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Reliance: Can they make it work?

May 22, 2002

The acquisition of IPCL by Reliance seems to have got the street talking on the economic rationale backing the bid. Based on replacement cost, we believe the group has paid a sizable premium. However, valuations, like beauty, is a subjective issue and lies in the beholder's eyes.

      Cost savings: Will they save the day
Net fixed asset turnover 1.7 0.8 2.1
Working capital to sales 16.3% 23.2% 0.7
Inventory holding period 36.0 55.0 0.7
Avg. debtor days 13.0 23.0 0.6
Revenue/employee (Rs m) 22.9 3.6 6.3
Profit/employee (Rs m) 2.4 0.2 13.2
Interest cover 3.8 2.1 1.8
No. of employees* 11,083 13,731 0.8

One theory could be that fair price of an asset is what the market is willing to pay for it. The theory to a certain extent incorporates the bigger fool concept. However, the level of imprudence depends on the assumptions that have been implicitly or explicitly incorporated into the acquisition price. Workability of the assumptions is the acid test, which will decide on the rationality of the bid. As an outsider, one is not privy to the assumptions or considerations incorporated into the bid price of Reliance group. As mentioned above a lot will depend on making those assumptions work.

Reliance bid of Rs 231/ share is at a premium of Rs 79/ share to our estimated fair value based on replacement cost. On an aggregate basis, Reliance is likely to shell out Rs 26.4 bn, which is ahead by Rs 9.1 bn to our fair price. The assumptions are likely to have justified the excess investment, which the group should recover if all pans out as per plan. One of the possible streams for higher earnings is cost savings. Also, any positive surprise in the petrochemical cycle will further justify the bid price.

Despite the company making a few blockbuster announcements in the past three months the stock performance has been languishing. In March '02, the company announced the merger of subsidiary Reliance Petroleum (RPL) with itself. The group has now emerged the winner for IPCL. Also, the petrochemical cycle is expected to be on an upswing leading to better earnings.

Going forward, the merged entity is likely to undergo a phase of capital intensive projects. These include exploration & production activities, building of petro retail outlets, participating in the privatisation of HPCL and/or BPCL and execution of infocom project. Consequently, the project and investment risk has increased, which could have dampened stock performance. Also, with the aggressive bid price for IPCL, concerns arise on bidding for bigger jewels, which are likely to involve larger stakes. Having said that, the group enjoys strong financials and new investments are not likely to stretch leverage ratios. Barring any adverse developments on the border, the scrip is trading on an attractive multiple of 8x based on our FY03E earnings.

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