Less Than A Year Old, Cash-Guzzling Reliance Jio Is Already Too Big To Fail 

The announcement by Mukesh Ambani last week, that Reliance Jio will be making a Rs 20,000 crore rights issue of optionally convertible preference shares at Rs 50 apiece (Rs 10 face value plus Rs 40 premium) is straight out of the Dhirubhai Ambani playbook. Reliance Industries Ltd, the parent company, owns almost the whole of Jio’s shares, and thus the rights issue will essentially be subscribed by Reliance itself.

What this issue, like an earlier one, will do is expand the total number of shares outstanding in Jio, while also setting a kind of floor price below which a future public issue of Jio shares will not be sold.

Dhirubhai Ambani had three simple elements in his strategy.

First, raise large amounts of debt for projects. Next, use the share value of Reliance to convert this debt at huge equity premia, thus lowering the cost of debt. And when more money needs to be raised, he floated new companies to raise money again, and repeated the first two steps.

A corollary: if the new companies had weak profits, they could be folded back into the mother company at share swaps that favour the mother company rather than the merging company. Overall, this strategy has worked well for all parties over time, as shareholders got to be a part of the flagship company, which usually had large free cash flows.

The bonus issue of 1:1 announced by Mukesh Ambani is also part of the Dhirubhai playbook, for this will keep share prices of Reliance high enough to support more debt conversions to equity in the mother ship, if needed.

However, there is one thing that is different in Mukesh Ambani’s scenario.

In his father’s time, the new companies were essentially forward and backward integration into the oil discovery, refining, petro-products and petrochemicals chain. In Mukesh Ambani’s time, the cash is spewing out from the old vertically integrated businesses, but it is being spent in cash-guzzling unrelated areas like retailing and telecom.

So, while Dhirubhai could launch subsidiaries and fold them back in at will, it is not going to be as easy to do the same if life gets tough for Reliance Jio any time.

The money is being raised on the balance-sheet strengths of Reliance Industries, which, from being a zero-debt company five years ago is now a huge debtor with gross debts of over Rs 200,000 crore. Net debts (that is gross debt minus cash assets) totalled Rs 128,567 crore as at the end of June 2017.

No prizes for guessing where this borrowed money went – and will continue to go. For example, in June, Reliance announced that it will be raising Rs 25,000 crore through redeemable non-convertible debentures, and this has been followed up by the right issue for Jio’s optionally convertible preference shares of Rs 20,000 crore this month.

Despite the huge sums being invested in Jio, we know little about its real profitability since the bulk of the operating losses are essentially being converted to equity.

Under Indian laws, expenses incurred before full completion of a project can be capitalised, and this is essentially why we don’t know the real losses being made by Jio after six months of free services. A large part of the current 123 million subscribers have been migrated to paying customers at super low tariffs. This means revenues per subscriber will initially be low.

In the half-year to March 2017, Jio reported losses of just Rs 22.5 crore, but its equity was already swelling to over Rs 45,000 crore, and debts well above that level. The current rights issue of Rs 20,000 crore is intended to keep the debt-equity ratio comfortably below 1:1.

But this does not say anything about Jio’s operating metrics, which is a matter of speculation. According to financial services company IIFL, Jio will be making losses of Rs 19,600 crore this year (2017-18), and a further Rs 11,500 crore next year. It sees breakeven only in 2021-22.

According to last year’s Reliance Industries balance-sheet, Jio had net assets of Rs 70,864 crore – which was nearly 27 per cent of the parent company’s net assets (that is, total assets minus liabilities). Going forward, this share can only go up, as Jio is the main focus on investment in the year ahead too. These assets are essentially debt-funded, either at the Jio level or the parent company.

The massive build-up of equity in Reliance Jio and debt on both balance-sheets means that when it is listed, massive amounts of equity can be raised for very low dilutions – that is assuming Jio becomes profitable in the next three years.

Jio already has an equity base of Rs 45,000 crore. When the rights issue is converted, another Rs 4,000 crore will be added to equity, at the rights issue conversion price, we are talking about a company valued at around Rs 250,000 crore even before it is listed.

However, even without reaching high profit thresholds, the massive equity valuations implied in the current rights issue gives Jio three advantages.

One, it will be possible to acquire large companies merely through a share swap. Reliance Communications, with a market share of about 7 per cent (prior to merger with Aircel), is valued at all of Rs 6,000 crore due to its near debt default. If Anil Ambani wants to call it quits and sell out to his brother, he will get only a minuscule share of Jio through a share swap.

What this means is that Jio can swallow a large operator or two with minimal cash outflows.

Two, given the massive scale of investments made by and on behalf of Jio, effectively the company has entered the “too-big-to-fail” category already.

Three, since Jio’s entry has damaged the balance-sheets of all its rivals, government will have to consider giving the industry some fiscal or revenue share relief. But what is given to rivals cannot be denied to Jio. Jio will thus benefit from the concessions offered to the industry as a whole due to its own entry.

Reliance has essentially bet the farm on its telecom foray, having invested nearly Rs 200,000 crore in it, and Mukesh Ambani proposes to take this investment all the way to Rs 250,000 crore. Failure is not an option for him. Or for those who are lending him money.

(This is a corrected version of the earlier post where we had wrongly said that operating losses will be routed through the balance-sheet instead of simply saying expenses can be capitalised)