Negatives priced in

We believe that most negatives are getting factored in the valuations, and upside possibilities could be savings in fuel cost at Mundra UMPP due to blending of low GCV (gross calorific value) coal (about 20% of fuel cost), tax efficient structure for mining Holdco/UMPP, possible upwards revision for UMPP tariff and reversal of impairment provision given the softening coal prices.

Tata Power provided for MTM (marked-to-market) losses of R7.4 bn in Q2FY12, but it is comfortably positioned, as while translational gains from higher earnings at KPC/Arutmin mines can be retained; the increased costs are a pass through by way of higher tariffs in Mundra UMPP.

We have cut our FY12/13 earnings by 8%/3% to factor in lower production from KPC/Artumin mines (73m ton in FY14 vs 83m tons), lower contribution from Maithon project (Unit 2 CoD—commercial operation date—in Sep 2012), lower merchant contribution (100 MW Trombay transferred on regulated basis), and tax on dividend received from mining Holdco (holding company) to meet cash flow commitments at UMPP (while dividend gets eliminated in consolidation, tax remains). We now expect Tata Power to report consolidated EPS of R8/share for FY12e (up 8% y-o-y) and R9/share for FY13e (up 13.4% y-o-y). SOTP (sum-of-the-parts) based TP (target price) stands at R91/share. Maintain Neutral

Mundra UMPP’s estimated project losses (at R1.1 bn in FY12, R5.9 bn in FY13 and R17 bn in FY14) are largely from the constrained PPA (power purchase agreement) structure, and not due to poor project economics. We calculate the Year 1 all inclusive generation cost from the project at R3/unit, which is competitive when compared with tariffs of R2.5-2.8/unit for several of NTPC’s new capacities (based on domestic coal linkages).

Tata Power had charged off an impairment provision of R8.2 bn in Q2FY12 on the Mundra UMPP to factor in expectations of increased coal prices, vs its earlier review by $9-10/ton. Current estimates factor prices of $125-115/ton in FY12-14, and LT (long-term) average at $83/ton. Given recent softening of international coal prices, with RB Index down from $123/ton in Mar-11 to $103/ton recently; we expect that a large part of these provisions could be possibly reversed in Q3/Q4FY12.

To provide comfort to the bankers, the company is transferring 75% of its investment in mining Holdco (KPC/Arutmin mines) to Mundra UMPP SPV (special purpose vehicle). This will entail that project funding continues at agreed DER (debt-equity ratio) of 75:25, as the bankers had earlier capped the debt funding at 63% of the project cost till further review. However, any dividend received from the overseas subsidiaries will attract tax (FY12 at MAT—minimum alternate tax-rate), and thus leads to valuation impairment.

Options to improve the viability of Mundra UMPP and possibly salvage profitability include operating the project at contractual norms, which entails 100% recovery of fixed charges at 80% plant availability (PLF of 72-78%), usage of low grade coal, possible capacity expansion by 1.6GW (brownfield) and leveraging tax benefits on losses. Any regulatory concessions can lead to improvements in project economics.

We have not factored a large part of these upside possibilities in our estimates. We believe that Tata Power is still relatively better placed amongst other private IPPs and stock correction helps build an LT investment case.