BHEL reported a loss in Q3FY16 led by very sharp y-o-y rise in raw material costs to sales and high provisioning; the explanations given in the concall provide little clarity on the path ahead. While order inflow will be strong this year, incremental ordering potential continues to shrink. Given likely significant variability in near- and medium-term earnings on several known unknowns (execution, margin, inflow, WC), we remain SELLers; revise target price to R100 (from R145). Investors looking for Ben Graham net-net opportunity may look at the stock in a range of R75-R95 (70-90% of FY2016E NWC, including cash).
Q3: Extremely weak quarter and low visibility ahead
Everything that could go wrong went wrong for BHEL in Q3FY16: (i) Execution was poor with yoy/q-o-q decline in sales, and (ii) very large Ebitda loss of R16 bn and PAT loss of R11 bn led by higher raw material costs (up 1,100 bps to 64.8%), higher provisioning towards net dues and projects put on hold.
Are the past two quarter precursors of continued weak performance ahead?
The sharp jump in raw material costs to around 66% of sales (up ~1,000 bps) for the past two quarters has been led by (i) lower sales realisation yoy/qoq as orders booked during higher competitive intensity period have started impacting financials, and (ii) higher costs for supercritical orders executed in the quarter led by joint deed of undertaking (JDU) related costs. We think that gross margin trajectory will remain highly volatile in the coming period as (i) BHEL continues to bid aggressively to win orders and (ii) the JDU-led cost is uncertain (varies from project-to-project) and will amplify the volatility in certain quarters. Competitive intensity-led price decline may largely negate any benefits from (i) internal steps taken to reduce costs, and (ii) no JDU led costs in certain contracts.
Low BTG ordering potential (10 GW p.a.) negative for medium-term potential of the company
Our analysis (390 GW coal capacity by FY2030) suggests incremental BTG ordering potential of 152 GW until FY2030 or only 10 GW p.a., given (i) current coal capacity of 168 GW and (ii) 70 GW under-construction coal capacity. Low demand and high capacity are bad news for BTG players in general and BHEL in particular.
Reduce target price to R100; maintain negative stance
We sharply revise our EPS estimates downwards to R(2.8) and R5.0 from R4.9 and R9.6 for FY2016e and FY2017e respectively, incorporating changes in execution, margin and other estimates. We reduce our one-year (Sep 2017e) forward target price to R100 (based on 12X P/E multiple), from R145 earlier.
Significant variability likely in near- and medium-term estimates
Estimating near- and medium-term Bhel’s financials has become twice as hard given (i) uncertainty/lumpiness in yearly ordering as witnessed over the past few years, (ii) Rs 330 bn worth of slow-moving orders in order backlog (33% of total), (iii) large orders awarded by Telangana (Manuguru-R50 bn and Nalgonda-R180 bn), in the past one year, do not have environmental clearance and accordingly estimating execution timeline is difficult, (iv) R78 bn order from TANGEDCO (Ennore project), which was awarded in FY2015, that has recently moved to slow-moving orders could be cancelled (case in Supreme Court, hearing complete and likely outcome soon), (v) BHEL continues to bid aggressively to win orders, which should have ideally led to lower contribution margin, and (vi) uncertainty on employee costs (Seventh Pay Commission hike) and net provisioning (high debtor days given high absolute debtors >12 months).
We concede that (i) from a reported order inflow perspective, FY2016 will be a strong year for BHEL, with R283 bn already booked to date and L1 in about R170 bn worth of orders, of which ~R120-140 bn will be awarded next year in our view, and (ii) probable bid pipeline remains at 21GW, to be awarded in next 1-2 years. However, post that, it is difficult to reasonably foresee the potential ordering pipeline (private capex to remain muted, NTPC and states’ major ordering is largely done, and UMPP ordering remains in a state of flux).