We are optimistic about the Indian utilities space as higher average power tariffs and spot tariffs will drive greater sustained project returns. We think the worries about oversupply are overdone. The consensus view among most investors and analysts is that the recent surge in spot rates is likely to be short-lived and industry profitability will fall sharply as new capacity comes on stream. We disagree. Our extensive analysis suggests India?s power generation is unlikely to increase by more than 11.2% compound annual growth rate (CAGR) over the next five years, which is insufficient to bridge the demand-supply gap of 13% even assuming that the entire new capacity of 102 gw, which is 65% of current industry capacity, is commissioned during the period.
We believe distribution firms are no longer constraint for electricity sales. The big change for generation companies in India is that annual collections of distribution firms, at $31 billion, is now sufficient to cover power purchase cost of $29 billion without any significant budgetary support. Furthermore, the regulator has approved open access or last-mile connectivity, where consumers can choose their supplier in areas which account for 14% of all-India power sales. These two changes imply that distribution companies can afford costly power and generation companies have an option for last-mile connectivity wherein reliability, not price, is key differentiator.
We expect the spot tariffs to rise over the next few years. Our analysis suggests that 95% of the existing capacity of 156 gw and 83% of new capacity of 102 gw being set up over FY10-15e are under the long-term power purchase agreements. We estimate that the average of all-India tariffs should rise from Rs 2.3/kWh in FY10e to Rs 3.08/kWh, a CAGR of 6% per annum, assuming that spot rates for new capacity are Rs 4/kWh. However, if we assume that average spot tariffs rise to Rs 6/kWh, the average pan-India tariffs would increase by less than 2% to touch Rs 3.2/kWh in FY15e.
We estimate additional supply should create its own demand in India as the current demand is restrictive in nature due to loadshedding. Many households and industries would switch to electrical power once reasonable supply is assured. Key risks to our assumptions are reversal in financial health of distribution companies and adverse regulatory action to curtail power tariffs.
Within Indian utilities space, we believe that pure power plays offer greater potential upside than diversified players. Power developers such as Lanco Infratech, Adani Power and JSW Energy are likely to benefit the most from exposure to higher spot tariffs. Our top sells are Jaiprakash Power Ventures (JPVL) and Tata Power, as they have already locked in long-term power purchase contracts at relatively low rates. We also rate NTPC and diversified players such as GVK and Jaiprakash Associates as buy which appears less risky, but their stock prices also offer relatively lower upside than our top picks. Lanco Infratech is our top sector pick with a target price of Rs 79. We estimate the open-ended capacity of Lanco could continue to give a positive earnings surprise, especially at time when we estimate that merchant tariffs could see a strong rise. Adani Power is our second pick with a buy rating and a target price of Rs 150. The important triggers for the company are commissioning of 660 mw in FY11e and 3,960 mw in FY12e, giving the company management the option to sell 25% (1.9bn units) and 70% (23.7bn units) of its power output in FY11e and FY12e, respectively, in the short term.
We initiated coverage on JPVL with a sell and a target price of Rs 55. We feel the company would not be a beneficiary of positive headwinds in the sector as it has the lowest leverage to merchant power market within our coverage universe: 1% in FY11 and 17% (1.2 bn units) in FY12e would be sold in the short term. High interest cost on the securitised debt would cast its shadow in near-term earnings. We rate Tata Power as a sell at a target price of Rs 1,140. Upside from uptick in merchant market looks limited as cost structure of Rs 4/unit is among the highest in peer group. Also, government approval for selling incrementally 160 mw in spot market versus 200 mw being sold today looks uncertain.