With the GDP growth slowing sharply, the risk perception of regulated business models has risen. While earnings certainty is higher, cash flows would see higher discounting. Delays in tariff hike and lower coal prices have taken a toll on Tata Power. However, it is our preferred pick as steps towards a tariff hike continue. We prefer Power Grid Corporation of India Ltd (Buy) to NTPC (Hold) for its better profit CAGR (compound annual growth rate). We upgrade Adani Ports to Hold from UP (Underperform) as the slowing CAGR is priced in.
Tariff hike commentary delayed, but gaining ground: Aggressive bidding has led to the non-viability of power projects in the private sector. The scale of these projects, especially given the debt exposure apart from equity, has led government authorities to look for solutions. Incremental steps are clearly in this direction, especially with the Deepak Parekh committee recommending a 57-58 paise tariff hike for Tata Power and Adani Power’s loss-making projects. However, the vacuum in decision-making in the past 12 months has taken a toll on Tata Power's share price.
The ball is currently in CERC’s court to gauge the extent and conditions and subject to these, the hike should be passed. Note that consumer forums have requested CERC (Central Electricity Regulatory Commission) for a hearing before approving a hike, given that electricity will become costlier. We believe an eventual hike is the likely outcome so that, at least, the project debt becomes repayable.
Groups involved in tariff revision plea account for 25% of the upcoming private sector capacity addition: As the private sector increased interest and investments in the power sector, two forms of bidding emerged gradually. In Case-I bidding, the bidders are not given land or related tie-ups for setting up capacity and they commit to supplying power at the price that they bid.
In Case-II bidding, bidders are given land and related amenities for the project and have to supply power at a price based on their independent fuel and project cost assumptions.
An example of Case II bidding is the ultra mega power project (UMPP). About 12,000 MW of power projects bid under Case-II among Tata Power, Adani Group and Reliance Power are currently involved in petitions for tariff revision. Essentially, given the aggressive nature of the bids, we believe these plants will be loss-making, with the potential of debt repayment also being a question mark. While one can debate whether any relief should be given, these groups will account for about 25% of upcoming power capacity (excluding renewables), apart from banks having an exposure of more than $2-3 bn in these non-viable plants.
Reported financials of Tata Power and Adani Power provide ample evidence on the financial strain due to non-viable power plants. These companies along with Reliance Power are currently involved in tariff revision negotiations. Clearly, if there is no resolution, setting up incremental power capacities for these companies would be tough, going forward.
While one could argue that these companies are suffering due to their aggressive bidding, statistics show that they account for 25% of the incremental capacity addition, 10% of overall India’s capacity and closer to 15% in terms of generation, cannot be ignored. This is further accentuated by the banking sector’s exposure and the criticality of power availability in India, especially given the deficit prospects.
Power demand; a critically watched element: In two of the three periods when GDP slowed sharply in the past 20 years, power demand rose by 8-10% year-on-year, while in one instance it rose 3% y-o-y. Power demand rose by 7% y-o-y in April-May 2013, and has been negative for June-July 2013. However, June-July 2012 had a high base effect with a 13% y-o-y rise in demand vs the 7% y-o-y demand rise for FY13 . With slowing GDP growth, power demand would be lower than previous peaks of 9-11%. However, backed by household consumption of electricity, FY14 demand could be potentially higher than the 3% seen in Apr-July 2013.
Ports demand still subdued: All-India cargo growth at major ports declined in April-May 2013 despite the low base effect and y-o-y decline in April-May 2012. Some uptick has been seen in June-July 2013, driven by thermal coal. We believe growth will be at sub-5-6% levels, compared with 8% levels in earlier years, given the sharp slowdown.
Buy Tata Power, Power Grid; upgrade Adani Ports to Hold from Underperform: Earnings volatility is limited for these companies compared with E&C(engineering & construction)/capital goods companies. We have reduced our price targets by 5-15%, and within this, we prefer Tata Power and Power Grid, given their stronger earnings traction on company-specific events and execution.
We have cut our FY14e and FY15e estimates for Tata Power, factoring in lower coal prices and higher currency assumptions. Mundra losses in FY14e make the base PAT (profit after tax) for the group fairly small and, hence, the estimate reduction is fairly sharp for FY14e. A sharp rise in FY15e profits is linked to the resolution for the Mundra UMPP project.
While we continue to like Power Grid, the 15% fresh public offering would cap upside in the near term, especially given the past government issuances going at a discount to market price. We upgrade Adani Port to Hold from Underperform, as slowing growth has been priced in the correction. Maintain Hold on NTPC.