Headwinds in core biz can lead to RIL's earnings growth decline in FY20

Headwinds in refining and petrochemical businesses can lead to earnings growth decline in FY20

Reliance Industries (RIL) has corrected over 10 per cent since May 2 high (post-March quarter results). The fall continued on Thursday, with the stock declining over 3 per cent. Even as Thursday’s move may be attributed to foreign brokerage Morgan Stanley turning ‘equal-weight’ on the stock after being ‘overweight’ for many years, the downgrade is in sync with concerns raised by analysts on RIL’s core refining and petrochemicals segment. 

Analysts at Morgan Stanley say the rising glut in the gas and polyester markets could slow growth in 2020. They expect RIL’s two-year earnings upswing to reverse, and though investors may be dismissing refining headwinds, they feel the upside appears limited as core business may drag, with no material capacity additions.

The core challenges for RIL stem from cyclical headwinds in the energy business. Refining and petrochemicals remain a major contributor for RIL. These segments contribute about 51 per cent and 22.3 per cent to gross revenues, respectively, and 30 per cent and 48 per cent to the total segmental profits, respectively, in 2018-19 (FY19), thus, proving to remain crucial to RIL’s earnings growth.

This also explains the RIL stock price correction. Weakness in gasoline cracks and contraction of light-heavy oil price differential could weigh on refining margins. Refining margins were seen at an 18-quarter low of $8.2 a barrel in the fourth quarter (Q4). The segment’s operating profit or earnings before interest, tax, depreciation and amortisation (Ebitda) was 40 per cent lower from its peak, about six quarters ago.

Rising premiums on heavy- and medium-grade crude oils due to lower availability of Venezuelan and Iranian barrels indicate that the pressure on refining business may continue. This, in turn, could suppress RIL’s 2019-20 earnings by 6 per cent and cash flows by $0.5 billion, according to analysts.

Petchem Ebitda was resilient in the past and was at a near all-time high in Q4 despite lower volumes, though margins have begun to soften. “Petrochemical margins were at a cyclical peak and are expected to go down, given the large capacity additions in ethylene and paraxylene,” says Jyoti Roy, deputy vice-president, Angel Broking.

Rising global glut in paraxylene and methylene glycol (MEG products), which are about 30 per cent of chemicals production, could also see a fall in earnings — about 3-4 per cent — say analysts at Morgan Stanley, as margins may decline below cash costs in 2020. This again is due to a glut in gas markets and can lower earnings expectations from new petcoke gasifiers by 5 per cent.

All these concerns bunched up, Morgan Stanley has reduced its earnings estimates by 17-20 per cent for RIL.  

Reports on the US Department of Commerce imposing fresh duty on polyester yarn from India could also add to the weakness in RIL counter, as RIL remains the largest global producer of polyester fibre and yarn. 

Meanwhile, analysts will be watchful on the impact of revised International Maritime Organization (IMO) regulations that would limit sulphur content of fuel, an important factor which can boost benchmark refining margins.

Abhijeet Bora of Sharekhan, though, is confident of a sharp improvement in diesel cracks after the implementation of revised IMO regulations in January 2020. He is also positive about the rising share of consumer businesses (retail and telecom) in RIL’s consolidated Ebitda, share of which has already risen from about 2 per cent in 2014-15 to 25 per cent in 2018-19. This, he says, could reduce volatility from oil-related businesses. Sustained high growth in retail and telecom businesses, along with focus on balance sheet deleveraging, could act as key triggers.

RIL’s telecom arm Jio’s momentum is seen continuing on back of its wider 4G coverage and cheaper tariffs, and analysts at Bank of America Merril Lynch expect Jio to become the No. 1 player in the next 12-18 months. 

Overall, for investors with an appetite for cyclicality in RIL’s core business could consider the stock on dips.