DSP Merrill Lynch: RPL and E&P evaluation of RILs options

RPL may be merged with RIL eventually; Switch RPL to RIL Reliance Industries (RIL) recently sold a 4% stake in Reliance Petroleum (RPL) taking it down to 71%. Chevron, which holds 5% RPLstake, has option to raise it by 24% by buying from RIL. RIL’s stake in RPL would fall to 47% (below majority) in that case. This is one more reason Chevron hiking stake in RPL appears unlikely. It is likely to exit RPL by July 2009 as per the other option it has. Post Chevron exit RPL is likely to be merged with RIL like its other subsidiaries in the past. We view RIL more favorably than RPL. We reiterate switch to RIL from RPL

RIL-RPL merger if soon done would not be earnings accretive for RIL if RIL’s stake in RPL of 71% is not cancelled. In most other mergers RIL stake has not been cancelled creating treasury shares. Our calculation is based on swap ratio based on market price (12:1) and fair value (20:1). The downside to RIL’s FY09-FY10E earnings in the two scenarios is 6-14%. Downside to fair value is 2-4%.

Merger likely by July 2009; merger then may be accretive Chevron has to decide whether to hike stake in RPL or exit by July 2009. RIL-RPL merger is likely only after Chevron’s exit. RIL’s fair value is likely to rise further by 2009 driven by E&P, retail and SEZ. RPL’s share price may however decline as refining downturn nears. Swap ratio may then be earnings and value accretive.

E&P demerger unlikely as it would not be accretive RIL’s E&P business being demerged is expected by some. We think it is unlikely as it would not be earnings and value accretive. This is because if demerged, income tax outgo would be more as minimum alternate tax (MAT) has to be paid.

RIL’s options on RPL investment Chevron stake hike in RPL appears unlikely RIL’s sold 4% stake in RPL; its stake down to 71% from 75% RPL was formed by RIL in end-2005. RIL held 75% equity stake in RIL after its IPO in April 2006. International oil major Chevron also holds 5% equity stake in RPL with balance 20% being with minority shareholders. In November 2007 RIL sold 4.01% of its equity stake in RPL in the Indian stock exchanges on which it was listed. Following this sale RIL’s stake in RPL has declined to 71% and minority shareholding is up to 24%. Chevron continues to hold 5% stake in RPL.

Chevron has option to buy 24% stake in RPL from RIL Stake hike if RPL-Chevron crude supply & product offtake agreement Chevron has an option to hike its stake in RPL to 29% by buying 24% stake from RIL. Chevron’s raising stake in RPL is dependant on whether Chevron and RPL sign

  • 10-year crude supply agreement for up to 35% of spot crude purchases by RPL
  • 10-year product offtake agreement for up to 45% of RPL’s product slate

Stake hike decision by July 2009 if refinery commissioned as scheduled Chevron can hike its stake in RPL from 5% to 29% 39 months (three years and three months) after it took its 5% stake, i.e. by July 2009. Technically it could be a later date, as the other reference point is three months after the refinery has operated at 80% for 30 days. Thus, if RPL achieves this utilization rate only after April 2009, Chevron could hike its stake within three months thereof.

RIL’s stake would decline to 47% if Chevron hikes stake RIL’s stake in RPL would decline to 47% from 71% if Chevron buys 24% RIL’s stake in RPL woul decline from the current 71% to 47% if Chevron does exercise the stake hike option. This would mean RIL would stop holding majority stake in RPL in that event.

Probability of Chevron stake hike in RPL appears low It appears that the probability of Chevron hiking stake in RPL is low. This impression is due to the following factors

24% stake hike would cost Chevron US$6bn (cost of RPL refinery): Chevron has to buy 24% stake in RPL from RIL at 5% discount to market price if it exercises option to hike stake in RPL to 29%. It would cost Chevron almost US$6bn at current market price of RPL to hike stake therein. Cost of RPL refinery is US$6bn. Thus Chevron would be spending the cost of the entire refinery to get just 24% additional equity stake therein. This appears unlikely.

RIL’s stake sale in RPL suggests Chevron’s stake hike in unlikely: If RIL still had 75% stake in RPL, its stake in RPL would have been 51% even if Chevron exercised 24% stake hike option. However now its stake in RPL is down to 71%. Chevron hiking stake by 24% in RPL would take RIL’s stake in RPL to 47% (ie below majority). It therefore means that either RIL does not mind not holding majority stake in RPL or RIL believes probability of Chevron hiking stake in RPL is low. We think the latter is more likely.

RPL appears confident of sourcing crude & product sale on its own: RPL appears confident of sourcing crude and selling products even in the US on its own. RIL’s existing refinery has been sourcing crude efficiently. In fact it is one of the main factors enabling it to consistently achieve far higher margins than benchmark Singapore margins. RIL also exports a large
proportion of its production having converted its existing refinery in to export oriented refinery. RIL management also confirmed at recent analyst meet they are confident of marketing RPL’s products in US on their own.

Chevron’s stake will go to 0% if it does not rise to 29% Chevron to disinvest if no crude supply & product offtake agreement Chevron has no intention of retaining its 5% stake in RPL if the crude supply and product offtake agreements are not signed. Chevron will sell its 5% stake in RPL back to RIL if the crude supply and product offtake agreements are not signed by

  • July 2009 if the refinery has operated at 80% for 30 days before April 2009
  • Three months after the refinery has operated at 80% for 30 days if this date is later than April 2009
  • Chevron will sell back its stake to RIL even if the refinery is not commissioned by December 2009.

RIL’s options if Chevron exits RPL Chevron may thus not exercise option to hike stake in RPL and in fact may exit RPL. RIL in that case has several options on what it can do with its refining subsidiary RPL. The options it has in our view are

  • Merge RPL with RIL
  • Demerge its existing refinery and merge it with RPL, Keep RPL as a subsidiary

Merger of RPL with RIL most likely option in our view All subsidiaries of RIL have been eventually merged with it Over the years all of RIL’s subsidiaries involved in refining or petrochemicals have eventually been merged with RIL. RIL’s existing refinery was in a separate company also named Reliance Petroleum (RPL). The old RPL, which started operations in FY01, was merged with RIL wef FY02. RIL acquired petrochemical company IPCL in FY03 as a part of privatization in India. IPCL was merged with RIL in FY07. Even in the past several petrochemical companies either promoted by RIL or acquired by it have eventually been merged with RIL

RPL shareholders to benefit from merger in the longer term We believe that RPL shareholders would benefit in the longer term from merger with RIL. We believe that this gain would be due to Gains from upside in E&P, retail and SEZ: RPL shareholders gaining from upsides from RIL’s E&P business after merger. We see strong value accretion in RIL’s E&P business as it explores large unexplored acreage in highly prospective areas that it has. Possibly they would even gain from upsides in RIL’s diversification in to organized retail and SEZs.

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  • Mehul Shah

    Dear Sir,

    I read your article. I am currengly holding 8000 share of RPL @62. I am long term investor.

    If you say RIL-RPL merger in this article. But If they merge than what about RPL tax benefits 100% for 5 years and 50% for next five years.

    If evaluate today than currently Gross Refinery Margins are arodun $14 which is there when the crude was around $65-$75. Today it is $100. They expect it to rise to $120 in next 1 year. Considering that the GRM would also improve marginally.

    I am not technically that sound.

    But please provide your views.

    Thank you very much.