Upgrade to Buy–Time to Buy the Behemoth: We downgraded Bharat Heavy Electricals Ltd (BHEL) in Mar-10 as we felt the order cycle had peaked. Average inflows over FY11-14 declined to R272 bn from R576 bn over FY08-11. We expected this to remain at R300 bn for the next two years followed by a recovery to R400 bn levels in FY17e (estimates).
However, better inflow prospects suggest that inflows could be R400 bn over FY15e-16e itself, which has arrested the downcycle. Further, after a 35% EPS (earnings per share) decline over FY12-15e, we expect BHEL to grow EPS at a CAGR (compound annual growth rate) of 43% over FY15-17e. As a consequence we upgrade BHEL to Buy (from Sell) and increase our target price to R335 (from R176 earlier). After five years of underperformance vs the Indian market over CY09-CY13, the outperformance phase has just about begun in CY14.
Our target price increase factors in: (i) 26% cut in FY15e EPS and 45% increase in FY16e-17e EPS, based on trends from H1FY15 and robust order inflow prospects; (ii) increase in target P/E (price-to-earnings multiple) to 23x (from 18x earlier) set at 10% premium to 1 standard deviation above mean (given the EPS is still early cycle); and (iii) roll forward of target P/E to Sep16e (from Mar16e earlier).
The EPS change factors in the following developments:
Telangana order–a ‘black swan’ event: We had expected that the downcycle (FY11-14) would last two more years. We had not foreseen the Telangana 6GW (R300bn) order. As we dug deeper we were surprised by the bid pipeline of 14GW beyond this (our inflows estimates have been increased 20-37%).
Solid cost control: Logically, a pricing collapse over the last three years should have led to a gross margin contraction. But margin has expanded by 475bps in H1FY15 on faster localisation, raw material cost decline and renegotiations with vendors. Our gross margins assumptions are 42.5%-42.8% now (vs 39.0-30.3% earlier).
Staff cost impact is much lower than expected earlier: In the next four years, 8,000 people will retire and will not be replaced. Provisioning for VIIth Pay Commission might start only from Q4FY17 and a full-blown recovery of power capex cycle by FY18e is very much on the cards, which could lead to better absorption of the increase in wages.
High operating leverage: Over FY1993-FY2014, BHEL’s Ebit (earnings before interest and taxes) margins have varied from 0% to 17.8%. The business has tremendous operating leverage. More orders imply higher sales, which leads to disproportionately high margins.
Thesis for the Upgrade
Why bullish on BHEL: It is a fact that India’s energy and peak deficits collapsed to historic lows of -4.2% and -4.5% respectively in FY14—a collapse that has been fairly dramatic in the last two years. Power demand growth in FY14 was flat year-on-year due to slowing GDP growth.
This is despite the fact that India’s thermal power plants are operating at 15-year lows in terms of plant load factors (PLF), which reflects a decline in utilisation levels on lower demand and constraints in availability of fuel. These trends stand even for September 2014 with energy and peak deficits of 4.1% and 3.5% respectively. However, our bullish thesis is based on the following:
- Regional imbalances: The all India deficit number might not capture regional imbalances in the deficit. So, the states of UP, Rajasthan, Maharashtra, Telangana, AP, Karnataka and Bihar might continue to add capacity even though the all-India deficit number is not high.
- But power can be transmitted cross-region: Yes, that is true. But, first, it is well-known that transmission constraints exist and power does not flow as freely from one region to another as earlier envisaged in the short term. Second, no state would prefer depending on other states for their power supply needs entirely over the long term.
- Understated demand statistics: Whenever we have talked to employees of government and private sector power companies, they have tended to disregard the all-India deficit numbers, saying these numbers are grossly understated. CEA’s definition of electricity demand factors in total generation required (at the bus bar) to meet demand from load connected to the national grid, including provision for AT&C losses (aggregate technical and commercial losses). It does not include non-electrified consumers and it does not factor in widespread scheduled power outages or blackouts which have persisted over the years.
- CPSUs and SEBs don’t add capacity based on economics: Decisions on capacity addition are based more on the country’s needs and government’s directive and not just on economic reasons. So NTPC might keep ordering 5GW or more every year irrespective of whether they get PLF-based incentives or PAF (plant availability factor)-based incentives.
- Creation of a new state: The creation of Telangana and the consequent good fortune of BHEL of signing an MoU for 6GW is a black-swan event, which has arrested the downcycle for the company.