Why Reliance Industries has stopped bingeing on debt

It does look like the next generation of Ambanis will be dealing with a lot less debt. “We have a very clear road map to becoming a zero-net-debt company within the next 18 months, that is by 31 March 2021," Ambani said in RIL’s annual general meeting (AGM) last month. He also suggested capital expenditure will begin to fall substantially. The company has made investments worth ₹5.4 trillion in the past five years.

Such an extreme shift in strategy has led to some concern that the ₹6.23-trillion oil-to-retail conglomerate is hedging its bets ahead of an impending slowdown. But as Sanjeev Prasad, MD and co-head, institutional equities at Kotak Securities Ltd, says, “It does not make sense to link RIL’s recent asset sales and divestments to some sort of preparedness for any impending slowdown; these moves by the company are far more long-term in nature than any slowdown."

So, what gives? Ambani’s AGM speech appears to be targeted at investors and lenders who had raised questions about the scale of the company’s debt. In fact, RIL’s statements almost amount to guidance on its debt, something it has been loath to do in the past. This was accompanied by the announcement of a mega deal with Saudi Aramco, to sell a 20% stake in its refining and petrochemical business for about $15 billion.

“Such clear communication and its openness to induct strategic partners in retail and telecom and monetize real estate suggests that the company wants to allay concerns that had crept up in recent times among some investors, lenders and perhaps rating agencies about its leverage, and also to address the ambiguity around its debt numbers," says Somshankar Sinha, head of India equity research, Jefferies India Pvt. Ltd. RIL did not respond to an email questionnaire sent by Mint.

The flip side of debt

Between 1 May and 9 August, in the run-up to the AGM, RIL shares had fallen 16.6% to ₹1,162.1, far higher than the 5.4% fall in the Nifty 50 index. The shares of RIL closed at ₹1,198.60 NSE on Thursday. The primary concern among shareholders was the company’s rising debt. As chart 1 shows, debt has helped amplify RIL’s returns to shareholders in the past. But debt levels appeared to have reached a tipping point, where the law of diminishing returns came into play.

The concerns got compounded when some analysts came out with their own estimates of RIL’s indebtedness, which were far higher than reported numbers. There is a difference between RIL’s reported net debt ($21.6 billion or ₹1.54 trillion) and analysts’ estimates of its debt because the latter add some other liabilities such as dues from vendors, while the company leaves them out on the basis that these aren’t interest-bearing loans. Analysts, however, believe that unusually long credit periods imply some sort of structured financing deal, where the interest costs may not be apparent.

A little ahead of the AGM, analysts at Credit Suisse Securities (India) Pvt. Ltd had added other measures such as advances from customers and a portion of credit from crude suppliers, and came up with a vastly higher net liabilities figure of $65 billion as on March 2019. The broker has since toned down its estimate of RIL’s debt considerably. But even after the AGM, many analysts like Jefferies India are still working with an estimate of about $35 billion.

According to calculations by Moody’s, RIL’s adjusted net debt to Ebitda (earnings before interest, tax, depreciation and amortization) ratio had reached 3.2 times in FY19, although the asset sale announcements at the AGM will result in a fall in the ratio to around two times. Among the credit metrics tracked by the rating agency to assess downward rating pressure on RIL are an increase in the adjusted net debt to Ebitda ratio to over three times. A fall in the ratio to below two times would be a factor that would aid a rating upgrade.

Since there were vastly different estimates of debt floating around, and with concerns around it also leading to an underperformance in RIL shares, it became imperative to quell these doubts.

Blame it on Jio

Between FY01 and FY14, RIL’s net debt has hovered largely in the band of ₹10,000 crore and ₹50,000 crore, numbers collated by Jefferies show. In the past five years, the debt has risen exponentially, thanks largely to the company’s huge investments in telecom arm, Reliance Jio Infocomm Ltd. In FY19, just before the company transferred liabilities worth ₹1.1 trillion to two separate infrastructure investment trusts (InvITs), its net liabilities had risen to ₹3.63 trillion. Of this, Jio’s net liabilities stood at about ₹2.1 trillion before the hive-off of the tower and fibre infrastructure businesses.

This not only caused a spike in leverage ratios such as net debt to Ebitda, but also a surge in interest costs. Five years ago, RIL’s interest costs, including capitalized expenses, amounted to 16% of the company’s Ebitda; they have now risen to 32%. Of course, the debt also fuelled large investments and growth at Jio. After years of underperformance, RIL shares have jumped about 130% since the time the company announced it will charge subscribers for its Jio mobile broadband services in February 2017.

In less than three years of its launch, Jio has attained clear market leadership in terms of revenue market share. Jio’s return on its massive capital employed, however, has been abysmal. In FY19, the telco arm reported earnings before interest and tax (Ebit) of ₹8,700 crore, which translated into a return of capital employed of only around 3.2%. Earlier this year, Hong Kong-based analysts of Sanford C. Bernstein & Co. ruffled some feathers when they said Jio may report losses of as much as $2.1 billion in FY19, if certain adjustments are made to the profit and loss account. The adjustments they highlighted were for non-standard depreciation metrics in the company’s accounting, and handset subsidies provided to Jio customers, which were parked in another group firm. As a result, these costs were understated, according to the broker.

But just like the calculation of RIL’s net debt, Jio’s net profit calculation is an area where there is much disagreement between the company and some analysts. To keep things simple, some analysts follow a fairly simple yardstick to assess Jio’s operating performance, which is to check the company’s cash flows. After all, cash is king. As it turns out, Reliance Jio’s annual report shows that it burnt cash worth ₹46,000 crore and ₹41,000 crore, respectively, in the last two fiscal years. Jio’s capital expenditure in FY19 stood at ₹67,000 crore. No wonder its own debt and that of its parent has kept rising.

The good news, of course, is that the company has said it is nearing the end of its largest capital expenditure cycle. But since there is often a slip between the cup and the lip, it remains to be seen to what extent Jio’s capex and leverage comes down.

The InvITs gambit

A large part of Jio’s liabilities has been transferred to two InvITs, which will be managed independently. The company has already found one investor in Brookfield Infrastructure, while the search is on for more investors, as well as tenants for these infrastructure assets. But since the infrastructure is no longer being housed within the company, Jio will now be paying lease rentals to these hived-off infrastructure units.

This means that operating expenses, in the form of lease rentals, would rise. In fact, analysts feel this may almost be in the same proportion as the extent of savings from the reduction in finance costs related to the liabilities that were hived off.

“Value accretion from the InVIT structure will depend on non-Jio external revenues for the special purpose vehicles (SPVs). Creation of SPVs and InVITs does not create value by itself," analysts at Kotak Institutional Equities wrote in a note on Jio’s FY19 earnings. While RIL remains optimistic about finding external tenants for its tower and fibre infrastructure, some analysts are sceptical. In the tower business, for example, having Bharti Airtel Ltd or Vodafone Idea Ltd as clients would mean the two competitors will be effectively subsidising Reliance Jio, which can then in turn hurt them more in the mainstay telecom business.

What’s more, Jio still spent ₹8,500 on capex in the June quarter, even after carving out the capital intensive infrastructure arms. All eyes will now be on RIL’s second-quarter results announcement, to see whether capex is indeed being wound down, as was suggested in the AGM.

Then there is the mystery around Jio’s 5G plans. As things stand, the government is still expecting a fortune from spectrum auctions in this band, and a bid by Jio will mean capex stays high for some more time to come. It also remains to be seen how Reliance Retail Ltd’s online-to-offline plans affect the group’s capex.

But if capex indeed reduces, and with Jio expected to reach its stated 500 million subscriber target in 2021, the company could well start generating higher cash flows going forward. Of course, other revenue streams such as fixed line broadband are yet to come into play, and these will begin to accrue at a time when capex intensity is expected to reduce. But Jio and RIL’s massive valuations appear to capture some of these upsides already.

The bigger picture

Over the past few years, RIL has increased exposure to the retail, consumption part of the domestic economy, while reducing exposure to the wholesale part of the business. The stake sale to Aramco is part of the bigger picture. “This is essentially a move to reduce exposure to the firm’s old businesses and increase focus on new and future-proof businesses such as digital solutions and organized retail. There seems to be a realization that with the move towards electric vehicles, the demand for oil could see a structural decline in the long-term," says Prasad.

It’s also interesting to note that in the businesses that the company has sold stakes in so far, such as shale, refining and petrochemicals, much of the exposure pertains to overseas markets. “RIL’s moves can also be seen as an enhanced bet on the domestic economy, vis-à-vis overseas markets," says Sinha of Jefferies.

Without doubt, the Aramco deal and other deleveraging steps will free up enormous resources for RIL. In the AGM, Ambani also talked of bringing in strategic and financial investors in Reliance Jio and Reliance Retail. As far as the initial public offerings of these units go, the company has set a time-frame of up to five years, which came as a bit of a surprise, since reports had suggested an earlier listing.

Of course, since RIL has often used a “high debt, high cash" strategy, it may well retain some of its debt and also maintain high cash levels to keep its investment options open.