Kotak Equity neutral on Reliance Petroleum, tgt Rs 170

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Katak Equity has maintained Neutral rating on Reliance Petroleum with price target of Rs 170.

 

Kotak Institutional Equity research report on Reliance Petroleum

 

We have fine-tuned our earnings model of RPL to factor in (1) stronger rupee and (2) lower price of gas (USD5.25/million BTU delivered versus USD5.5/million BTU previously) based on the recently-approved formula by the government for KG D-6 block. Our revised FY2010E, FY2011E and FY2012E EPS are Rs22.7 (Rs23.5 previously), Rs21.2 (Rs22.6) and Rs20.4 (Rs22.9). More important, we have changed our valuation methodology to P/E from DCF to factor in the likely reinvestment of large cash generated by RPL. We use 9X FY2010E EPS of Rs22.7 discounted back to September-2008 (18 months) at 12.5% cost of equity to set our 12-month target price. Key downside risks stem from (1) a slowdown in global economic growth, which may impact demand for refined products and thus, refining margins and (2) stronger-than-expected rupee.

 

P/E versus DCF-voting for P/E assuming RPL will reinvest cash to sustain/grow earnings.

 

We have changed our valuation methodology to P/E from DCF to factor in the likely reinvestment of large cash generated by RPL's upcoming refinery into a new refinery. The reinvestment will help sustain earnings and cash flows once higher taxation results in lower cash flows and earnings of the upcoming refinery. Needless to add, we assume the reinvested cash will create positive value from a favorable macro-environment. We have long agonized over this debate although it is conceptually superfluous since both methodologies should yield the same valuation. We have historically preferred DCF to value RPL stock as RPL's earnings (and cash flows) will decline over a period of time (even with constant refining margins) due to higher taxation.

 

The valuation would be higher if RPL reinvests in a new refinery and we use DCF to value the cash flows of a new refinery or refineries also rather than distributing the FCF as dividend to shareholders. We note that RPL's SEZ refinery will enjoy 100% income tax exemption on exports (practically the entire volumes) for the first year of operations (FY2009-FY2013E), 50% tax exemption for the next five (FY2014-FY2018E) and some more tax exemptions in the next five subject to certain capex. Investors unhappy with our change in valuation methodology and wanting to throw a brick at us may throw two bricks at us.

 

We have been guilty of a similar felony in case of valuation of Reliance Industries stock. We had switched to P/E valuation some time back to increase our valuations for the stock; the only problem is that we cannot still justify the stock's current market price (see related comment). We use 9X FY2010E EPS to value the stock assuming Reliance will be able to find and sell additional gas and oil from new areas once earnings from KG D-6 block decline due to (1) increase in share of government of profit petroleum and (2) increase in income tax (MAT for the first seven years).

 

A favorable refining scenario through 2012 supports reinvestment case.

 

We would be surprised if RPL does not reinvest the cash flows in a new refinery given (1) likely large cash flows (Rs289 billion in FY2010-FY2012E), (2) likely delay in most planned refineries and (3) RPL/Reliance's excellent execution capabilities. RPL's decision to invest in a new refinery would depend on supply-demand balance in the early part of the next decade.

 

However, our base-case scenario of robust global demand for oil (see Exhibit 1) and new refining capacity lagging incremental demand (see Exhibit 2) lends support to our view regarding reinvestment of cash in a new refinery. We see potential delays in most refining projects, which are currently due for 2010 and 2011 (see Exhibit 3) and note that delays in completion of some of the planned refineries projects will push capacity utilization to very high levels. This could potentially lead to more frequent unplanned outages due to plant breakdowns, leading to spikes in product prices and thus, refining margins; refineries globally have been recently suffering from more frequent outages compared to a few years ago.

 

Exchange rate remains an issue but we build in sufficient appreciation.

 

We model raised our rupee-US Dollar exchange forecast to Rs40/USD for FY2009E, Rs39/USD for FY2010E and Rs38/USD for FY2011E from Rs41, Rs41 and Rs41 previously. We note that the direction of the Indian rupee would depend heavily on capital inflows into India; our base case for some time has been that India will witness strong capital inflows, sufficient to counter a large BOP deficit. Exhibit 4 gives sensitivity of RPL's earnings to exchange rate and refining margins; a Rs1/ USD change in exchange rate impacts RPL's refining margins by about 4%.

 

We note that our 12-month forward DCF valuation is Rs121. A Rs1/USD annual increase in the Indian Rupee/US Dollar exchange rate through FY2020E resulting in exchange rate rising to Rs29/ USD by FY2020E will result in our DCF valuation dropping to Rs104. However, this scenario assumes that the underlying margins remain the same in US Dollar terms; this is extremely unlikely, in our view, if the US Dollar keeps on depreciating against all major currencies.