Jio Financials: Does the demerger from Reliance have value?

***Update (as of Aug 21st, 2023): ***Jio Fin is listed at almost the same price (261/-) as its price discovery on the ex-date, valuing the overall company at approx 1.6 Lac Cr.

Reliance Industries is, well, huge. It has telecom, oil and gas, retail and a bunch of other businesses, but what it also has is a small financial company, and that’s getting demerged. We take a look at Jio Financials, that small little big thing that becomes a separate entity in a demerger in July 2023. (Disclosure: We are interested in Reliance, so consider us biased)

In a nutshell:

• Reliance will demerge its NBFC arm into Jio Financial Services

• The demerger saves Reliance from having to sell or cancel a hefty 6.1% of its own shares

• Jio Financials is set to be India’s largest NBFC by net worth

• The deal: Synergies with Reliance’s retail and telecom businesses for consumer lending

• And yet, Jio Financials growth trajectory remains a mystery

On July 20, 2023, Reliance Industries (RIL) will demerge it’s NBFC arm, Reliance Strategic Investments, which will be renamed Jio Financial Services. For every share of RIL held, shareholders will receive one share of Jio Financial Services (demerger ratio 1:1). After the spin-off, the Ambani family will continue to act as the promoters of Jio Financials, holding 50.4% of the shares.

Why the Demerger?

**What people think: Value Unlocking & Synergy **

The popular notion is: Oh, Reliance has so much going on, and if they unshackled the lending business inside them, it would scale very well.

Interestingly, Reliance is the only major conglomerate in India without a captive financier (partly due to the previous non-competitive agreement with the ADAG group). Other conglomerates such as Tata, Birla, Bajaj, Mahindra, L&T, Adani, and so on, all have their own NBFC arms, which they have scaled across lending, AMC, mortgage, insurance, etc. Makes sense for Reliance to establish its own NBFC arm to get some financial lending love from its other ventures, such as Reliance Retail, Reliance Digital, and Jio Mart.

The curious case of the 6.1% of Treasury shares

This story stretches back two decades. In 2002, Reliance Industries (RIL) merged with its subsidiary, Reliance Petroleum (RPL), in a share-swap deal. Due to complex cross-holdings between RIL and RPL, Reliance Industries ended up owning 12.1% of its own shares. These treasury shares were held by the ‘Petroleum Trust,’ a 100% subsidiary of RIL. The company sold around 6% of these shares in two instances in 2009 and 2010 to raise some funds, continuing to own 6.1% of its own shares. This was recorded as part of the “promoter holding” in RIL.

Sounds simple? Here’s where it gets interesting.

In March 2022, a report from the Ministry of Corporate Affairs said, effectively, “Guys, this concept of owning your own shares is not right. You have to either sell or cancel these shares within three years.”

This posed two problems for the company. Firstly, RIL didn’t want to sell these shares. Secondly, even if it did, that would be a huge chunk to offload (~1.1 Lac Cr), creating a significant overhang on the RIL stock price.

To address this, in October 2022, RIL announced that will hive off its financial services division as Jio Financials, transferring its 6.1% treasury shares as part of this move. This arrangement ensures that RIL won’t need to sell this 6.1% portion because Jio Financials is not owned by Reliance Industries - just that they share common shareholders.

*click on the image to expand

Jio Financials: A Five-Point Summary

1) It starts off absolutely massive in size

As per the 2022 Annual Report, RIIHL’s net worth is approximately 26,184 Cr. The true value, however, lies in the 6.1% of RIL shares they will receive as part of the deal, which are worth around 1.1 Lac Cr. Combined, the total net worth will be approximately 1.4 Lac Cr, surpassing Axis Bank, Kotak, and Bajaj Finance to become the fourth-largest financial company & the largest NBFC in India.

There is still a little doubt - will RBI allow them to call it “net worth”? They own shares, sure. But these shares may have to be recorded as the purchase price, not the market value. Which means the net worth won’t be that much. But we’ll have to wait to see.

2) There’s a big market for them: Consumer Lending

Reliance Retail operates 18,000 stores across India and has a registered customer base of 24 Cr. customers. Jio Financials plans to leverage this customer base, initially venturing into consumer lending, which includes electronics, merchant financing etc. Over time, they aim to expand into other sectors such as AMC, insurance, broking, and payment banking.

RIIHL already has investments in Reliance Retail Finance, Reliance Retail Insurance Broking, and Reliance Payment Solutions, all of which will now be part of Jio Financials. These holdings will give us insight into Jio Financial’s focus areas for the next few years.

*Source: RIL AR 2022

The scope of consumer lending can be massive. Lending for the buying of white-goods, even with 0% EMI for instance, is a source of great profit for a number of finance companies. (Read: How do no-cost EMIs work?)

And then, there are a lot of customers in their Jio telecom offering as well, and the scope for digital lending to individuals has only gone up dramatically with entirely online end-to-end execution with aadhaar validated signatures. Individual personal loans are the second largest category of loans made now, just behind housing loans, in terms of value. With the distribution available to Reliance for direct consumer lending (i.e. no need to use distributors) Jio Financials could immediately get a fillip.

3) Big Capital Buffers in Place

The 26,000 crore net worth of the Jio Financials subsidiary itself provides enough buffer to lend about 100,000 cr. or more. Beyond that, they have the shares of RIL, which can be sold in the market to provide for additional capital requirements where needed.

Remember that financial companies must have a certain amount of their own capital (‘net worth’) for every rupee they lend. Typically, they need about Rs. 15 to Rs. 20 as capital for every Rs. 100 they lend. That means if their net worth is X, they will be able to lend 5X or more. If you include the treasury shares of Reliance at its market value, that would yield a net worth of over 140,000 crores, which allows it to lend a staggeringly high number (5X of that) without needing to raise any further capital.

Note: Return on equity will suck until the time that it actually lends that much money. Till then, the ROEs will be suboptimal, simply because they have too much capital. Usually, “too much” capital is not considered a problem in the financial lending world, but in Jio Financials, it might just be a burden for a while.

Also, Reliance Industries is a massive borrower in the debt market. Given that Jio Financials is no longer a subsidiary, it can lend to RIL as well, with certain RBI limits, as long as the transactions are at arm’s length. This can be bad news for a large number of debt funds and banks that park their money in RIL debt, but it’s a positive for Jio Financials for the stable portion of their asset book.

4) Valuation

Even though the actual value of JFSL lies in its 6.1% equity shares, according to RBI rules, these cannot be considered as core capital for capital adequacy calculations. For it to be considered as Tier-1 capital, Jio Financials must sell these shares, which may take its own time. (They could sell shares and immediately buy them back, generating the profits, paying tax on them, and then increasing their net worth to that effect.)

At the listed price of 260/- per share, the company is valued at a market cap of ~1.6 Lac Cr.

Jio Financials will see ex-ICICI CEO KV Kamath as the Chairman of Jio Financials, and Hitesh Sethia (also from ICICI Bank) as the MD & CEO of Jio Financials. This team seems to be in place - but lending hasn’t yet started in a meaningful manner. Valuations will make sense once they have a good lending book.

5) Don’t ignore the risks

The company currently has only a 1000 Cr loan book, which is minuscule compared to the scale at which RIL operates. For the market to assign a sustainable premium, similar to that of Bajaj Finance, this loan book must see exponential growth over the next few years.

Historically, except for RIL, none of the listed Reliance subsidiaries such as Reliance Industrial Infrastructure, Network 18, Den, Hathway, etc., have created any wealth for their shareholders. The value creation has always occurred at the parent level and not quite as much at the subsidiary company level. Jio Financials isn’t technically a subsidiary, but we’ll have to see if that trend changes of value only being at the parent.

Note that every single index fund will have to sell the shares of Jio Financials after it lists, because while Reliance Industries (RIL) is part of the Nifty 50 Index (and a bunch of other indexes), Jio Financials is not. (It is temporarily going to be in the index till it lists, and then will be removed, just for index management purposes) Therefore, the amount of forced selling that might come could be a large amount on the first day itself. Jio Financials will list sometime in the future, but this overhang is likely to weigh it down in the initial days of listing.

Piecing Together Reliance: Sum of the Parts Valuation

If we expect the demerger of JFSL as an indicator of forthcoming value unlocking in Reliance, it is important to look at each segment for its respective value contribution.

Reliance’s revenue is structured around five main segments:

• O2C, the powerhouse with a 60.9% revenue contribution

• Retail, with a substantial share of 26.7%

• Digital Services (Jio Platforms) 10%

• Oil & Gas at 1.7%

• Others, collectively contributing 0.7%

A back-of-the-envelope calculation suggests a SOTP valuation of ~24 Lac Cr market cap for Reliance, based on its major segments. This implies a 25% upward movement from the current market price, but only after the value has been unlocked.

Note that in the recent buyback fiasco of Reliance Retail, the company was valued at approx 7.7 Lac Cr, higher than the above estimation of 4.5 Lac Cr. But that transaction is for a VERY small number of shares, and the higher price was offered only because investors have to pay tax on it as a deemed dividend. So don’t consider those lofty figures for actual valuations.

Should you buy Jio Financials now?

Not yet.

One significant concern is that a clear growth path for Jio Financials has not yet been articulated. While a strong team has been assembled and there’s a JV with BlackRock, everything beyond that remains nascent. Mukesh Ambani and Reliance are known for setting challenging targets and achieving them ahead of time, but this clear vision seems to be absent in Jio Financials at the moment. Moreover, there’s hardly any lending of a meaningful sort as of now.

If they truly aim to elevate Jio Financials to impressive heights, it will be a narrative that unfolds over a decade. Missing a quarter or two will not have a significant impact on an investment. Without this clarity, what we’re observing now is a small business brimming with potential — a demerger that will unlock its value well after the actual dates of separation. We advise caution; make your decisions carefully.

Subscribe to the Capitalmind Focused smallcase for access to the full portfolio

Capitalmind Focused smallcase by Capitalmind Momentum

Other related posts:

• Deepak’s Twitter space on Reliance Retail buyback fiasco

• Reliance: Counting on Retail & Jio to drive growth

• What’s cooking at Reliance?

Disclosure: Please note that Reliance shares are held in both the Capitalmind PMS and our model portfolios. This article is intended solely for informational purposes and should not be construed as an investment recommendation.