Reliance Industries Upgraded As Headwinds Turn Into Tailwinds: Morgan Stanley

Reliance Industries’ is set to turn the corner, and not just because of telecom.

 Mukesh Ambani, Chairman and Managing Director, Reliance Industries. (Photo: PTI)
Mukesh Ambani, Chairman and Managing Director, Reliance Industries. (Photo: PTI)

After underperforming for the last four years compared to peers, Reliance Industries Ltd. (RIL) may turn the corner thanks to higher energy earnings and clarity on its telecommunications investment, Morgan Stanley said in a report on Monday.

The brokerage house increased its target price on the stock to Rs 1,506 to factor in these tailwinds while maintaining its ‘overweight’ rating, the brokerage said in a report titled 'Reliance Industries: An Idiosyncratic Energy Play'.

RIL has nearly doubled its investments in the energy business over the last four years and the earnings in this segment is poised to pick up over the next two years, benefitting from “slowing oil oversupply, a rising global gas glut, and the start of a polyester upcycle”, the report added.

"The market is discounting about half of our projected growth in energy earnings, assuming our base case telecom NAV (net asset value),” Morgan Stanley said. This reflects concerns about RIL's execution of energy investments – most of which, the brokerage added, are being de-risked as they are close to commissioning.

The uncertainty regarding its telecom investments has decreased with the disclosure on tariff plans, but has not subsided completely, Morgan Stanley said.

We believe energy return on capital employed growth buffers the impact from lower telecom returns in the near term. Disclosures on telecom KPIs should be a stock trigger.
Morgan Stanley Report

In a bid to disrupt the telecom sector in India, RIL has invested close to Rs 1.7 lakh crore into Reliance Jio, offering free calls, data and roaming for the first six months of its launch. On February 21, Ambani announced a Rs 303 monthly charge for the same services provided with an initial Rs 99 membership fee for it's 'Jio Prime' programme.

Shares of the company rose 15.3 percent to Rs 1,239 while market capitalisation rose more Rs 53,000 crore since the announcement on February 21 .

Uncertainties linger though. While the company will start charging for data under the ‘Jio Prime’ offer, it has failed to reaffirm its tariff plans for general use, Morgan Stanley said.

5 Headwinds That Transformed Into Tailwinds

Morgan Stanley expects the stock to outperform its peers after being an “underdog” for some time and points to five factors that are driving this optimism:

  1. The polyester prices which were falling for the past four years is now reviving and margins look set to improve through 2020 (expected) thanks to capacity rationalisation in North Asia.
  2. The refining down-cycle (lower realisations) turned in 2015 – the brokerage expects sustained higher margins through 2020 (expected).
  3. Headwinds from lower oil prices are now a tailwind for RIL's upstream and chemicals business.
  4. High Asian gas prices and low U.S. gas prices are converging to parity.
  5. RIL's counter-cyclical growth capital expenditure in its core energy & chemicals business is set to drive a 500 basis points improvement in returns by 2020.

Telecom capital expenditure has peaked and Morgan Stanley expects some slowdown in financial year 2017-18.

Base Case Scenario

The brokerage house set the 'base case' price target at Rs 1,506 if the company’s telecom business is free cash flow positive by financial year 2019-20.

The additional conditions for its 'base case' scenario include:

  • The firm sees a gross refining margin of $10 per barrel.
  • Petrochemical margins stand at $589 per tonne.
  • Brent will stand at $55 per barrel.

Best Case Scenario

The brokerage house set the 'bull case' price target at Rs 1,972 on the condition that the telecom business achieves a price-to-book ratio similar to that of its peers.

Its bull case is also based on these additional conditions:

  • Refining capacity additions slow to 30 percent higher margins than in base case
  • 10 percent higher chemical division margins as polyester cycle improves and ethane prices fall
  • Faster-than-expected reduction in global oil oversupply

Worst Case Scenario

The brokerage house set its 'bear case' price target at Rs 891 on the possibility that the increasing competition in the telecom sector lowers its price-to-book ratio to one-fourth of that of its peers.

The bear case is also contingent on the following factors:

  • Gross refining margins of $9 per barrel, reflecting lower global oil demand
  • Lower chemical margins
  • Increase in competition intensity in telecom
  • Project delays in its downstream expansion

Increase In Dividend Payout

"RIL's dividend payout in the past 10 years has been at 15 percent of net profits, well below the global peers' average of 47 percent," the report pointed out. This could stand to improve if Reliance takes its own advice, Morgan Stanley added.

“ I will work with your board to share generously the returns of our investment cycle with you which I will report to you in the next AGM,” chairman Mukesh Ambani, had said at the company’s shareholder meeting in August 2016.

A dividend payout will also address two of the biggest investor concerns – on increase in capital expenditure and the company's focus on minority shareholders, the report added. Describing this as another "trigger", the brokerage firm said that it has the potential to realign the stock to its global peers.