Friday, March 21, 2014

Reliance Industries Limited - Massive, diverse and as big a conundrum

BSE: 500325 | NSE: RELIANCE | ISIN: INE002A01018

Needless to say this company has been the poster child for rapid growth and shareholder returns. Today its a huge conglomerate which still generates most of its revenue from refining. Given the size it might be hard for the company to grow like it did the in the past. This also makes it a challenge for me to do justice to this massive company in one little piece. The company claims they want to be a top 10 player in the hydrocarbons space and I think they will achieve that given the history of business execution excellence. Given that buffet is holding Exxon Mobil stock the refiners are likely to be a good long term bet as long the execution is excellent.

1. How good is the moat?

Grade B moat.
  • Scale is the biggest factor in the moat. The company is the largest private sector refiner in India. India is likely to require massive refining capacity and the plastics consumption in India is likely to go up rapidly.
  • Exports are a large part of the moat - largest exporter in India. 64% of the revenue comes from exports. Going to 116 countries. 89% are petroleum products and balance 11% are petrochemicals. 
  • Refining margins are driven by the crack spread which is driven by refining capacity globally. This is the part where the moat looks weak as most refining companies cannot control their margins because of the product being a commodity.
  • Performance during recessions - The demand for its petrochemicals and petroleum products is fairly inelastic but in the global market the spreads might be thinner. 

2. Risks

  • Overcapacity in the refining space may put pressure on the margins
  • Given the fall in the rupee I would have expected Dec 2013 margins to be significantly higher as the import side is hedged by increases in prices to the Indian market and the export margins should be higher. Financials show only a small increase.
  • Increased capital expenditure leading to no growth in earnings - in FY 2010 revenue was almost half and the profits were higher! My concern is that the higher capital investments and revenue are not leading to higher profits.
  • Lots of cash on the balance sheet is invested in various instruments. These may or not not be good investments. This entire cash and investments portfolio is funded by debt.
  • Retail and telecom businesses are being invested in - businesses that the company has little experience in.
  • Upstream assets are limited for crude and downstream sales stations are missing due to subsidized gas sales by government companies.

3. Financials

  • FX exposure - despite the massive export of refined products from imported crude the company is a net importer. These import costs I suppose are passed on to the customers.
  • Returns are worse off than BP or Exxon - and both those companies trade significantly cheaper than Reliance. Also reliance financials are stated in a currency that has 8% inflation - after this adjustment the returns are dangerously low at the moment.
  • Margins also concern me - as the net margin of BP and Exxon are significantly more than Reliance.
  • Cash flow from operations is actually higher than net income, which is a first.
  • Company claims to be net debt free after offsetting cash and current investments against debt. This is probably being done to remain liquid in order to execute rapid investments once the opportunity arises.
  • Focus on returns on capital is not very high - the company talks about shareholder returns more than returns on capital employed.
  • There are 35K Crores of assets in the "Other" Category where the return on capital is around 1% before tax. This is 19% of the net worth of the company invested in low output assets.
  • Inventory % of sales is around 13% which is high but has been the case for years and should not be a case for too much worry. 
  • Of the 4 segments - Petrochemicals, Refining, Oil and Gas and Others - Petrochemicals as the best pretax return on capital employed - which is 14% or so.

4. Soft factors

  • Shareholding: 45% or so owned by the promoter group - rarely does the promoter group in India own less than 50% - but given the size of this company this is not much of a concern. All directors hold a good amount of shares in the company
  • Large share buyback program done by the company shows that the promoters and management believe in their investments.

5. Pricing

  • You can buy this company today for the same price as you could in July of 2007. Normally for a company with such a great track record it would be a screaming value investment. In this case however in July of 2007 the company's returns on equity with north of 15% and the margins were north of 9%. Today the margins are around 5% to 6% and the return on equity is around 11%.
  • The right price to buy this is hard to judge. The conundrum is between the stellar track record of this company and the off late not so great financial performance. Given the complexity and the risk this might not really be a value investment.
  • That said this could become the largest retailer in the country and a top 10 hydrocarbon company. Growth is imminent but the risk surrounding the company is high. Once the retail and telecom businesses stabilize this can be looked at again.
  • Bottom line: I don't understand the risk well.

References:


http://www.opec.org/opec_web/static_files_project/media/downloads/publications/WOO2012.pdf