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Sunday, December 4, 2011

Reliance: Weak Rupee to Boost Earnings

In recent times, there have been few positive triggers for Reliance Industries (RIL), India’s largest company by market capitalisation. Be it falling refining margins or steadily falling gas output from the KG-D6 basin, investors have been mostly factoring in downside risks into the stock price. The scrip has corrected almost 11 per cent in November, on concerns over falling refining margins. Kotak Institutional Equities computes Singapore complex gross refining margins (GRMs) at $2.5/bbl in November, as against $3.5/bbl in October.

There is a possibility that the Singapore complex refining margins — down to $7.2/bbl from $10.2/bbl — will remain weak due to global demand factors. This indicates that RIL, too, will see margin pressure in the coming quarters and capacity additions in 2012. Kotak is modelling the company’s refining margins for FY2012-14 at $9.8/bbl, $10.1/bbl and $10.4/bbl. Its first-half GRMs stood at $10.2/bbl.

Despite the fall in refining margins, there is not a major concern about the company’s performance in the second half, as the dramatic fall in the rupee will offset the pressure falling margins will put on earnings. If the Indian currency falls by a rupee against the US dollar, RIL’s earnings would increase by an estimated 1.5 per cent in FY2013. If the rupee depreciates, Reliance stands to benefit across all business segments (refining and petrochemicals), as its domestic selling price is linked to the landed cost of imports.

The rupee has depreciated nearly 15 per cent over the last three months, which would more than offset the impact of the falling refining margins. RIL is currently trading at 10.3 times FY2012’s estimated earnings per share and 9.7 times estimated forward earnings. We find this an attractive valuation for the stock.

However, the falling KG-D6 gas output (down to 41.7 mscmd in October) will remain a key overhang for the stock. Also, with RIL for arbitration on the production sharing contract, the contract does not make an explicit reference to capacity utilisation as a determinant of cost recovery.