A strategic fit for RIL’s cash deployment plans

RIL has announced the acquisition of 40% stake in US-based Atlas Energy’s core Marcellus Shale acreage of 300,000 acres for $1.7 billion-$340 million upfront and $1.36 billion as drilling carry. The acreage has net resource potential of 13.3tcf (5.3tcf net to RIL). At $14.2K/acre ($11.8K/acre adjusted for time value), the acquisition cost compares favourably with recent transactions (APC/Mitsui JV at $13.2K/acre) especially given the option to acquire additional acreage at lower cost ($8K).

RIL’s share of capex and acquisition cost is ~$5.1 billion (~$5.3/boe). This compares favourably with KG-D6 F&D cost of ~$4.6/boe, especially given the favourable terms of the shale gas acreage (13% royalty). Based on the development plan, we estimate net value accretion of $2.8-4.9 billion for RIL at $5-6 gas price, with the option on additional acreage opening up potential upsides in future. Breakeven gas px is $3.7 (IRR=10%) and gas px of $5.0 yields a 38% IRR.

In addition, RIL can acquire Atlas’s Appalachian acreage (280,000 acres) at $8K/acre if the latter decides to sell (Atlas has overall ~580,000 net acres in Marcellus). It also has the option on 40% in any new acreage that Atlas acquires in Marcellus (potentially 150-200,000). RIL indicated that gross long-term acreage target in Marcellus may be 800-1,000,000.

Marcellus Shale is believed to hold a huge amount of gas (260 tcf) and is one of the most economic shale plays in the US. Though NPV accretion for RIL is modest at this stage, it can expand over time and this E&P acquisition is a better strategic fit compared to other options which were explored recently, in our view. It gives RIL access to technology in an area that is seeing the natural gas market go through an unprecedented transformation. In addition, since shale gas wells have lower risk, this fits well with RIL’s search for cash deployment avenues over an extended period of time. The deal is expected to close by the end of the month.

We rate RIL as Buy/Low Risk (1L) with a target price of Rs 1,100. We believe that higher refining utilisation and greater leverage to a recovery in distillate cracks should benefit RIL over FY11-12. Further, its E&P business looks set to become significant in the next 2-3 years as new discoveries over the next few months are crucial. Given the track record of past exploration success and the evolving portfolio (much beyond KG-D6), we value RIL’s E&P business as a going concern and accord it a value of Rs 444/share on P/E multiples, at a 42% premium to NAV of known reserves. Petchem margins have been robust, and could improve further on sustained global economic recovery. Our Buy rating is premised on present valuations leaving risk-reward favourable.

Valuation: Our target price of Rs 1,100 is based on an average of a sum-of-the-parts value (Rs 1,005/share) and a P/E value (Rs 1,202/share). Our SOTP is derived by: 1) Valuing RIL’s core petrochem and downstream oil business (now merged with RPL) on an EV/EBITDA of 7.0x FY11E, in line with regional chemicals and refining peers; this also captures the expected recovery in global refining; 2) Valuing total E&P assets, including oil & gas prospects and other blocks at Rs 444/share based on 12x FY11E P/E multiple; 3) Valuing investments in the organised retail business, SEZ, etc., at Rs 44/share, based on book value of investments so far; and 4) Valuing treasury stock (post stock sale) at target price. For the P/E valuation, we ascribe a 15x FY11E multiple, in line with the market multiple. We believe RPL and KG gas commencement will lead to the market now focusing on FY11 earnings (which capture the impact of both), prompting us to give equal weightage to a multiple-based methodology as well as an SOTP while deducing our target price.

Risks: We rate RIL Low Risk, as opposed to the High Risk rating suggested by our quantitative risk-rating system, as diversified earnings and significant value contribution from the emerging E&P business partly mitigate the impact of the global slowdown on the cyclical components of its business, while commencement of the new refinery and KG gas production limit execution risks. Downside risks to our target price are: RIL’s margins are exposed to the global petrochemical and refining cycles; delays in the ramp up of production of KG-D6 gas; negative outcome on the KG gas dispute; delays in drilling plans and/or negative news-flow for the new blocks (D9, D3, MN-D4); and the organised retail business would call for significant investment in non-core areas.

Source: Financial Express

__________________________________________________________________________________