Analysts pare Reliance Industries estimates after Q4 show

Stung by lower-than-expected fourth quarter profits from Reliance Industries (RIL), analysts have cut their future earnings estimates for the company. On Friday, RIL had reported a net profit of Rs 4,710 crore, lower than consensus expectations by around Rs 300 crore, even as revenues doubled thanks to the merger of its former refining subsidiary.

“To factor in higher depletion charges, lower production estimate for KG-D6 and revised dollar-rupee estimates, we are reducing our EPS (per share profit) forecasts to Rs 71.3 (from Rs 77.3) for FY 2010-11 and Rs 88.1 (from Rs 98.4) for FY 2011-12,” analysts Ballabh Modani and Parikshit Shah of Enam Securities wrote in a note to clients.

Macquarie Equities Research, too, cut earnings target for the current fiscal by 11% and for the next fiscal by 7% “given lower FY10 actuals”.

The two factors that have caught the street by surprise seem to be the lower profits from the oil and gas business and the slower-than-expected recovery in the profitability of the refining business, which accounts for around 80% of RIL’s revenues.

Contrary to the practice among companies such as ONGC and Cairn Energy, RIL accounts for all exploration expenses on its balance sheet, instead of its profit and loss accounts. While ONGC and others report lower quarterly profit when exploration efforts turn futile, RIL does not, as the expenses are passed on to its balance sheet. It is thus able to post higher immediate profits than it would have been able to, if it was paying for the exploration efforts from its revenue accounts.

But analysts are seeing the other side of the coin now, when RIL has started producing gas in the earnest. With production in full phase and hardly any reserves being added, the company is writing back the pent up exploration expenses from many of its old blocks to the strong cash-flow from KG-D6 gas in the form of high depreciation costs.

Therefore, even as the KG-D6 added brand new, incremental pre-depreciation profits (Ebidta) of around Rs 3,300 crore during the quarter, most of it was sucked up by an increase of more than Rs 2,000 crore in depreciation, taking the total depreciation to Rs 3,390 crore during the last quarter. The trend is likely to continue until RIL adds new reserves that can absorb part of the exploration
expenses.

“With the commencement of production from KG-D6, the depletion charge will now rise sharply. So what is now getting included in the depletion charge is not just the cost of developing the entire KG-D6 block, but also the spending on other E&P blocks in the country,” noted another recent report on the company.

“Even after considering the enhanced depletion rate, the lifting costs for the KG-D6 block appear unusually high. RIL’s management has not disclosed specific lifting cost numbers and we assume these costs will fall in FY11 and beyond,” the report added. The other area where analysts have been caught by surprise is the slow recovery in refining, which contributed Rs 52,000 crore out of Rs 60,000 crore overall revenues of RIL. This too, they expect, will only look up in the coming quarters.

“Gross refining margins at US$7.5 [per barrel] disappoint... Premium to Singapore margins narrowed to $2.5, the lowest level in several years,” rued Citibank analysts Rahul Singh, Saurabh Handa and Garima Mishra. “Though this could be partly on account of the sales tax benefit being exhausted (on domestic sales) in Q4, it was still disappointing esp. given strong gasoline spreads and slight widening of Light Heavy crude spread,” they added, forecasting an average margin of $8.6 in FY-11 and $9.5 in FY12.

Macquarie analysts Jal Irani and Abhishek Agarwal too held out hope for a turnaround in the coming months “Management confirmed our view that a sustainable margin revival has commenced as 1.4 million barrels per day refining capacities (equivalent to RIL’s total capacity) have permanently shut in the West during the downturn, while Asian demand surged.

The company expects a fall in global crude oil surpluses from 9% currently to 4% by 2012E to revive light-heavy crude price differentials from near-zero levels currently,” they pointed out.
Macquarie, which lowered profit estimates, did not revise its share price target, pointing out that the recent shale gas
acquisition was “value accretive”.