Thermax has announced a 51:49 joint venture (JV) with Babcock & Wilcox (B&W) to manufacture supercritical boilers (unit size of 660 MW and above). The JV will also manufacture subcritical boilers over 300 MW in size. The facility will have a 3,000 MW capacity at a cost of Rs 700 crore. This JV is over and above the existing technology partnership with B&W for sub-300MW boilers.
We view the JV as positive for the long term as it will help Thermax graduate from the short-cycle industrial segment to the long-cycle utilities segment. However, the JV?s near-term earnings impact is marginal and can effectively add Rs 14-25 in earnings by FY ?15. We expect the order inflow only in 2HFY11 and contribution to earnings only post-FY12. This announcement already appears to be priced in by the market, as the management had, about six months ago, stated its intention to enter supercritical projects through JVs.
We prefer BHEL over Thermax: We believe BHEL (current price Rs 2,423.50, target price Rs 2,850) offers better upside and strong visibility, trading at a 5% discount to Thermax (vs historical premiums of 15-30%). BHEL?s medium-term growth outlook is robust, given its strong order backlog of $ 29 billion, or 4.1x FY10 revenue. Thermax?s order backlog is $1.1billion, or 1.6x FY10 revenue. We expect BHEL to have a 30% earnings CAGR for FY10-12 versus Thermax?s 25% for the same period. We believe that the ramp-up to the utility boiler segment will be gradual and that Thermax will have to compete with established players like BHEL and new entrants like Larsen & Toubro.
Valuation and risks: We use a target multiple of 18x FY12 earnings, a 10% discount to our BHEL (large-cap peer) target multiple. We maintain our estimates as we see no near-term impact; our target price is Rs 645. Upside risks include a greater-than-expected pickup in industrial and utilities capex, leading to higher order inflows and higher-than-expected margin expansion, given lower commodity prices.
Downside risks, we believe, include execution risk; competition, and a possible re-focus of competitor BHEL on captive power plants.
For BHEL, we use MACC valuation methodology?MACC range of 9-10%, with a long-term CROIC of 9%? to derive our 12-month target price of Rs 2,850. At our target price, BHEL would trade at 24x
FY11 earnings: Under our research model, for stocks with a volatility indicator, the Neutral band is 10 percentage points above and below our hurdle rate for Indian stocks of 10.5%, or 0.5-20.5% around the current share price. At the time we set our BHEL target price, it suggested a potential return that was above the Neutral band; thus, we have an Overweight (V) rating on the stock.
Potential catalysts, in our view, include equipment ordering for the 12th Plan, faster-than-expected execution, and better-than-expected margins. Downside risks, we believe, includes a slowdown in capacity execution under the 11th Plan, impacting revenues; a slowdown in 12th Plan ordering, impacting order inflows and revenue; higher-than-expected competition; and lower-than-expected margin improvement.