Merrill Lynch on REL

Operating Results Disappoint; Treasury Boosts PAT

Reliance Energy’s 1QFY08 operating results were 10% below MLe at Rs1.2 billion & down 6%YoY (MLe Rs1.3 billion). Key reason for EBITDA de-growth was a mismatch in passing on the hike in costs into retail tariff. However, higher other income, at Rs 3.6 billion (+103%YoY) led by forex gains of Rs 1.9 billion, led to 64%YoY growth in Rec. PAT at Rs 2.9 billion (Mle Rs 2 billion). We maintain our Buy rating as the stock offers potential growth on privatization of the power sector & relative value - cash of Rs 286 per share (42% of share price) & 17x FY08E EPS. However, the stock may remain volatile till RNRL concludes gas supply agreement with RIL.

Tariff Uncertainty Hit 1Q

Reliance Energy’s 1QFY08 operating results were 10% below MLe at Rs 1.2 billion & down 6%YoY (MLe Rs1.3bn) despite a 41% increase in sales at Rs 16.2 billion (MLe Rs 15.2 billion). Key reason for EBITDA de-growth was a mismatch in passing on the hike in purchase costs (April 1) into retail tariff (April 24). However, higher than expected other income, at Rs 3.6 billion (+103%YoY) led by forex gains of Rs 1.9 billion, led to 64%YoY growth in Rec. PAT at Rs 2.9 billion (Mle Rs 2 billion). Reported PAT was lower at Rs 2.2 billion (+25%YoY) due to mark-to-market loss on forex derivatives.

Rosa work starts; help convert cash into power assets

Work on REL’s 1200MW project (v/s REL’s current capacity of 941MW) has started with Phase I of 600MW achieving financial closure. This project (Phase I), costing Rs 26 billion, is funded through 80:20 D/E. Project cost/MW at Rs 43 million appears unimpressive especially given that REL is using low cost Chinese equipment (Shanghai). This project is on regulated regime basis i.e. 14% RoE + incentives.

Key potential triggers ahead, in our view, are

Reliance Natural Resources concluding a gas purchase contract with RIL at competitive pricing

Start of construction of now up-rated 5600MW Dadri (UP) & other coal/Hydro power projects & expand generation/acquire distribution franchise.

Improve visibility on infra SPVs like Metro rail (Rs 22 billion) and roads (Rs 28 billion).

We maintain our Buy rating on REL based on:

Expansion in its distribution franchise & generation outside Mumbai and reduction in T&D losses at its Delhi JVs - BSES Rajdhani (29.9%); BSES Yamuna (39.1%) for FY07. Our 12-month PO of Rs 730 is based on its sum-of-parts valuation. At Rs 730, the stock implies a P/E of 17.7x and an EV/EBITDA of 13.6x (FY09E).

Price objective basis & risk

Our 12-month PO of Rs 730 is based on its sum-of-parts valuation. At Rs 730, the stock implies a P/E of 17.7x and an EV/EBITDA of 13.6x (FY09E). Risks: Ability to source quality power/viable gas supply and discontinuity/delay of power sector reforms.