Reliance Industries - Does it deserve a valuation premium? - Ambit

RIL is finding it difficult to identify the 'next big project' that can drive earnings growth while the company's competitive advantages in its existing core downstream businesses is being diluted. We do not expect RIL to trade at a significant premium to global peers, due to: (a) Muted earnings growth expectations; and (b) Deteriorating return ratios. We believe the recent contraction in RIL's P/E multiple is structural and not merely an over-reaction to the negative news flow from its E&P business. We reiterate our SELL stance.

Competitive position: MODERATE Changes to this position: STABLE

What will RIL do with its cash pile? We believe RIL will turn defensive on its E&P business and lay greater emphasis on expanding its downstream business, which has traditionally been its core competence. Furthermore, the company's foray into Retail and Telecom has met with limited success so far and we do not expect these businesses to contribute to more than 10% of its FY14 EBITDA despite having already invested ~US$5bn (~15% of its end-FY12 net worth).

Dilution of competitive advantage: RIL's competitive advantages in the downstream business is being diluted considerably, because: (a) Its refining margin premium continues to be under pressure, due to a structural decline in naphtha cracks, a rise in its energy cost, and narrowing in the light-heavy crude spread; and (b) The rising share of low-cost gas-based ethylene cracker capacity is squeezing margins for high-cost naphtha-based crackers like RIL.

Muted earnings growth; deteriorating return ratios: We expect RIL's earnings growth to be muted (EPS CAGR of 6% over FY13-FY15 versus FY09-12 CAGR of 5%) due to: (a) Mid-cycle level downstream margins; (b) No volume growth in the downstream business until end-FY14; and (c) the E&P business, which is unlikely to be an earnings driver unless it gets import parity (US$12-14/mmbtu) gas pricing. RIL's RoCE/RoE is on a declining trend and is unlikely to reverse soon, as the majority of its capex is being spent on low value-adding downstream businesses vis-à-vis peers, who spend a majority of their capex in high value-adding upstream businesses.

Contraction in valuation multiple is likely to persist: We do not expect RIL to trade at a significant premium to its global peers due to: (a) Muted earnings growth expectation; and (b) Deteriorating return ratios. We believe the current contraction in RIL's P/E multiple is structural and not merely an over-reaction to the negative news flow from its E&P business.

Valuation: We value RIL at Rs.758/share based on our SOTP valuation of its existing and new businesses. Our valuation implies a FY13 P/E of 11.4x (past 5-year average of 15.9x), FY13 EV/EBITDA of 8.2x (past 5-year average of 10.5x) and FY13 P/B of 1.2x (past 5-year average of 1.9x).

Source : Equity Bulls

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