1. Utilities: Earnings growth strengthens with fuel and interest cost moderation

Utilities: Earnings growth strengthens with fuel and interest cost moderation

Utilities have reported adj. PAT growth of 30% for 9MFY16; cost reductions likely to continue driving profitability for the sector

By: | Published: February 29, 2016 12:05 AM

Profitability expands on fuel and interest cost savings: Near-term results strengthen our belief: (i) the fuel cost decline is leading to gross margin expansion— with a 15% decline vs. just 6% reduction in tariffs; (ii) IPPs with PPA had higher growth—private IPPs saw 39% volume growth y-o-y, despite weak 3.5% demand growth; (iii) interest costs declined, despite no debt reduction. We believe cost reductions will continue to drive profitability for the sector, from 6.8% ROE to 12.7% ROE—350bps for all regulated companies—NTPC, Powergrid and NHPC; and CESC, Tata Power and Adani. We have the most Buys in the sector since our coverage started— our pecking order is NTPC, Powergrid, JSW Energy, CESC, NHPC and Tata Power.

Implied 9M16 shows more upgrades

DB utilities reported adj. PAT growth of 30% for 9M FY16. Fuel costs have declined ~15% y-o-y, vs. a 6% decline in tariffs for Q3, after an average 9% decline in Q2—leading to margin expansion across the board. Our FY16 estimates imply growth of 28% for Q4 16 which looks achievable. While Powergrid, NHPC and CESC’s estimates look easily achievable, NTPC and JSW could also meet expectations given the lower fuel price.

Hurdles for the sector are being removed

Government policies and action are helping to remove the sector hurdles—domestic coal availability, interest cost reduction and now, the restoration of SEBs’ financial health, which will result in strong earnings recovery, and utility valuations at a 30-40% discount could revert to the historical mean earlier with ROE expansion. (i) Coal availability has improved and international prices have dropped to multi-year lows. (ii) ROEs are expanding on capacity addition, lower fuel and interest costs. (iii) Although demand is low, the financial re-structuring of SEBs could improve demand and remove payment risks. (iv) With RBI pushing banks to make provisions for bad loans, M&A could pick up pace.

We have six Buys—and we prefer NTPC, JSWE, Powergrid and CESC:Our pecking order is NTPC, Powergrid, CESC, JSW Energy. We also have Buys on NHPC (~7% dividend yield, and 25% regulated equity growth in FY17e) and Tata Power (de-leveraging, reduced receivables, and expectation of compensatory tariff for Mundra). We have cut Reliance Power’s target price by 13% to R40/sh, on account of higher short-term debt. NTPC’s stock has fallen 15% post Q3 results on: weak profits due to a high base effect, weak generation, GCV ruling negatively, and the possibility of Government OFS. However, we see the following surprise elements in the coming months: (i) Government tariff policy now allows excess power sale or deemed generation benefits. (ii) Power cost is declining for NTPC, which will help to increase PLF; (iii) UDAY reforms and imported coal substitution will wipe out SEB cash losses, and hence, higher power purchases are likely; (iv) Capacity addition of a 70% increase in regulated equity over three years will drive profitability.

Valuation using combination of DCF and P/B; key risks: We value the regulated models on P/B (using the Gordon Growth Model) and private IPPs on the NPV of current power projects. Key risks to our view are lower/higher coal price, execution, INR depreciation and demand fluctuation.

Q3 & 9MFY16 results show good gains

Ebitda growth is strong, despite weak demand environment: The power sector continues to deliver stronger growth– the private sector is driving the savings this time. Regulated PSUs delivered 14% Ebitda growth, and private IPPs saw 39% growth y-o-y, despite weak 3.5% demand growth in the quarter. The biggest positive surprises were on Powergrid, Tata Power and Adani Power, whereas NTPC, JSW and CESC delivered a negative surprise. Industry players are benefiting from cheaper fuel costs; Ebitda growth was 23% despite just 6% revenue growth in the Q3FY16.

Two major things achieved, operationally

Q3FY16 results have shown early signs of recovery, especially for coal-based IPPs, on the back of declining coal prices internationally and higher domestic coal substitution in tandem with less of a decline in tariffs. Fuel costs have declined ~15% y-o-y, vs. just a 6% decline in tariffs—leading to margin expansion across the board.
While Indian generation grew by just 3.3%, listed entities, especially with PPAs, delivered much higher growth of ~9% y-o-y growth. State Power project generation continues to suffer with old, inefficient projects (-7.5%), and

NTPC generation was weak (-1% y-o-y), vs. private IPPs clinching 23% growth – with outperformance largely from RPower’s Sasan UMPPs’ (+237%) cheaper power—which seems to have substituted high cost power.
All IPPs saw cost reductions ~15%, except CESC and Adani Power—which saw ~5% fuel cost increase/unit.

Profit expansion across the sector

With the fall in commodity prices (coal & gas) and the government’s efforts to revive stalled projects, the net profits of power companies have improved across the board. Profit after tax increased by 29% y-o-y, largely aided by lower commodity prices, the availability of cheaper domestic coal, and a drop in interest costs on account of refinancing and the 5:25 scheme.

Debt continues to be elevated; however, interest cost has reduced for stable business

Industry has been able to reduce interest costs under 5:25 refinancing. Financial leverage remains high—debt for the utilities has moved up, largely from Adani Power, NTPC and Powergrid. The JSW debt increase is due to the acquisition of assets from JPVL, which is largely netted.

Graph

Implied Q4FY16 shows more upgrades than downgrades

Utilities have reported adj. PAT growth of 30% for 9M16. Our FY16 estimates build in profit growth of 19%, implying 28% growth in Q4 profits—which looks achievable. While Powergrid, NHPC and CESC’s estimates look easily achievable, NTPC and JSW could also meet expectations given lower fuel prices.

Gr1

Expect significant improvement in financials

We believe cost reductions will continue to drive profitability for the sector from 6.8% ROE to 12.7% ROE. This is likely to be characterised by 350bps ROE expansion for regulated companies—NTPC, Powergrid and NHPC; and similar significant gains for CESC, Tata Power and Adani Power. We have the most Buys in the sector since our coverage began—our pecking order is NTPC, Powergrid, JSW Energy, CESC, NHPC and Tata Power.

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