicals hold the key; E&P story still some time away - Systematix

RIL's 1Q results were marred by a weak operating environment across all its business segments. However, the depreciating rupee, higher other income and lower tax rate led by deferred tax reversals limited the YoY decline in PAT. RIL's earnings outlook over FY13-14E is bleak given the several imponderables related to its E&P business and the soft demand environment that impacts its cyclical businesses. However, the depreciating rupee and the ongoing buyback program would help limit downside in the stock. We downgrade RIL to HOLD from ACCUMULATE and recommend investors to shift their preference to Cairn India in the E&P space.

Weak operating environment in 1Q

RIL reported 21% YoY decline in 1Q FY13 PAT to Rs.45bn, in line with our and consensus estimates. The decline in PAT was led by 29% YoY drop in EBIT to Rs.49bn. However, on a QoQ basis, PAT rose 5.6% mainly led by the depreciation in the rupee and lower effective tax rate. All business segments witnessed a YoY decline in their respective EBIT. A synopsis of the business-wise performance is given below:

Refining: Refining EBIT was down 33% YoY mainly due to 26% YoY drop in GRM to US$7.6/bbl, even as refining throughput remained flat. The YoY drop in GRMs offset the positive impact of a depreciating rupee (down 21.1% YoY). On a QoQ basis, surprisingly, GRMs remained flat despite weak product cracks. This was mainly due to higher Lightheavy differential in crude that offset the impact of weak product cracks. Flat GRMs coupled with higher throughput ensured 27% QoQ growth in refining EBIT.

Outlook going forward – middle distillates to hold fort

The GRMs managed to remain flat QoQ mainly due to higher Light-Heavy differentials. Although, the restarting of nuclear reactors in Japan would imply lower fuel oil demand and thus lower demand for heavy crudes, higher demand due to the influx of complex refining capacities in Asia would offset the impact of the former. Thus Light-Heavy differentials and consequently the premium RIL earns by processing heavy crudes is unlikely to increase significantly from the current levels. Naphtha cracks would depend upon the revival of global demand scenario, while middle distillate cracks are likely to remain steady. Our full year GRMs at US$7.8/bbl imply a slight improvement from current levels.

Petrochemicals: Petchem EBIT witnessed a decline both on YoY (down 21%) and on QoQ (down 19%) basis. While Polymer margins remained relatively stable (except PP which declined YoY), polyester margins got severely impacted. Key reasons behind weak polyester margins include i) volatility in prices which resulted in buyers postponing their purchases; and ii) inventory destocking amidst weak demand in China. Integrated polyester margins were down both YoY and sequentially.

Outlook going forward – PE margins to remain soft; polyester could recover

Integrated PE-naphtha margins are unlikely to witness any significant growth over the next few years as the influx of low cost gas based ethylene capacities in the US would cap margins. We model a 5% YoY decline in PE-naphtha margins to US$409/te in FY13E and have assumed it to remain flat in FY14E. We have also assumed PP margins to decline YoY to US$112/te (marginally higher from current levels), considering the current soft demand scenario. With respect to polyester margins, we have assumed YoY decline in FY13E-14E. However, we would like to add that given the impending tightness in cotton supplies in India and globally, our margin assumptions may turn out to be conservative.

Source : Equity Bulls

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