After 25% correction over past six months, valuation multiples have adequate headroom and FY18F FCFE yield of 8.5% is healthy
On our revised earnings forecasts for JSW Energy (JSWE), wherein we build in a steeper-than-guided y-o-y fall in FY17F merchant realisations and conservative profit for its Barmer project (assuming returns are based on project cost approved in the FY14-17F true-up order, 16% below actual cost), we still see FY17F-18F RoE at ~14% and a decline in leverage (net D/E to drop from 1.8x to 1.1x by FY18F) enabling calibrated inorganic expansion without stressing the balance sheet (as exhibited by the agreement to acquire 1GW capacity from Jindal Steel & Power
(JSPL). After the 25% correction (vs -4% for the BSE Sensex) over the past six months, valuation multiples have sufficient headroom (1.1x FY18F P/B, 12M forward P/B—1SD below three-year average) and FY18F FCFE yield of 8.5% is healthy. Our SOTP-based 12MTP for JSWE drops by 17% to R79, but still implies 17% upside plus a 3% dividend yield.
Accordingly, we maintain our Buy rating on JSWE.
Catalysts: Reasonable valuation, FCF generation, value accretive M&As Besides the headroom in valuation, we also view sanguine capital allocation i.e. FCF deployment and value-accretive M&As as key catalysts. Further, earnings could potentially surprise if FY17F merchant realisation is in sync with mgmt guidance (implied tariff of R4.2-4.3/kWh) and the approved project cost for its Barmer project is enhanced in subsequent tariff orders.
Earnings: We are a tad below consensus; 6% FY16-18F EPS CAGR
We cut FY17F/18F EPS by 22%21%, and now expect a 6% FY16-18F EPS CAGR. After the expected Ebitda uptick in FY17F (full-year contribution from hydro projects offset by lower merchant spreads and conservative earnings of RWPL), we forecast an Ebitda decline in FY18F owing to the absence of capacity expansion plus lower spread on merchant sales. We expect FY18F EPS growth to be driven by declining ‘net finance costs’.
Why has the stock underperformed over past six months?
In our view, JSWE’s 25% share price correction (vs -4% for the BSE Sensex) over the past six months can be attributed to the following: (i) weak growth in electricity demand plus a 35% y-o-y average decline in spot electricity tariffs in South India, raising concerns on offtake and realisation from its merchant capacity (34% of total capacity) in FY17; (ii) a halt in the downtrend in FOB price of high GCV coal (Richard Bay index), which is the bulk of JSWE’s feedstock for its coal-fired capacity; (iii) the true-up tariff
order for RWPL (Barmer project) wherein the regulator (RERC) approved only 84% of petitioned/incurred project cost, potentially weakening the project’s earnings outlook; (iv) the Government of India (GoI) doubling the ‘clean environment cess’ on coal to R400/ton with effect from March 1, 2016, thus denting the profitability of merchant sales; (v) management pegging project cost of 240MW Kutehr hydro at Rs 29 bn, vs Rs 20 bn previously; and (vi) risk that M&As under consideration may be concluded on unfavourable terms.
Why do we retain our Buy rating on JSWE?
Our revised earnings forecasts for JSWE (we cut FY17F/18F EPS by 22%/21%) capture reported FY16 financials and notably build in: (i) steeper-than-guided y-o-y decline in FY17F merchant realisations; and (ii) conservative base earnings forecasts for RWPL, assuming RERC’s final tariff order will not approve a higher project cost. Still, we believe JSWE will be able to sustain an RoE of ~14% over the next two years and cash flows + leverage levels will continue to enable calibrated inorganic scale-up, in turn providing earnings growth visibility.
Our TP for the stock continues to be based on a SOTP valuation methodology (FCFE-based value of operational and under-construction projects and fair value of cash and book value of investments). Accordingly, based on our revised earnings forecast for JSWE, our 12-month TP for the stock drops by 17% to R79, still implying 20% total return potential. Together with benign valuation multiples at FY18F P/B of 1.1x (12M forward P/B-1SD of its three-year average) and FCFE yield of 8.5%, we believe the risk-reward remains favourable at current levels. Accordingly, we maintain our Buy rating on the stock.
Besides the headroom in valuations, we also view sanguine capital allocation and FCF deployment, including calibrated capacity scale-up by acquiring distressed power generation assets with sufficient turnaround visibility in value-accretive deals, as the key catalysts for price performance. Further, earnings could potentially surprise if JSWE manages to tie-up the bulk of its open-ended capacity in 12-15-month contracts at tariffs that are in sync with mgmt guidance (implied realisation of R4.2-4.3/kWh), and RERC enhances the approved project cost of JSWE’s Barmer project in subsequent tariff orders and/or disallowed project cost is recouped from favourable orders from the Appellate Tribunal (we estimate if 50% of disallowed cost is approved, FY17F/18F EPS would rise by ~5% and TP would rise by ~3% to Rs 81).