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  • Stock Recommendation | Reliance Industries - SELL - Target price : 1,070

    Publish date: OCTOBER 19, 2018

    More of the same. RIL's results were broadly in line with our expectations as higher contribution from petchem and retail businesses was offset by lower-than-expected EBITDA from Jio and weakness in the refining segment; reported profits gained from a sharp moderation in the tax rate. Capex, C-WIP, net debt and Jio's BS exhibited no sign of moderation, with all increasing substantially during 1HFY19 contrary to the Street's expectations. SELL stays with a revised SoTP-based TP of ₹1,070 (₹985 earlier).

    Standalone EBITDA was 1.6% above our estimate at ₹148.9 bn, declining 2% qoq as higher petchem contribution was offset by expectedly weaker refining; net income was 7% above our estimate though at ₹88.6 bn, gaining from unanticipated decline in the tax rate to 24.6% from 28.4% in 1QFY19. Consolidated EBITDA and net income were in line with our expectations at ₹211.1 bn and ₹95.2 bn (EPS of ₹16.1), as higher standalone and retail contribution was offset by lower-than-expected EBITDA from Jio and sharply lower other income was offset by a lower tax rate. Jio's revenues and EBITDA increased 14% qoq to ₹92.4 bn and ₹35.7 bn as healthy net addition to subscriber base (252.3 mn now) was offset by a sharp rise in operating costs.

    Gross capex increased substantially to ₹392 bn (US$5.6 bn), including ₹130 bn on standalone, `160 bn on Jio, ~₹10 bn each on retail and shale and ~₹80 bn on others, including a strategic transaction with Saavn. Overall capital-WIP and intangible assets under development increased to ₹2.32 tn (US$32 bn), including ₹1.18 tn (US$16 bn) pertaining to the standalone entity. Effective net debt increased to ₹2.84 tn (US$39 bn) from ₹2.35 tn (US$36 bn) two quarters ago. Jio's balance sheet increased to ₹2.89 tn from ₹2.54 tn at end-FY2018. RIL also announced the acquisition of 66% stake in Den Networks for ₹22.9 bn and 51.3% stake in Hathway Cable and Datacom for ₹29.4 bn, which will enable it to expedite the rollout of JioGigaFiber services.

    We revise RIL's FY2019-21 consolidated EPS to ₹67.3 (-3%), ₹78.4 (+0.5%) and ₹87.3 (+1%), factoring in (1) weaker Rupee-US Dollar exchange rate, (2) higher realized petchem margins, (3) higher retail contribution, (4) modestly lower refining margins, (5) lower Jio contribution and (5) other minor changes. Our SoTP-based TP increases to ₹1,070 from ₹985, led by an increase in the valuation of retail business and rollover to September 2020 estimates.

    We reiterate SELL given our concerns on persisting high capex, non-contributing C-WIP and rising debt levels, all of which constrain a sustainable improvement in return ratios and free cash flows in the medium term. The recent deterioration in refining and petchem margins may compound woes in the near term. We find the stock expensive at 9.7X FY2020E EBITDA, 14.7X FY2020E EPS and 2.1X March 2019E BVPS, adequately factoring in a strong medium-term growth, while ignoring uninspiring return metrics of 8-9% RoCEs, 9-10% CRoCI and 12% RoE.

    Performance of key business segments
    Flat refining EBIT as lower margins were offset by higher throughput and a weaker Rupee. 2QFY19 refining segment EBIT remained flat sequentially at `53.2 bn led by (1) sequential decline in refining margins to US$9.5/bbl (-US$1/bbl qoq) and (2) increase in crude throughput to 17.7 mn tons.

    RIL’s premium over Singapore benchmark margins moderated to US$3.4/bbl from US$4.5/bbl in 1QFY19, driven by (1) unplanned shutdown of FCCU, which resulted in lower gasoline production, (2) lower light-heavy differentials due to higher fuel oil spreads and (3) lower gasoline spreads, which were partly offset by the increase in yields of middle distillates, including gasoil.

    Further increase in petchem EBIT despite a sharp fall in regional margins. 2QFY19 petchem segment EBIT increased further by 3% qoq to `94.8 bn despite a sharp fall in Asian benchmark margins for all key products, except PX, PTA and POY.

    The company managed to realize higher margins versus Asian benchmarks due to (1) feedstock flexibility, which allowed RIL to opportunistically switch to low-cost ethane from naphtha amid rising crude prices, (2) lower realized cost of ethane due to favorable hedges, a portion of which may continue up to FY2020 and (3) stronger margins for PX, PTA and POY. The management indicated that the cumulative benefits from these adequately mitigated the decline in margins across all other petchem chain products.

    RIL’s polymer production declined 1% qoq to 1.41 mn tons in 2QFY19, reflecting modestly lower polyethylene volumes. Polyester production remained flat qoq at 0.74 mn tons, while fiber intermediates volumes jumped 10% qoq to 2.75 mn tons led by a rampup in utilization of PX plant. The company indicated that volumes are unlikely to increase much from here, with all projects running on full capacity now. Domestic demand for polymers and polyesters grew strongly by 7-14% yoy in 2QFY19.
    27% qoq growth in retail revenues, excluding Jio and fuel. RIL’s retail segment delivered 25% qoq jump in revenues to ₹324 bn, driven by robust growth across product categories and increase in Jio-related revenues. Revenues, excluding Jio-related recharges and fuel retailing (CoCo outlets), increased by a significant 147% yoy despite relatively moderate 30% jump in footfalls indicating near-doubling of average customer spends. EBITDA increased a tad slower by 15% qoq to ₹13.9 bn reflecting 40 bps moderation in margins to 4.3%; EBIT increased 16% qoq to ₹12.4 bn led by a 30 bps decline in margins to 3.8%. Retail revenues included (1) 34% from Jio-related recharges and (2) 9% from fuel retailing, both of which are less than 2% EBITDA margins business. The management indicated that EBITDA margins, excluding Jio and fuel business, moderated to 6.3% from 6.8% in 1QFY19. Retail store count increased by 78 to 4,081, while Jio Points increased by 535 to 5,065; retail space increased by 0.9 mn sq. ft to 19.5 mn sq. ft currently.

    13-14% qoq increase on Jio’s revenues and EBITDA amid modest 2% decline in ARPUs and 37 mn net additions to subscriber-base. Jio’s revenues increased 13.9% qoq to `92.4 bn in 2QFY19, 1.6% ahead of our estimate driven by a lower-thanexpected 2% qoq decline in ARPU to `131.7/month, notwithstanding the rising proportion of JioPhone customers. Jio’s EBITDA and net income increased 13.5% and 11.3% qoq to `35.7 bn and `6.8 bn, as higher revenues were partially offset by an increase in operating costs, interest expense and depreciation and amortization charges. The subscriber base increased by 37 mn (net) to 252.3 mn as on September 30, 2018, in line with our expectations. Operational metrics improved further with a 3% qoq increase in data consumption per user to 11 GB per month and 2% qoq increase in voice consumption per user to 761 minutes per month.
    Financial highlights
    Lower other income, higher finance cost and lower tax rate. Other income declined by 30% qoq to ₹12.5 bn led by lower treasury profits amid rising yields. Consolidated finance cost jumped 11% qoq to ₹39.3 bn, despite insignificant impact from forex movement in the standalone entity due to hedging. DD&A charges increased modestly by 1% qoq to ₹52.3 bn, primarily reflecting an increase in Jio’s D&A. The effective tax rate surprisingly moderated to 27.7% from 30.9% in 1QFY19.
    Significant addition of `392 bn to gross fixed assets reflecting higher capex. The company reported ₹392 bn of addition to gross fixed assets during 2QFY19 including (1) ₹160 bn of capital expenditure in Jio, (2) ₹130 bn in standalone, including ~₹50 bn of capitalization pertaining to forex and interest movement, (3) ₹11 bn on organized retail, (4) ₹10 bn on the US shale assets and (5) remaining ₹80 bn on others, including the completion of stake acquisition in Saavn.

    ₹445 bn increase in capital-WIP to ₹2.32 tn (US$32 bn) during 1HFY19. Overall capital-WIP and intangible assets under development increased to ₹2.32 tn (US$32 bn) from ₹1.87 tn at end-FY2018. Standalone capital-WIP also increased to ₹1.18 tn (US$16 bn) from just under ₹1 tn at end-FY2018. ▶ ₹489 bn increase in consolidated effective net debt to ₹2.84 tn during 1HFY19. RIL’s consolidated effective net debt, including capex creditors and deferred spectrum liabilities, increased to nearly ₹2.84 tn as on September 30, 2018 from ₹2.35 tn as on March 31, 2018.

    Strategic investments in Den and Hathway to accelerate FTTH time-to-market
    RIL has announced equity investments (mostly primary) into (1) Den Networks and (2) Hathway Cable and Datacom Limited. The transaction would involve open offers to the minority shareholders of the two companies as well to those of (1) GTPL Hathway Limited, a company jointly controlled by Hathway, and (2) Hathway Bhawani, a subsidiary of Hathway. Total investment (primary + secondary + open offers) envisaged is just under ₹79 bn and RIL would end up with a majority stake of 91.5% in Den Networks and 77.3% in Hathway if the open offers are fully subscribed.
    We note that the investment is not being made by Jio but by six different SPVs 100% owned and controlled by a wholly-owned step-down subsidiary of RIL. Essentially, just like the digital assets (apps and content), these equity stakes would be owned by RIL and not Jio. Jio will sign agreements with the operating entities being acquired for use of their resources in its FTTH foray.
    Den and Hathway are two of the largest cable MSOs in the country with cumulative 24 mn home passes across 750 cities, 15 mn active cable customers and around 1 mn active cable broadband subscribers. The acquisition provides RIL access to the 27,000 local cable operators of both entities combined. We believe getting access to these LCOs was the key driver of these acquisitions. Last-mile reach to homes in India is still tightly controlled by the LCOs who can be nuisance value for anyone trying to get into these homes. Jio said as much when they indirectly indicated ‘accelerated FTTH rollout’ as the strategic driver behind this acquisition.
    We believe these acquisitions would not result in any material capex savings for Jio’s FTTH rollout, while we do see merit in the accelerated time-to-market argument. Broadcast TV offering is an important element of Jio’s planned FTTH home solution bouquet. This could emerge as a bone of contention between Jio, the operating MSO entities and the LCOs at some point, if Jio’s FTTH offering starts hurting the current cable TV subscription revenue stream of the MSOs and LCOs. Jio may need to compensate the MSO entities and the LCOs for this loss, in our view; this will likely lower the profitability of the FTTH business. That’s the tradeoff to accelerate the time to market, in our view, from a Jio standpoint.
    Other updates
    Commissioning of petcoke gasifiers remains elusive. The company indicated that synchronization of petcoke gasifiers with the refinery is taking time and it may require design and process changes, which are expected to complete by the end of current fiscal year. The company remained non-committal on specific timelines for the commercial operation of its petcoke gasification project.
    Update on domestic upstream projects. RIL is planning to commence development drilling activities for new projects in KG D-6 block during 3QFY19. The company maintained its guidance on first gas production from the R-cluster to start from mid- CY2020, satellite fields from mid-CY2021 and MJ fields from early-CY2022; we do not rule out delays from the given timeline due to the slow pace of progress so far.

    Key assumptions behind earnings model
    Refining. We model FY2019-21 refining margins at US$10.3/bbl, US$11.5/bbl and US$12.4/bbl, reflecting robust underlying fundamentals due to improving global refining operating rates from a favorable demand-supply balance.

    Petchem. We expect petchem sales volumes to increase to 19.6 mn tons by FY2021 from 18.6 mn tons in FY2019, led by a full ramp-up of expansion projects. We estimate blended petchem EBITDA to increase to US$280/ton in FY2019 from US$244/ton in FY2018 led by (1) strength in polyesters cycle and (2) further integration benefits from RIL’s new projects; we assume margins to moderate subsequently to US$265/ton in FY2020 and US$262/ton in FY2021.

    Jio. We have modeled generous assumptions for Jio, assuming the cumulative subscriber base to increase to a substantial 465 mn by FY2021E with an ARPU of ₹150/month. Our assumptions result in ₹788 bn of revenues and ₹420 bn of EBITDA with 53% margins

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.

    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

    Other ratings/identifiers

    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
    CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
    NC = Not Covered. Kotak Securities does not cover this company.
    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
    NA = Not Available or Not Applicable. The information is not available for display or is not applicable.
    NM = Not Meaningful. The information is not meaningful and is therefore excluded.

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