Guest post by Varadharajan R. He tweets at @varadhar1 
Varadharajan_RVaradha is a self taught investor who views investing as an intersection of economic incentives, psychological motivations and on the ground triangulation. He focuses on hypothesis that confluences several broad ranging factors and picks stocks that have an asymmetric risk-reward trade-off. He has done several sessions on forensics, triangulation, scuttle butt and writes occasionally. He is an engineering graduate from IIT Madras, and has studied finance at IIM Ahmedabad.  
Current price : 651
52 Week High / Low : 693/365
Market Cap : 16450 cr
FY 2017 EPS : 42.9
Disclaimer: This is not a recommendation to buy / hold / sell any securities mentioned in the blog post. The published post is for information purpose only. The intention to share write ups on this blog is to create a repository of ideas so that investors can have a look at various frameworks & approaches. Please read the detailed disclaimer at the bottom of the post. 

Thought Process…
Continuing with the theme of out of favor stocks, i try to look at beaten down stocks that have multiple cushions – yawning gap in perception vs reality, change in promoter behavior, reversion to mean on multiples, reversion to mean on earnings & low institutional ownership & sell side coverage. If you buy these at low enough prices, eventually you make good money and if your thesis is wrong, you end up not losing much – say 10-20%. To do this, I apply a principle of triangulation – where I validate three independent data points and see if I can build a very robust, tight thesis. Usually I look for consistency in management actions, financials and independent industry/third party feedback (from someone who is not in the industry).
Given the obvious shift in savings to financial instruments  and financial instruments like mutual funds, insurance – general/health benefiting from this shift as also the massive growth in affordable housing, I looked at Reliance Capital – only of course to be taken aback at the long and dubious history of all ADAG companies. However, I saw several slivers of hope.
‘Anmol Effect’: Anil Ambani Says Son Is Lucky Charm For Reliance Capital 
Anil Ambani’s son Anmol joined Reliance Capital (and only Reliance Capital out of all his entire set of companies) as an additional director in September 2016.
Bajaj’s finance Devang Mody joined Reliance commercial finance recently. He was instrumental in building Bajaj Finance to its premier position over the last decade.

Company Background
Reliance capital was floated in 1990s as a financial services outfit for reliance group which was under the aegis of Dhirubhai Ambani. This got split and was allocated to Anil Ambani in 2005 and ironically since then is the only business which has grown well fundamentally. You can read here about the entire business.
I prefer to focus on interpretation of facts as most of these facts are covered in analyst reports/company presentations.
Business lines
Company Presentation
BSE announcement
a.   Mutual fund business – Crown jewel business
This is the crown jewel of the business. It is a cash cow and generates stable, predictable free cash flows given the incredible operating leverage of the AUM business.
This business was valued at Rs. 8542 Cr. a couple of years back  – with the tailwinds of post demonetization and improvement in market share of reliance mutual fund, this business is worth upwards of Rs. 10,000- Rs. 12,000 Cr.  Nippon now holds 49% in this business which generates free cash of upwards of  Rs. 500-600 cr.
Given that the next round would involve either IPO or  Nippon crawling up beyond 51 % which would give complete control, this should happen at a significant premium to the last round which valued it at Rs. 8542 Cr.  Also, given that Nippon holds 49% and has a board representation and has very good profitability numbers. We also gather from scuttle butt that since it is a stand alone fund house, it has been focusing on getting direct B2C business through the internet – which should improve its profitability numbers in the long run. Also, persistence of SIP’s which lower the cost base in the long run will help all AMC’s improve upon profitability numbers
Valuation should be in the region of Rs. 12-15,000 Cr. for the business in case of an IPO or even higher in case of  a stake sale.  The AMC has RoE’s of 25 % and is expected to touch 30% based on my calculations by FY ’19 – making it truly a durable franchise business. So, the attributable value for reliance capital with 51 % stake would be in the region of Rs. 6-7,500 Cr.

b. Reliance General Insurance – A small, High Growth Business With Tailwinds
Reliance General Insurance (RGI) is a leading private sector insurer with a 5 year CAGR of 24%, and has become a highly profitable company. RGI has formed key alliances with over 20 firms including IndusInd Bank, Bank of India, Andhra Bank, Catholic Syrian Bank, City Union Bank, Paytm and Freecharge. RGI processes over 10 lakh claims annually and has the lowest ‘complaint ratio’ amongst peers. Anil ambani has indicated that he is open to selling stakes – he has already got offers from several global majors to sell stake in his general insurance company.
Reliance owns 100% of this business and at 20x FY ’18, this could be valued at about Rs. 3,000 – Rs. 4,000 Cr. Reliance health insurance (RHI) is a new initiative that focusses on an under penetrated segment. RHI has significant experience in managing the business and has the second highest reach amongst stand-alone health players. A “Digital First’ approach, value unlocking opportunities through strategic partnerships and focus on profitable growth in one of the fastest growing insurance companies.  This is not a great business unlike the MF business and I would conservatively estimate its worth about Rs. 4,000- 5,000 Cr.

c. Reliance Nippon Life Insurance – Consolidating for superior profits
Reliance Nippon Life Insurance (RNLI) has a wide nationwide footprint with 770 offices and approx. 1 crore individual policies issued and 30 lakh in force. Nippon Life Insurance is a very strong and committed partner. It holds a 49% stake in the company. Nippon Life has invested over Rs. 5000 crore, valuing the business at approx. Rs.10,000 crore.  RNLI’s focus has been on profitable and healthy growth. Over the last one year, it has weeded out unprofitable and poor quality business, resulting in right sizing the expense base and corresponding reduction in premium growth. RNLI has an Embedded Value of Rs. 3,074 crore as on Sept 2016, and AUM of Rs.16,247 crore as on Dec 2016. Market leader like HDFC max is valued at about 4.3x EV while ICICI prudential trades at 3.4x. This should trade at 3.0-3.5x given the reliance pedigree and its independent distribution network. Given Reliance capital’s 51 % stake, it should be worth Rs. 5,100 Cr. or so.

d. Reliance Broking:
Reliance’s broking business is quite small and has a PBT of Rs. 40 Cr. on a topline of Rs. 300 Cr. However, what’s interesting is the wealth management business that has more than Rs. 4,100 Cr. AUM. This has a value of about Rs. 15x FY ’18 E of about Rs. 50 Cr. – roughly around Rs. 750 Cr.  Reliance has a strong digital platform and is seeing increasing traction in IPO funding.

e. Reliance Commercial Finance:
Mr. Devang Mody who was instrumental in building up Bajaj  finance, here has been appointment of Mr Mody as CEO, who was the erstwhile President of the consumer finance business of Bajaj Finance and leverage on his expertise in tapping  SME lending segment. The current AUM is 16, 000 Cr  . The Equity Invested in this  business is Rs. 3,280 Cr.. The business has grown 10% over last year and its expected to do a profit of 200 crores in FY2017 with an ROE 12.2% which would improve with operating leverage kickin in. This can get valued at 1.2-1.5 x PB that translates to a a valuation of Rs. 3,500 – Rs. 4,500 Cr.

f. Reliance Home Finance 
Reliance home finance has a good differentiated offering with affordable housing and self employed/salaried book forming 53 % of its AUM. It would be demerged from its parent and listed shortly – all the approvals needed for it are already in place. At a 15 x PBT, this should trade at about Rs. 2,500- Rs. 3,000 Cr.

Valuations :
1st Cushion/Trigger
Reversion to mean – All ADAG group stocks have been hammered ever since end of may ’17 when Rcom’s bonds got downgraded on fears of default. While Relcap belongs to the same group, there is nothing material here to get worried about. Relcap has an exposure of Rs. 293 Cr. in equity and about Rs. 100 Cr. in loans (as of March ’16) and even if one were to take a conservative write-off of Rs. 1000 Cr on the networth, it will not materially impact valuations.
2nd Cushion/Trigger
Impending de-merger and listing of home finance : All the approvals are already in place for demerger and listing of reliance home finance. Given its PBT, it should trade at a Rs. 4000 – 5000 Cr. Mcap. Given that 50% of the stake will be held by Reliance capital, this will add Rs. 2500-Rs. 3000 Cr. value to Relcap’s books.
3rd Trigger
Potential stake sale/IPO of MF : The MF is a crown jewel where reliance holds 51 % with Nippon holding 49%. Given that the last round of stake sale happened at about Rs. 10,000 Cr. and that was 2 years before demonetization and the tailwinds if any have become much stronger, this should be done at Rs. 15,000.
4th Trigger/cushion
Deleveraging of BS by divestment of non-core investments: One has to remember that these were non core investments for Reliance capital and have not contributed to the ROE in anyway over the years. It has some good investments in companies like ICDEX, paytm, yatra all of which combined can return in excess of Rs. 1000- Rs. 1500 Cr. The company has committed to clean up all these before March ’18 as it wants to become a Core Investment Company – a pure holding company with stakes in other companies and has already begun the process with RBI/SEBI.
5th Trigger/cushion
De-merger/QIP on Reliance Commercial Finance: Given that commercial finance is bound to grow and will need fresh funds, a sensible option would be list it or get in private equity money at more than 1 PB. This is likely to happen post March ’18 and will be another trigger to create value in the long run.
6th Trigger/cushion
Stake sale in General insurance : Given that FDI interest in general insurance is substantial and reliance has a good, niche proposition in general insurance/health insurance, a stake sale here again would add Rs. 1,000 – Rs. 1,500 Cr. to the kitty with an optionality to sell at a higher valuation at a later date once FDI rules allow for 51 % +.  Reliance has also announced a plan to do an IPO to sell down some stake in this.
Said all of the above, given the fact anil ambani treats this as his crown jewel and is creating value, we may see lesser sand bagging and improved governance standards.  Also, listing these separately might help attract better quality talent – like it has happened with edelweiss/IIFL where even top guys of foreign banks have joined them.

Valuation
Valuations are undemanding at about 1.2 FY 17 BV. One must remember that the mutual fund business requires very little incremental capital and generates terrific free cash flows. The insurance businesses too, if run well can generate good amounts of float for the owner. Doing a sum of parts valuation,
Thinking Through The Risks 
One has to remember that in the short run the market is a voting machine – what does that mean ? with all these developments on, there is little or no movement in the stock. That is because ambani has had a long track record of shoddy execution and broken promises to shareholders. The majority do not believe this time it will be different – However, looking at the pointers above, I believe it is different this time.  Hopefully, the market will accord this business its due in the near future.
My Interpretation Of Anil Ambani
My interpretation of Anil Ambani is that he is a good salesman – someone who can craft good deals and get a great value for the sell side – aka an investment banker. Needless to say, based on his track record, his execution is very patchy.  However, one must remember that he has set some lofty benchmarks in selling his business to foreigners:
  • He has sold stakes in each of his businesses – mutual fund, life insurance to Nippon at good valuations.
  • He is a great deal maker and has been able to sell a dream in each of his deals including IPO’s
  • He realizes that this is his crown jewel (hence the induction of Devang Mody from Bajaj Finance and also his son Anmol to the board) and has takena series of progressive steps to unlock value – demerger of HFC, IPO of MF, stake sale in general insurance business and potential QIP of the commercial finance.
He is a bit like Mohammad Aamir  – the Pakistani bowler who was banned in 2010 for match fixing and lost a promising part of his career. Yet he came back stronger than ever in champions trophy and won the match for Pakistan against India.

What Can Go Wrong ?
Mis-allocation by promoters: Given that the promoters are just coming out of a de-levering cycle, I do not expect reliance capital to again invest into non core businesses.
Stake sale/pledge: Any stake pledge by ambani to raise money to fund other businesses will create a over hang on the stock.
Regulatory approvals : Given that anil ambani’s other businesses are levered and have a lot of debt repayment issues, there could be potentially costly litigation or delay in getting approvals from SEBI/RBI/lenders. 
Acknowledgements:
I have used inputs from :
  • Annual reports 14,15, 16 and companys’ investor presentations and conference call transcripts
  • ICICI securities research reports on Reliance capital
  • Inputs from people in the financial community

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