BHEL: Not yet out of the woods

ownside risk to new orders forecast remains high: Bhel faces twin risk of delay in new project ordering as well as a falling power deficit scenario in the country limiting the need for large scale investments in thermal power generation. While new ordering outlook for thermal power project equipment has improved to c33 GW over FY15-17e, 98% of these planned projects are being developed by the Government sector (central and state), which in the past have witnessed delays due to several reasons. Most of these planned projects are yet to receive environment clearance and/or acquire necessary land and/or lock in fuel supply. While the conclusion of the ongoing coal auction might provide clarity in due course on fuel supply, projects with de-allocated coal blocks might find it difficult to reacquire them. Hence visibility on these projects ordering currently remains low.

Telangana opportunity not very large as made out to be: The Telangana government has signed an MoU with Bhel for setting up 6GW of projects in the newly formed state. In addition the Andhra Pradesh Reorganisation Act suggests NTPC will build 4GW projects in Telangana. Investors have argued that this improves visibility of a turnaround in new order inflows and margins (negotiated bids). However, we reason that near term opportunity from this arrangement is only 2.7 GW over the next 12-18 months.

Bhel MoU: Of the 6 GW contracts, Bhel has already received 800 MW order for the Kothagudem project in January 2015. The 1,080 MW Manuguru project is yet to complete acquire land and environment clearances.

NTPC: NTPC currently runs 2.6GW Ramagundam plant in Telangana. It plans to set up part of the new 4GW power plant adjacent to the existing station. The company is now setting up 1.6GW (2 x 800 MW) project for which it is currently seeking approvals. There is little clarity on the timelines for the remaining 2.4 GW projects on land acquisition.

Falling demand-supply gap reduces visibility on new ordering: Our analysis suggests India’s power demand-supply gap will be met by a mere 15 GW of annual thermal power capacity. Central government and states might continue to add fresh capacities to close out regional demand-supply gaps. However, pace of fresh capacity addition might not cross 15-16 GW p.a. over next few years, visibility on which is already low. We also argue that Bhel’s much hyped new orders from Telangana could top out at 2.6GW against estimates of 6-8 GW over the next 12-18 months.

Structural capacity oversupply and pay revision will keep margins under pressure: With c30 GW of annual capacity, the sector will continue to work at suboptimal utilisation over the next 3-5 years. This will keep Bhel’s pricing under pressure. The impending Seventh Pay Commission led salary revisions will curb operating leverage driven margin expansion for Bhel.

Lack of meaningful business diversification will restrict RoE scale up: Despite running an average cash balance of $1.5 bn since 2008 and being a net cash company since FY98, Bhel’s attempts to diversify into new businesses has been slow and less yielding. Existing power equipment business improvement alone in our view will not support any large scale RoE expansion from current cyclical lows. This will put pressure on current high valuation in the near to medium term.

We establish a Reduce rating and set our fair value target price at R205 (R228 earlier). We value Bhel at a FY16e PE of 20.4x, and it now trades at 23.5x. While we value the shares above the business cycle mean to factor in a 37% earnings CAGR over FY15-17e, we do not expect current valuations to be sustainable given Bhel’s poor RoE profile over FY15-17e. A sharp jump in order book execution and new orders are key upside risks to our investment outlook.