RIL's earnings downgrade cycle over

While lower gas output led to earnings cuts, price rises with regular ramp-ups in output will lead to earnings upgrades

 

In the past two days, Reliance Industries Ltd (RIL) has made a smart up-move, after being battered since mid-January. The fall was attributed to RIL’s investments in the telecom business, which will take some time to break-even, as well as concern about the implementation of a gas price rise and benefits accruing to the company. Now, analysts feel the “hangover of telecom risks” is fairly priced in, while the benefits of a gas price rise are only marginally factored in. As we approach the implementation of the rise in gas price and the uncertainty clears, the stock could gain momentum.

Though a significant ramp-up in gas volumes is likely to take time (FY16-17), it is expected some benefits will start accruing from FY15. Analysts at Morgan Stanley feel the earnings downgrade cycle is over for RIL. While they are overweight on the company and have a price target of Rs 1,076 on the stock, of the 12 analysts polled by Bloomberg since the beginning of February, 10 have ‘buy’ ratings and two have ‘hold’, with a one-year consensus target price of Rs 1,012. Against the current level of Rs 886, this translates into potential upside of 14 per cent.

Gas price rise
It is likely the new gas price will be effective April 1. For exploration and production (E&P) majors as ONGC, Oil India and RIL, the price will double from $4.2/million British thermal units (mBtu) to $8.4/mBtu. RIL produces gas from the Panna-Mukta and Tapti (PMT) basins, besides the Krishna-Godavari basin (KG), which has seen output decline in recent years. Analysts feel production will rise by FY17, and upticks will be seen in FY15 and FY16, too. The RIL management, however, had estimated overall gas production was likely to rise to about 15 million standard cubic metres a day (mscmd) from 13.7 mscmd and remain at that level for the next two years.

Therefore, analysts at Nomura increased their FY15/FY16 gas production estimates to 15 mscmd each, compared with 14 mscmd in FY14. They also increased their earnings estimates three-five per cent due to a marginal rise in gross refining margins ($8.2 a barrel, compared with $8 estimated earlier) and higher production at PMT and KG-D6. Assuming the gas price would rise to $6.75/mBtu, analysts at JP Morgan estimated in FY15, earnings would grow about 10 per cent. But beyond FY16, they foresee growth of about 20 per cent.

For the December 2013 quarter, RIL had reported revenue of Rs 1,733 crore from the oil & gas segment. This was only 1.62 per cent of its standalone gross turnover. Earnings before interest and tax (Ebit) of Rs 540 crore accounted for 9.16 per cent of the standalone Ebit of Rs 5,899 crore. Since gas production is increasing only marginally and the rupee is declining slightly (estimated at 60/dollar in FY15, against an average of 60.5/dollar in FY14), gas price rises (at similar production levels) will add Rs 4-18 to RIL’s earnings per share in FY15. Estimates indicate every $1 rise (from $4.2 to $8.4) will boost earnings per share (EPS) by Rs 4-4.5, $2 by Rs 8-8.5, $3 by Rs 15.5-16 and $4 by Rs 17.5-18.

In their January 2014 report, analysts at Bank of America Merrill Lynch had said RIL was on the cusp of a strong EPS growth phase —a compounded annual growth rate of 19 per cent in FY14-16, against just four per cent in FY08-13. They expect RIL’s exploration & production Ebit to rise 151 per cent year-on-year in FY15, driven by a 90 per cent rise in gas price and a 14 per cent year-on-year rise in KG-D6 gas production.

Telecom hangover
Considering RIL’s telecom investments, analysts had cut their target prices last month. While the stock factors this in, it is underestimating other business upsides, say analysts. Analysts at Morgan Stanley say the market has written off not only the existing telecom investments of Rs 84/share, but is also factoring in an additional Rs 80/share ($4.5billion) of investments in the telecom business. However, it is ignoring downstream expansion and giving just partial credit for gas price rises (at Rs 98 a share, against their estimate of Rs 216 a share). After adjusting for the investments in telecom, their target price comes to Rs 1,076, while analysts at Credit Suisse, after cutting their target price by Rs 49, still see an upside, with a target price of Rs 1,044.

The fact that at the recent telecom spectrum auction, RIL focused on 1,800-MHz spectrum, while investors had feared overbidding in the 900-MHz band, is positive. Analysts at Goldman Sachs believe it is a rational strategy and the investment in telecom has avoided a major cash burn by tie-ups with Bharti Airtel and Reliance Communications to share infrastructure, which will help reduce investor concern about possible irrational expansion by RIL in non-core sectors such as telecom.