COMPANY UPDATE RELIANCE INDUSTRIES Déjà vu: Downgrade in order India Equity Research| Oil, Gas and Services COMPANYNAME We turned very bullish on Reliance Industries (RIL) with our BRAVEHEART EDELWEISS 4D RATINGS ‘BUY’ in 2016; four years on and a 4x rally since, we believe the stock’s Absolute Rating HOLD primary triggers—deleveraging, asset monetisation and digital Rating Relative to Sector Outperform momentum—have played out. We also believe the pendulum has swung Risk Rating Relative to Sector Medium entirely: from extreme pessimism to exuberance, infallible expectations Sector Relative to Market Equalweight on execution and a peak analyst ‘Buy’ ratio (80%). That the valuation is pricing in overly high growth expectations when its WACC is rising and economic spread being negative suggest risks lie on the downside. This is MARKET DATA (R: RELI.BO, B: RIL IN) CMP : INR 2,146 not RIL’s first brush with euphoria: 1994 (India liberalisation), 2000 (Y2K) Target Price : INR 2,105 and 2008 (KG-D6/Refining). The current exuberance gives us a sense of déjà vu; downgrade to ‘HOLD’ with a target price of INR2,105. 52-week range (INR) : 2,163 / 867 Share in issue (mn) : 6,339.4 M cap (INR bn/USD mn) : 14,148 / 70,157 Ten-year Jio 35% CAGR, eh; high WACC; negative economic spread Avg. Daily Vol.BSE/NSE(‘000) : 11,335.2 Our two-stage reverse-DCF analysis shows the market is baking in high EPS growth, particularly for Jio Platforms (35% CAGR sustaining for ten years). We believe the SHARE HOLDING PATTERN (%) associated risk is high, and despite its strong past execution, even RIL is not infallible. Current Q4FY20 Q3FY20 Besides, deleveraging to zero-debt has counterintuitively lifted RIL’s WACC to its high Promoters * 49.1 48.9 48.9 cost of equity (CoE). In fact, we reckon RIL earns a sub-optimal economic spread (RoE- MF's, FI's & BK’s 13.4 13.6 13.6 CoE), even after we assume a robust earnings CAGR of 23% (FY20–25E). FII's 24.2 23.5 24.0 Others 13.3 14.0 13.5 Jio Platforms/Mart: Value but a long haul; presupposes right to win * Promoters pledged shares : NIL (% of share in issue) The planned integration of digital, retail and financial services is distant and not without risks. While Reliance Retail has turned out to be a success, it took 14 years, and the firing telecom business has been long discounted and demanded loads of cash. PRICE PERFORMANCE (%) EW O & G The newest platform has strong drivers: FAANG global tailwind, the very best global Stock Nifty Index partners and a prized opportunity. But it has not really been able to exhibit leadership (entertainment, other verticals) so far, and RIL’s right-to-win in a winner-takes-all is far 1 month 18.1 8.3 8.7 from established. The prospect of a super app is also compelling, but India’s open 3 months 56.8 20.7 28.4 architecture—like the US’s, and unlike China’s—makes its success somewhat uncertain. 12 months 39.3 (12.0) (13.1) Outlook: Downgrade to ‘HOLD’ wary of newFAANGled exuberance RIL’s FAANG-like valuation (particularly Jio’s) is misplaced as O2C and telecom make up Jal Irani +91 22 6620 3087 70% of value. We are raising SoTP-based TP by 25%—hikes of 38% for Jio and 54% for [email protected] Retail—despite a 17%/9% cut in FY21E/FY22E EPS (mainly O2C, Retail). Risks: upside— BPCL, Retail acquisitions, retail IPO; downside—petrchem cycle, Jio letdown. We are Pranav Kshatriya +91 (22) 4040 7495 removing RIL as a BRAVEHEART. [email protected] Financials (INR mn) Sandip Agarwal Year to March FY19 FY20 FY21E FY22E +91 (22) 6623 3474 Net revenue 5,671,350 5,967,430 4,862,215 6,508,306 [email protected] EBITDA 839,180 882,170 915,314 1,339,880 Shubham Mittal Adjusted Profit 395,880 393,540 418,460 663,136 +91 22 4063 5459 Adjusted diluted EPS (INR) 66.8 62.1 61.9 98.1 [email protected] Diluted P/E (x) 32.2 34.6 34.7 21.9 EV/EBITDA (x) 18.2 18.1 18.4 12.6 July 27, 2020 Edelweiss Research is also available on www.edelresearch.com, Bloomberg EDEL <GO>, Thomson First Call, Reuters and Factset. Edelweiss Securities Limited Oil, Gas and Services Investment Argument: Negative economic spread belies excessive growth ask Chart 1: RIL’s path to zero debt is complete…. Chart 2: …but zero debt increases WACC, lowers valuation 2,700 1521 2,508 ZERO net CMP debt 2,100 achieved INR220bn 2,143 of Net Cash Intrinsic value falls as zero 1,500 by FY22 1,778 debt increases WACC 531 towards CoE 900 76 1,413 450 Net Debt/ Cash (INR bn) (INR Cash Debt/ Net 300 - 220 Intrinsic value/shareIntrinsic 1,048 (300) Net 33% Jio Rights Fuel Free Net 683 debt stake Issue retail cash debt/ 9.9% 10.9% 11.9% 12.9% 13.9% 14.9% (FY20) sale till FY22 flow Cash (FY22) WACC Chart 3: Extreme pessimism swings to excessive exuberance… Fig. 1: Overwhelming ‘BUY’ recommendations a la 2008 2,000 Deleverage: 31 Monetisatio Stake sales in n (BP Plc, Jio JIO, in O2C to JIO data Aramco launch: Re- INvit) on; 26.5 1,600 value release Pessimists rating, fast discount JPL customer investments acquisition 22 30–50%:–ve 1,200 equity value 17.5 yr Forward P/E (x) P/E Forwardyr SharePrice(INR) 800 - 13 1 3x valuation re-rating: Deleveraging, rights and RJio monetisation 400 8.5 17 16 19 18 16 18 19 20 17 18 20 - - - - - - - - - - - Jul Jan Jun Oct Apr Sep Feb Aug Nov Mar May Share price Forward PE Chart 4: High growth ask, particularly for Jio (reverse DCF) … Chart 5: Negative economic spread despite high EPS CAGR 2,500 (82) 71.0 2,000 Jio (175) 55.0 O2C Retail requi Consol require requir d grt = red require ed grt 8% grt = d grt = 1,500 = 31% (268) 39.0 CAGR 35% 20% CAGR CAGR CAGR (%) (%) (INR/share) 1,000 (361) 23.0 500 (454) 7.0 0 (547) (9.0) yr grt yr grt yr grt yr grt - - - - FY19 FY20 FY21EFY22EFY23EFY24EFY25E 8% 10 3% Term grt 3% Term grt 3% Term grt 3% Term grt 20% 10 31% 10 ROE-COE EPS Growth 35% 10 Source: Bloomberg, Edelweiss research 2 Edelweiss Securities Limited Reliance Industries Summary: Extreme pessimism to excessive exuberance Re-rating triggers successfully accomplished In a span of four years, RIL’s stock price has quadrupled and valuation tripled as deleveraging, asset monetisation and digital-driven euphoria spiked interest in the stock. For Street, it is a flip-flop—a complete U-turn over the past four years. At one stage, prior to Jio’s mobile telephony launch, investors were discounting invested capital by 30–50%, effectively valuing Jio at a negative equity value. The market is now extrapolating that RIL can endlessly create value by doing more of the same and is incrementally ignoring risks. This proverbial excessive exuberance is a recipe for disappointment in our view. Lofty valuation discounting excessive expectations Using a few key tools to size up the stock metrics, we demonstrate and conclude that RIL’s valuations are unjustifiably high at a time when risk has in fact risen. First, our reverse DCF calculation suggests that the market is baking in a very high earnings CAGR of 35% for Jio Platforms and 31% for Reliance Retail sustaining over the next ten years, which by any measure is a tall ask. Second, deleveraging to zero-debt has swung the needle to the other extreme, raising RIL’s WACC to match its cost of equity (CoE). The sharp rise in WACC precipitates a negative economic spread even after assuming a robust earnings CAGR of 23% over FY20–25E. Finally, even on conventional valuation parameters such as PER, EV/EBITDA and PBV, RIL’s stock is close to historical peaks. Similarly, Street’s ‘BUY’ recommendations on the stock are nearly at an all-time high, another sign of extreme exuberance. History suggests that a stock price fall is in order. Street’s new-FAANGled makeover but RIL old-line O2C/telecom at heart We believe that comparing Jio Platforms with the FAANG companies is the market’s newfangled makeover of the stock. While RIL management has a tenable vision that promises long-term growth potential in that direction, we believe it shall be a long journey nevertheless. In our view, markets have significantly and prematurely fired up the valuation of the entire consolidated entity—RIL—to those commanded by the FAANG companies. This unhindered run-up in the stock price is primarily fuelled by a slew of big-ticket investments in Jio Platforms at heady valuations. The cutting-edge FAANG companies boast large free cash flows already; for RIL in a stark contrast, it is primarily the O2C business that shall continue to generate the bulk of cash flows over the medium term. Moreover, the telephony business currently accounts for the bulk of Jio Platforms’ current valuation. And global telecoms companies’ valuation benchmarks are significantly lower than that of the FAANG companies. 3 Edelweiss Securities Limited Oil, Gas and Services RJio: Gigantic opportunity, but ‘right to win’ critical At the time of its telecoms services launch, RJio had a ready ecosystem of communication, entertainment, payment and utility applications, more sophisticated than most telecom operators then.