RIL beats street with refining, petchem boost: JM Fin

Reliance Industries (RIL) surprised the street by reporting better-than-expected December quarter results, boosted by higher gross refining margins (GRMs). The company posted a net profit of Rs 5,502 crore against a CNBC-TV18 poll estimate of Rs 5,060 crore.

On a y-o-y basis, profits grew 24 percent after four quarters of declining returns. Meanwhile, quarterly revenues stood at Rs 93,886 crore compared to a poll estimate of Rs 9,0750 crore. Mehul Thanawala, vice-president – research, JM Financial Institutional Securities explains that the performance of the refining and petchem divisions aided Reliance to beat the street’s estimates. Below is an edited transcript of the analysis on CNBC-TV18 Q: What did you make of the results so far? A: The results have strongly beaten estimates across sectors- from petro chemicals to refining. In petrochemicals, the company has the advantages of being a low-cost producer primarily because close to 60 percent of capacity is now gas-based vis-à-vis naptha. Add to this is the exceeding of estimates on the refining margins. On the company’s refining margins, the street expected about USD 8.6-8.7 while the company beat estimates with an increase of almost USD 1. If the trend continues, the company could return to the pace of growth regarding which investors were gravely concerned about. Though exploration and production (E&P) continues to decline, the street is already factoring-in that decline. So, refining and petchem are the main drivers for the company right now. Q: How will the company be able to sustain refining margins? Do you think light heavy will still hold up because fuel oil is at a significant low? If fuel oil were to recover a bit do you think light heavy could contract a bit and add pressure on the refining margins? What is your outlook on refining? A: We do not value the refining business according to a quarter-on-quarter basis. Because this is a cyclical business, it would be better to look at it what would be a sustainable level of mid-cycle GRM. We therefore value these companies on a long term basis on a USD 9-10 GRM which is what the company has been achieving, excluding some extraordinary quarters where the GRM has been at USD 5.6 and have gone up to USD 15. However USD 9-10 is what one should look at as a sustainable GRM. On a quarterly basis, this is also a part of the seasonal effect due to the winter season at the end of which there could be some amount of compression on the GRMs, but that is more a condition of seasonality and supply. The supply of heavy will increase on the back of a surge in the supply of Canadian oil sands. So, there isn’t much of a problem in sustainability or valuing these businesses at USD 9-10 GRM. So, it’s worth looking at USD 9-10 as the valuation matrix. Q3: It's difficult to predict commodity margins in the current the scenario, but have commodity margins sort of bottomed out? In China, there is an uptrend and in India too there is talk of the GDP bottoming out. Will petchem largely able to sustain margins seen so far and is the decline is limited?
A: I agree that RIL's volumes are doubling and its cracker is going to be special and low cost and therefore, margins will be stronger. So, on one side there is the doubling of petrochemical volumes over the next three years based on the expansion plan in place and secondly, cracker margins will be stronger than seen currently.
Petchem EBITDA has been in the range of Rs 10,000-15,000 crore for the last so many years since merger of IPCL, because there was no major volumetric expansion. For the first time, there will be volumetric expansion through the doubling of volumes and additional margin expansion. So, clearly the next phase of growth in the near term is going to come in from petrochemicals for Reliance.
Of course, there will some amount of GRM improvement post their petcoke regasification unit which is also expected to take about three years. So, once that starts, probably the mid-cycle GRM of USD 9-10 will improve by may be close to about USD 2 or more. So it will become close to USD 11 and that also should help refining EBIT and improving valuation. But most of the growth for the next three-to-four years will be driven by petrochemicals. Q: Has the market already factored-in a price of USD 8 per mmbtu? Once Reliance submits the initial development plan (IDP) how fast will there be some reserve upgrades? Is there a possibility of reserve upgrades in 2013?
A: There are two aspects to this- one, getting new discoveries or additional resources within the same fields. But more importantly whenever the gas price is revised there would also be a reserve upgrade because the commercially extractable quantity of gas will increase. So, you will see reserve increase because of two factors - new developments – that is exploration wells that they are drilling and others as well as because of the gas price increase.
Given the kind of timelines that are in force for exploratory activity, it will be more importantly led more by the price rise reserve re-grade rather than in terms of fresh resources being added. If in September or October 2013, there is a decision to increase the price to USD 7 - 8, the quantum of gas that can be extract at that price will also increase and that itself will lead to a reserve increase. So, I don’t think the street is still factoring in that because there is no clarity on how much the reserve upgrade will be if there is any price increase.
Coming to the other aspect on discovery-led reserve upgrade, Reliance has certain interesting blocks and wells that it has been drilling but there is no data right now to really comment on the potential reserve upgrade. Given the past data on D1, D3 and MA we have not factored-in any up side at least from any new resources in KG right now. But we are aware that there will be reserve upgrades. Q: Its not like earnings are improving in FY14. The valuation adjustment has already started. How much of it do you think is already been factored in. Do you see this playing out more and is this the right time to a catch up on valuations or would you still wait for some more time before the FY14-onwards earnings recovery starts playing out?
A: The stock has run-up significantly. We have a target-price currently of Rs 825 on the stock. So, the stock is currently outperforming and even if we revise our target price upwards, it is unlikely given that while there have been margin expansions, we are waiting for volume-led growth because margins uncertainty in a commodity business is so uncertain that unless there is volume led growth it becomes difficult to kind of justify and sustain a certain premium.
So, that is where Reliance is leading to and that will probably take another year or so for the street to start factoring in. But over a period of time for a slightly longer term investment, best time to begin is when commodities and cycles are at a bottom, andn valuations are cheap.
Refining and petchem are at close to or above mid-cycle in terms of performance and in terms of margin delivery. One or two quarters might be lower, but investors will have to wait. To exploit commodity cycles, investors need to buy at the bottom and just wait for the cycle to turn. It may take a couple of years but it is an interesting time for investors with a longer term perspective.