We downgrade JSW Energy (JSW) to ‘HOLD’ from ‘BUY’ post a 13% surge in the stock recently since we find the risk-reward evenly balanced. Our rationale is: (a) even building in benefits of the potential 750 MW 3-year medium-term contract, FY17/18E EPS gets revised down 11.5% each—our numbers are now below consensus; (b) our revised SOTP-based target price of R77 (earlier R83) indicates marginal downside; and (c) we concede JSW is pursuing an interesting inorganic growth strategy, but this may entail additional risk if acquisition targets do not have PPA/pass through coal linkages. Positives in the stock are now more to do with further correction in thermal coal prices or push back in inorganic growth.
Inking medium-term PPA is clearly a better business model
A key positive working in JSW’s favour is management’s ability to gradually move from short-term to more medium-term contracts. And, yes, if what the press/company communiqué state gets ratified by regulators, the company’s business will carry lower risk of scheduling. As per our earnings model, JSW’s business will now probably have only 10% of output in spot (5% in PBT contribution) versus earlier 30% (50% of PBT).
Some risks in inorganic acquisitions/energy cost remain
Apart from the binding agreement with JSPL to acquire its Tamnar–I plant at a base value of R40 billion, JSW is evaluating possible acquisition of 1, 050 MW coal-fired thermal power plant being developed by Monnet Power at Angul, Odisha. While both these plants have sizeable portion of capacity which is yet to be tied up, fuel supplies also remain a grey area. Though Monnet has bid for Utkal-C coal block for R770/tn (forward), JPL’s bids for Gare Palma IV 2&3/Tara blocks have not been cleared. This, for us, is a grey area whose impact is difficult to assess.
Outlook & valuations
Based on our revised EPS, the stock is trading at P/E of 10.2x FY17E and 9.5x FY18E—the stock’s mid-quartile band. On the positive, the trading band can move up to that of NTPC as and when JSW is able to get coal pass through in tariff; however, current visibility on the same is limited. Additionally,declining thermal coal prices can also boost EPS. Given our estimates on target price of R77/share, we perceive marginal downside potential. Downgrade to ‘HOLD’.
Assuming the current bid of R4.38/unit gets ratified by the authorities our FY17E/ FY18E earnings get revised down by 11.7% and 11.5% respectively on account of lower than expected contribution from the Vijaynagar plant.
Key positive and negative developments that can change our valuations are detailed below.
Key positive triggers
1) Favourable APTEL order for Barmer plant: After the Rajasthan regulator disallowed certain capital cost for the Barmer plant, we had revised down regulated returns from the project. JSW has filed an appeal with the Appellate Tribunal of Electricity and if the company gets a favourable order, the value of the Barmer plant could rise from current R15/share to R18/share at 20% RoE.
2) Favourable PPA at JPL 1000 MW plant: At R40 bn of EV, assuming debt: equity of 75:25 and no change in operating matrix, the acquisition of JPL 1000 MW is value dilutive. However, if JPL inks PPA/pass through fuel linkages, the value could be accretive.
1) Correction in merchant prices: JSW, even after having significantly reduced its exposure to merchant sales, has 28-30% of total capacity open which contributes 35-40% to overall profitability. Any sharp reduction in merchant rates (especially for its Vijaynagar 860 MW plant) from current levels will dent earnings/valuations.
2) Uptick in spot coal prices: JSW continues to depend on international spot coal as feedstock for its 2GW capacity. Any material uptick in sea-borne coal prices will hurt profitability and thus valuations for the open capacities—860 MW in Vijaynagar and 400 MW in Ratnagiri— that do not have adequate pass through.
3) Disallowance of capital cost for Karcham plant: We have valued hydro assets on the assumption that the regulator will approve the petitioned capital cost of R70 billion for Karcham project. Disallowance of certain capital costs will lead to lower-than-expected tariffs for the project and cause drop in earnings/RoE and also valuations.
4) Acquisition of Monnet plant: Our calculations indicate that at an acquisition price of R65 billion EV, D/E of 70:30 and coal coming from the Utkal-C mine, the company will need to get in the PPA a fixed charge/unit of upwards R2.25 for break even.