Reliance Industries (RIL) has been a fascinating conundrum for analysts and investors alike. Between 2005 and 2008, it was the toast of the Street, rallying 10x, topping out at 1,400 a share. However, since then, for nearly half the past decade, it has significantly under-performed the broad market, while oscillating within a range of 900-1,200. This is despite the fact that the company has been reaching new landmarks in terms of profitability and scale in every single quarter. Today, it stands on the cusp of completing one of the biggest capex witnessed in corporate India with the launch of the world’s biggest start-up, Reliance Jio.
While there are little doubts on its core operations, the overhang of its massive telecom venture continues to plague investors’ minds while evaluating the stock. Has RIL finally turned a corner? Will 2017 see the big bang return of India’s biggest private enterprise? We certainly believe so. We see the stock as our top pick of 2017. Our confidence is underlined by the following three key points:
Commissioning of key oil-sensitive projects
RIL’s highly profitable core projects are nearing completion. This is at a time when oil prices are rising, which further enhances profitability of the petcoke gasification (higher GRM), off-gas cracker (higher spreads) and ethane import projects. While upcoming projects are sensitive to oil prices, empirical evidence indicates that RIL’s existing downstream business is defensive with superior profitability versus global peers owing to its greater complexity, integration to petrochemicals, advantage of crude sourcing and product placement.
Successful telecom foray
Reliance Industries (RIL) has adopted a shrewd modus operandi in its telecom venture — capturing value from internet-enabled content delivery and service platform, a la Xiaomi, Tencent etc — rather than being a me-too telecom operator. In our view, the increasing scale of users in the content aggregation business, post successful implementation, entails the potential to create a profitable franchisee with high entry barriers. Over the past decade, content aggregation has been a tremendous value creator, spawning near monopolies.
We believe RIL’s entry in the telecom space is a vehicle to deliver content and services riding the network. Our analysis of value creation in the telecom supply chain indicates that, globally, over the past decade, content aggregation has been a tremendous value creator and Jio is looking to emulate this model. The company’s focus on engaging consumers on its services platform is demonstrated by the precondition that they have to download MyJio app, a collection of Jio apps, to avail the ‘Jio Welcome Offer’.
Low internet penetration, limited data awareness and capacity advantage of the Jio network augur well for the content ecosystem business. With over 50 million subscribers in less than three months, Jio has grown faster than Facebook, Skype and Whatsapp and exceeding our March 2017 target of 40 million subscribers.
A word of caution, though. Jio will be competing against thriving and nimble startups and having an exemplary user interface (UI) and customer connect will be imperative to succeed. We have seen emergence of new business models which profit from latching consumers on an ecosystem rather than upfront sale of goods or services. A case in point is China’s Xiaomi, which sells high-end smartphones at rock-bottom prices, banking on monetising content, peripheral sales and other IoT products which can be controlled by the smartphone to create value over the entire consumer lifecycle rather than upfront sale.
In fact, RIL’s consolidated earnings is more sensitive to average revenue per user (ARPU) than subscribers — a 10% increase in ARPU leads to 6% increase in earnings per share (EPS). We are currently factoring in average APRU of 178 for FY19, assuming majority of the users (87%) subscribe to lower-priced data plan. According to Jio’s business head, the company is targeting ARPU of 300-500, which implies upside of 35-90% to FY19E EPS. We are taking the base case — estimated FY19 ARPU of 178, with subscriber base of 139 million.
Following the conclusion of ongoing mega capex, we expect free cash flow to turn positive and return on equity to improve in FY17. These two metrics are the most important for healthy shareholder returns. We expect non-regulated segments (refining, chemicals and shale) to contribute 90% of the incremental operating profits over the next few years. We are positive on both refining and chemicals business and believe refining margins in Asia will rise owing to a “paradigm shift in regional refining dynamics” from West to East, which will favour a complex refiner such as Reliance. Besides, global utilisation rates have bottomed out in chemicals.
The successful launch of Jio has reinforced our confidence at the long-term prospects of creating a mega telecom business, and that should trigger a valuation re-rating. At 1x estimated FY18 price to book, the stock trades at a near all-time low compared with the 4.2x it was quoting ahead of a similar capex completion phase during 2005-07.
Given investors’ past experience, we understand the sense of scepticism that usually accompanies the stock. However, things are certainly changing, and changing quickly. It is this small time-frame between scepticism and reality that creates large wealth creation opportunities. As Warren Buffett’s saying goes, ‘Be fearful when others are greedy and greedy when others are fearful'. It is perhaps time to get greedy about Reliance now.
The brokerage has a buy call on the stock, but the writer, in his personal capacity, does not own the stock