Kotak’s ‘Buy’ for Reliance offers oil business on a platter

Kotak Securities was one of the few broking firms that for long had a cautious view on Reliance Industries. However, after the recent sharp fall in the stock, the broking firm has upgraded the stock to ‘Buy’ from its earlier upgrade of ‘Add’ on July 25, 2011. Price of Reliance on July 25 was in the range of Rs 880. At 1.30 p.m. on Tuesday, the stock was trading at Rs 785, higher by nearly 4 percent over Monday’s close.

Kotak has a target price of Rs 1,045 for the scrip. The rationale given for the upgrade is the valuation has become attractive as at the current price, the market is not ascribing any value to the exploration and production business (E&P) business. In other words, at the current price of Reliance, its oil and gas business is available for free.

Even without the E&P business, Kotak values the company at Rs 856 per share, which includes refining and petrochem business at Rs 612 per share and cash and investments at Rs 244 per share.

Kotak gives a valuation of $17 billion for the E&P business, much lower than the $24 billion accorded by British Petroleum (BP) in a recent deal between the two. The report mentions that there will be few positive surprises from the E&P business which will continue to produce between 45-47 million cubic metres per day (mcm/day). The company does not have any deep water drilling rigs at its disposal, which also hints at limited upside.

The report, however, warns that the re-rating will depend on better corporate governance and prudent use of cash. According to the report, the recent fall in the stock reflects investor concerns, tough operating conditions for the company’s refining and chemicals business, limited visibility of its E&P business, potential negative implications from a CAG report and lack of clarity on the usage of its huge bounty of cash.

Interestingly, unlike other research reports, Kotak has gone one step ahead and suggested that Reliance should either increase its dividend payout or buy back its shares as a way to shore up investment sentiment in the stock. The overhang of treasury shares in the books of Reliance can be cancelled (extinguished), which will help bolster the company’s earning per share (EPS) by 9.8 percent. Reliance Industries holds its own shares, which it has been selling over the last two years. It is this overhang which is believed to be one of the biggest reasons for the fall in its share price. A company can cancel its own shares held in its treasury— as in the case of buyback of shares — thus reducing the share capital and increasing the EPS.

The report further goes on to suggest that it would augur well for Reliance if it can simplify its organisational structure by merging several investment subsidiaries, merging entities of major shareholders in the same line of business and reducing the number of subsidiaries.

Thus, what the report essentially attempts to tell you is that more than its various businesses, it is corporate governance that can help in improving the share price.

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