Big Trouble

It was billed as the biggest merger in India's corporate history. It created a conglomerate that became the country's first private sector entity to find its way into the prestigious Fortune Global 500 list. But big is not necessarily better. At least that's what the capital markets thought about this merger between Reliance Industries (RIL) and its sister concern, Reliance Petroleum (RPL). Ever since the decision was announced this March, the bears thronged the ring hoping to make another killing on the exchange.

In the past seven and a half months, the RIL stock has plummeted by over 20 per cent. In fact, in a space of just five days (September 30-October 4), the scrip lost nearly 9 per cent in market capitalisation. The story was repeated in the case of RPL, which too shed over 8 per cent the same week. (Trading in the RPL scrip was stopped on October 10 as part of the merger process.) The biggest sellers included both domestic and foreign institutional investors. And several investment analysts kept airing more bad news saying the RIL scrip could go down further in the near future.

So, why do the markets hate the new, bigger RIL? Especially since size is the name of the game in the global energy sector, which has witnessed a merger mania to create oil giants like ExxonMobil and BP-Amoco. To begin with, there's a difference between the two. While the global mergers were in the same areas of exploration and refining, the RIL-RPL one results in a company that is present in several diverse businesses: refining (58 per cent of the turnover), petrochemicals (40 per cent), exploration (1 per cent) and textiles (less than 1 per cent).

Institutional investors are generally wary of conglomerates and tend to invest in firms that are focused or concentrate on key core segments. In RIL's case, there are rumours that the group's telecom and infocom assets, now under Reliance Infocomm, may be merged with it. In that case, the stock may further lose its sheen among investors. Explains a Mumbai-based investment banker, "We go for companies whose businesses can be understood in a transparent and clear fashion. The merger has reduced the attractiveness of RIL as a pure chemicals play."

Another cause for discomfort is the realisation that RIL, post-merger, has to pay higher taxes and provide for higher depreciation, both of which are likely to depress its net profits. This is evident from its first merged balance sheet (2001-02), which incidentally was disclosed on September 30, the beginning of the week that saw selling pressure in the RIL and RPL counters. The company provided a whopping Rs 996 crore for deferred tax, compared to its actual tax burden of Rs 190 crore. And its depreciation of over Rs 2,800 crore was higher than individual figures for each of the two merged firms.

Deferred tax is an indicator that RIL's burden is likely to increase in 2002-03. This August, a report by Kotak Securities hinted at this although it added a caveat that even if it doesn't happen, the company "will have to (continue to) provide for (even higher) deferred taxation which will impact earnings to the same extent, if not cash flows". The reason: the group's traditional tax shields are no longer available due to recent legal changes. The only possible way this could change is if the telecom and infocom assets are merged with RIL, which will enable it to claim higher depreciation and, thus, lower tax incidence.

However, the company's management maintains it will continue to enjoy the benefits of concessional taxation. Given the complexity of Indian tax laws, one is not sure how this will happen and investors would rather wait for RIL to announce the results for the next couple of quarters to gauge the impact. Anyway, as K.R. Choksey, chairman, K.R. Choksey Shares and Securities, says, "The provision for (deferred) taxes and depreciation does not lead to immediate cash outgo. Thus, it will not affect the company's performance. In addition, its fundamentals remain unchanged."

There seems to be some agreement on what Choksey is trying to say about the fact that the money remains with the company, although its net profits get reduced in the p&l account. But not every investor is so sure about the fundamentals. For instance, pressures are building up in RIL's petrochemicals business with a slump in demand due to domestic and global slowdown, price cuts and a possible cut in import tariffs.

Here are a few indicators. Reports say that inventory levels of all petrochem companies went up during the April-September period this year. That's why RIL announced price cuts for several polymer products: Rs 2 per kg in the case of polyethylene and polypropylene and Rs 3 per kg for polyvinyl chloride. It did raise the prices of a couple of other products (like purified terephthalic acid) but these were minor. Global polymer prices too have slipped by $20 to $30 per tonne on an average, after a substantial reduction in Chinese demand.

The good news is that polymer prices are likely to go up a bit, now that there are no major capacities being added worldwide. But that could be negated if the Indian government decides to dramatically reduce import duties on these products. The petrochem business sensitivity to lower duties is established by several analysts' reports that contend that a 5 percentage point cut can depress RIL's net profits by nearly Rs 300 crore in 2003-04 and a further reduction could impact it negatively by another Rs 600 crore.

A few problems exist in the refining business too. For one, the margins are under pressure and two, RIL has not been able to set up a distribution network of its own. Although the company has the approval for 6,000 retail outlets across the country, it sells its products through a marketing arrangement (which lapses in April 2004) with the government-owned Indian Oil Corporation. The problem is compounded because Reliance may not want to invest huge sums in this area until the proposed disinvestment of PSUs like HPCL and BPCL is over.

RIL's first priority will be to acquire either hpcl or bpcl, which together account for a 50 per cent marketshare in key retail diesel and petrol markets. "Such a move would have benefited RIL as setting up a new distribution base is time-consuming and costlier," explains Ashit Kothari, an analyst with ask Raymond James. But since the privatisation of both these PSUs has been delayed, Reliance is caught in a trap: it can neither invest in new retail assets, nor can it wait endlessly for the PSUs to be hived off.

However, some experts think that RIL has no option but to wait for the privatisation of oil PSUs. Simply because it will not risk investing in new retail assets. If true, when (and if) the two PSUs are put on the block, RIL will have to bid aggressively (and risk paying too much) for these PSUs or risk losing them. This could result in lower returns and depressed cash flows in the near future. The same can happen with the group's ambitious investments in biotech, telecom and power. The telecom/infocom forays itself would require a massive Rs 25,000 crore. RIL, which has a 45 per cent stake in Reliance Infocomm, will not earn anything in the near future from this venture as it is not likely to break even soon.

"With Reliance making huge investments in areas where technology becomes obsolete fast, there are some concerns as to when the company will start generating returns. The investment in the infocom project is expected to be staggered over five to seven years," feels Hrishi Modi, senior investment analyst, ask Raymond James.Moreover, Reliance is likely to face stiff competition in this sector from rivals like Bharti Telecom and the now-Tatas-owned Videsh Sanchar Nigam Ltd.

Old Reliance watchers shrug off all these concerns. For them, the Ambanis invariably have a way of bouncing back when everyone's written them off. It can happen this time too. Therefore, despite major apprehensions and fears, investment bankers are still gung ho on the scrip in the long term. Most of them feel that the bear hammering is merely to earn short-term profits. And the scrip price could rise to over Rs 350 over the next 12 months. Well, when it comes to the Ambanis, anything's possible. Even a bear could change into a bull.