RIL to start churning free cash flows as operating income rises, says JP Morgan

• JP Morgan says that the stock’s performance is linked to earnings and not free cash flows.
• The recent weakness in the stock corresponds to 21% cuts to FY24 earnings per share forecasts since June 2022.
• Recent company guidance of maintaining net debt to EBITDA less than 1x also implies positive FCF generation.
  

Mounting debt and negative free cash flows have been a drag for shares of Reliance Industries, despite the company’s record quarterly profits. While many believe that the stock will continue to underperform till it resolves this issue, JP Morgan says that the stock’s performance is linked to earnings and not FCF (free cash flows). Consensus estimates show that the earnings of RIL have been cut primarily because of a deferral in telecom tariff hikes, underperformance of the petchem division and normalisation of refining margins after the pandemic.

In its latest report, JP Morgan says that the company will generate positive free cash flows the next three years, as capital expenditure peaks and operating income is rising. The global investment bank says: “This has caught some investor attention but there is little historical correlation of RIL FCF and stock performance. There is (as should be) strong correlation of share price with earnings forecasts. The recent weakness in the stock corresponds to 21% cuts to FY24 earnings per share forecasts since June 2022. Expectations are now more realistic; telecom and retail should help drive growth in the 12 months forward number hereon, which should help the stock.”

While a section of the market is concerned about the heavy investments that RIL has been continuously making in retail and telecom businesses, JP Morgan believes that it is not FCF that is the reason behind the stock’s underperformance. For all the complexities of RIL’s conglomerate structure, the stock has closely tracked growth in earnings over the medium term. The sharp stock move post 2017 coincides with earnings growth driven by Reliance Jio (telecom) and large new petchem capacities, the global investment says in its report.

What has impacted the stock’s performance is the 12 months forward earnings estimate, which has been cut by 5% since June 2022. RIL’s FY24/25 consensus PAT forecasts have been cut 21/15% over this period, says JP Morgan. This was likely due to a correction in refining margins (from post-pandemic highs) and weaker petchem segment earnings and deferral of the anticipated telecom tariff increases.

RIL has operated at material negative FCF for the last three years, driven by spending in telecom. As capex intensity moderates and EBITDA grows, Reliance is expected to deliver positive free cash flow for the next three years. Recent company guidance of maintaining net debt to EBITDA less than 1x also implies positive FCF generation.

JP Morgan has analysed the performance of RIL’s shares and has found that the correlation to FCF generation is minimal. The conclusion is that FCF is not enough to drive the share price. In fact, the global investment bank has found that there appears to be some negative correlation between FCF and RIL stock performance.

It has argued in this report that RI’s current earnings projections have limited downside hereon. “Petchem margins are close to lows and should have limited downside; refining cracks are higher than pre-pandemic levels, but are supported by supply dislocations and tightening utilizations. RIL��s consumer businesses (Retail/ Telecom) - are now 50% of EBITDA, and can grow bottom lines at double-digit rates. This should drive RIL��s forward EPS up again - as commodity cuts end,” JP Morgan explains.

RIL’s valuations no longer build in any premiums for new businesses; but the company is spending $10bn each on new solar power / petchem capacities. Rising consumption / incomes / penetration should drive low-volatility growth at Jio/Retail.