Chances of marginal re-rating

Updated: Nov 5 2012, 09:30am hrs
Management suggestions of declining competitive intensity a surprise: BHEL (Bharat Heavy Electricals Ltd) Q2 results looked like a repeat of the past five quarters with the company missing numbers, the stock falling 7% and management holding its customary earnings call in which it mentioned a slowdown in domestic and international markets and the demand revival efforts of various government bodies. So what now With a dividend yield at 2.8% and FCF (free cash flow) yield of 13.5%, valuations do not seem expensive.

Further, managements closing remarks of a 10-15 GW (giga watt) order pipeline and indications of a possible decline in competitive intensity suggest a turnaround could be in the offing. We maintain that it is difficult to time the bottom, and at current valuations we reiterate Buy.

Industry performance slides, power resilient: Industry sector sales contracted sharply by 31% year-on-year and margins fell 572bps on account of (i) an absence of short-cycle orders (we forecast 13% growth); (ii) lower dispatches to customers who were delaying payment; and (iii) instability in the Middle East affecting revenue recognition. The power sector continues to show resilience, with 15% sales and 34% Ebit (earnings before interest and taxes) growth. Despite the slowdown, NWC (net working capital) /sales did not deteriorate much.

New PSU projects of 9,100MW in tender pipeline: Order inflows for Q2, at R32 billion, suggest that full-year expectations can be met. Management detailed c9.1GW of fresh tenders, primarily from the PSU firms. The management plans to diversify into railway and mono-metro-rail and be competitive in the power space.

Twelve-month target of R300 per share based on DCFthis implies 12x FY13e PE (price-to-earnings ratio)We use a combination of target FCF yield of 10% and DCF (discounted cash flow) as the basis of our 12-month target price, which implies a marginal re-rating of the company to 12x (times) FY13 PE. We believe the de-rating in the stock, from 28x one-year-forward earnings in FY11 to 10x one-year-forward earnings for FY12, largely factors in the decline in the companys earnings in the current demand scenario. A big re-rating in the stock would happen only if the demand environment becomes more benign, likely in FY15e.

Risks: Key downside risks are a significantly larger increase in working capital requirements, lower-than-expected order inflows, delays in execution and the impact of raw material prices on margins. Based on our earnings model, if working capital requirements are 5% higher, FY14 FCF could be 28% lower.

If order inflows are 10% lower than our expectations, FY13 and FY14 earnings could be 1% and 4% lower than our forecasts, respectively.

Our RM (raw material)/sales assumption builds in a 60bps rise in FY13 and a 70bps fall in FY14. However, if commodity prices are higher or lower than we expect or the share of supercritical orders (high imported content in initial years) in execution is higher/lower than anticipated, then each 100bp rise/fall in RM/sales could raise/cut FY13 to FY14 earnings by 11% and 22%, respectively. Another important downside risk is liquidated damage for delays in implementation.

Deutsche Bank