On Dalal Street, an unusual lack of confidence in RIL

Is it controversies, size or a lack of gumption to take oversized bets that’s causing Reliance Industries (RIL), known in the eighties and nineties for its intrepid forays, plumb two-year lows on the bourses?

RIL has faced a welter of controversies in recent times, which have been compounded by a decline in gas output from its prodigious D6 block in the Krishna-Godavari basin off the Bay of Bengal.

Investors remain in the dark, with some complaining that the company did not use recent fora — such as its annual general meeting and the annual report — to clarify matters.

A recent draft report of the Comptroller and Auditor General (CAG), which alleged RIL had inflated bills on investments made in the D6 block, makes matters worse.

Another lingering worry is a multi-year insider-trading investigation by the Securities and Exchange Board of India, the report on which is yet to be made public.

Then came the stunning, unconditional apology RIL and its senior representative made to Union home minister P Chidambaram this week following some loose talk.

But guess what, for analysts, the problem lies not in all these sideshows but at a structural and psyche level.
Sanjeev Prasad, Gundeep Singh and Tarun Lakhotia of Kotak Institutional Equities Research have come up with a contrarian thesis on the underperformance of the RIL share, which has an 11% weightage in the Sensex.

“The size and success trap,” is what’s dogging RIL, said the Kotak trio, who have a ‘reduce’ rating on the share.
“RIL may need to change its business model and approach radically to deliver returns in line with the massive returns it delivered in the 1990s,” they said in a note to clients on Tuesday. “It may be too late for RIL to enter most of these business now unless it acquires certain companies.”

Sanjay Mookim and Saurabh Mishra of Credit Suisse, who have an ‘outperform’ rating on RIL, point to the uncertainty bedevilling the company.

“Apart from the reserve downgrade, ongoing negotiations between RIL and the Director General of Hydrocarbons and a fallout of the CAG audit report, create near-term uncertainty,” Mookim and Mishra wrote on Tuesday.

The use of cash thrown up by the company will decide the future course is the refrain. But so far, the signs haven’t been judged as good. Buying a substantial stake in East India Hotels and a majority stake in the Bharti-Axa joint venture have not built confidence.

“While clarity on exploration and production can be a significant catalyst, it does not seem imminent. In the longer term, RIL’s use of its cash can be a larger stock price driver,” Mookim and Mishra said.

Prasad, Singh and Lakhotia of Kotak concur. “RIL’s ability to fruitfully use likely large gross cash flow generation over the next few years would determine its stock price in the medium term,” they said. The nibbling that RIL has done has had nothing to do with its core energy business.

“In our view, its current businesses simply do not have the capacity to propel growth beyond cycles, this is unlikely to create significant value. RIL’s consumer-centric and knowledge-based businesses face certain challenges, which it may need to overcome to create value,” the Kotak analysts said.
The reason for the company to be de-rated is its failure to meet with the market’s “admittedly lofty” expectations, according to them.

The “RIL stock has enjoyed a historically enjoyed a large growth premium associated with RIL’s ability to use cash flows and capital markets aggressively to grow at scorching rates,” Prasad, Singh and Lakhotia said.

In the past, during the late Dhirubhai Ambani’s time, audacious moves by the company often surprised the market.
RIL’s acquisition of BSES, and the failed attempt to take over engineering giant Larsen & Toubro to help the group put together mammoth projects were considered quantum leaps.
The moves these days are more measured and time-consuming, say analysts.

Corrective steps for the retail business, which led to the group pressing the pause button when the environment turned difficult, is a case in point, they said.

“It seems to us that RIL has become fairly conservative  currently compared with its ultra-aggressive approach of earlier days. We may be wrong in this assessment. In the 1980s and 1990s, RIL overcame market size, licensing and funding limitations to create dominant businesses, in fact, it identified trends admirably and created new markets,” the Kotak analysts said.

According to them, the company faces two big challenges. “Size  and success - in delivering strong shareholder returns over the next few years. A gradual improvement in chemical and refining cycles may help but the value of its chemical and refining businesses is unlikely to change dramatically from current levels. RIL may have to explore new areas to cretate value but this may require a reassessment of its organisational structure, mindset and culture.

Its success in the energy segment cannot be easily replicated in the consumer centric businesses, the analysts believe.
Perhaps, Mukesh Ambani could read their minds. At the recent annual general meeting, he told a shareholder, “We don’t do everything.  Our core business is energy and materials and the next core business we want to build is with consumers.”

While analysts such as from Kotak were not very enthused that RIL’s “incredible success” in chemicals, oil and gas and refining may have made it less focused on entering consumer centric or knowledge based sectors, what they called the “success trap.” “It remains to be seen if RIL can create meaningful businesses in knowledge based and or consumer centric businesses,”
Chairman Mukesh Ambani tried to allay those fears at the AGM. “We have developed - and are developing — capabilities and competencies in both our retail and broadband businesses which will really enhance the quality of life. These are the two things that we are focusing on.” Clearly, the jury is out on that one.