Citigroup is bearish on Reliance Energy and has maintained sell rating on the stock with target price of Rs 510 implying downside potential of 54%.

Stock up 118% in the past 5 months

RELE shares have rallied up 118% over the past 5 months on expectations of blue-sky scenarios through capacity additions, EPC order wins and the value of CBM blocks.

The deepest shade of blue

Even our extreme blue-sky scenario of (1) additional 25,000MW capacity in 7 years, (2) execution of EPC orders of Rs800 billion to be executed over 7 years with EBITDA margins of 15%, (3) no fuel supply risks, (4) no execution risks, (5) generous multiples for valuations, (6) and 20% premium to our existing value of RELE (ex-cash) yields only Rs1,183/share. We reiterate our Sell/Low Risk rating.

Execution risks are real

RELE has re-rated every time a project has been announced. It was expected that RELE would capitalize on the opportunities thrown up by the passing of the Electricity Act 2003 (EA03). Projects were announced from time to time, but 4 years have passed and RELE continues to have only 941MW of generation capacity and distribution licenses in Mumbai and Delhi.

Some progress but....

RELE has made strides in terms of the (1) implementation of the Rosa project, (2) winning the Sasan UMPP, (3) clearance for the 3 transmission projects, and (4) winning a real estate project in Hyderabad. But the current stock price does not appear to factor in any execution risk and at Rs1,106.50 the implicit value of net cash/share is 3.5x book value.

Reiterate Sell/Low Risk

RELE has been re-rating every time a project has been announced. It was expected that RELE would capitalize on opportunities that the passing of the Electricity Act 2003 (EA03) would throw up. Numerous projects have been announced from time to time but 4 years have passed and RELE continues to have only 941MW of generation capacity and distribution licenses in Mumbai and Delhi. The only major difference has been the substantial build-up of cash and cash equivalents and the decent ramp-up of the EPC business.

Historical execution risks of course cannot be extrapolated to the future. The company has made strides in terms of the (1) implementation of the Rosa projects, (2) winning the Sasan project, (3) getting clearance for the 3 transmission projects, and (4) winning a real estate project in Hyderabad. However, even our extreme blue-sky scenario yields a value of Rs1,183 and the stock is at Rs1,106.50 (up 118% from May 16, 2007). Further, at Rs1,106.50 the implicit value of net cash/share is 3.5x book value, which in our view completely ignores execution risks. Reiterate our Sell/Low Risk rating on the company.

Investment strategy

We rate Reliance Energy Sell/ Low Risk (3L) with a target price of Rs510. Despite huge expectations about the company’s ability to capitalize on opportunities post the passing of the Electricity Act 2003 the company continues to have only 941MW of generation capacity and distribution licenses in Mumbai and Delhi. Most of Reliance Energy’s projects have hit regulatory, land clearance or fuel supply snags. The only major difference in the past 4 years has been the substantial buildup of cash and cash equivalents and the ramp-up of the EPC business.

Even our extreme blue-sky scenario yields a value of only Rs1,183 and the stock is at Rs1106.50 (up 118% from May 16, 2007). Further, at Rs1106.50 the implicit value of net cash/share is 3.5x book value, which in our view completely ignores execution risks. We reiterate our Sell/Low Risk rating on the company. Long-term steady state earnings growth in the 13-15% range and low RoCE of 2-4% (which is the lowest in our Indian Electric Utilities Universe as a result of 74% of the assets being cash) indicate inefficient capital deployment, in our view.

Valuation

Our 12-month target price for Reliance Energy of Rs510 is based on RELE (ex net cash) value of Rs229 and net cash value of Rs281 (1.1x FY07E Net Cash/FD Share). RELE (ex net cash) would comprise Mumbai business value of Rs117, other power assets value of Rs27, EPC Business value of Rs65 and Delhi distribution value of Rs20. At our target price of Rs510, RELE (ex Delhi) would trade at a P/E multiple of 10.1x FY09E.

Risks

We rate Reliance Energy Low Risk which is different from the High Risk rating that our quantitative risk-rating system accords. Our Low Risk rating is in-line with that of other rated Electric Utility stocks NTPC, Tata Power and CESC given: Stable and regulated earnings and cash flows from operations, with fuel costs being a pass-through.

Secular growth prospects for the power sector in India, given current shortages and low usage and penetration levels. The upside risks to our target price include: (1) Announcement of new projects, which leads to short term re-rating of the stock; (2) The company finishing any of its announced projects way before scheduled commissioning; and (3) Better than expected order wins and order execution in the EPC Business.