Indian power utility stocks have underperformed the stock market by 17% in the last six months despite most of them showing strong earnings growth and India achieving record levels of capacity addition in the first nine months of FY11. We believe this underperformance is due to a combination of demand side pressure on earnings and heightened concerns about the financial health of SEBs (state electricity boards).

We believe that lower than expected demand from SEBs during the last two quarters is short term. Selected utilities should be able to generate strong growth over the next two years as we expect high capacity addition to translate into earnings. We expect the record capacity addition in FY11 (14GW) to be followed by even higher capacity in FY12 (20GW) and FY13 (25GW). This will translate into strong earnings growth for our stocks.

The net profit performance has been mixed. PTC stock (+158% YoY), Power Grid stock (47%) and Tata Power (31%) have shown much stronger growth than CESC (13%), NTPC (-3%), and R-Infra (9%) . Lanco Infra reported 45% growth on a low base, aided by capacity addition in FY11. However, earnings were 5-10% below consensus for NTPC, Lanco and R-Infra on a 9M (9-month) basis.

While all the stocks in our domain are trading at a discount, our top picks have now become attractive both in terms of historical multiples and relative to global utilities. They are trading at a 28-33% discount to historical multiples?one-year forward PE (price-to earning) of 11.5x (times) and PB (price-to-book) of 1.4x on consensus earnings. This compares with global utilities in our coverage universe trading at 13.5x PE and 1.7x PB

We believe the price correction in the Indian utility space on the back of lower demand hurting earnings is overdone and we expect stocks with a good growth outlook and limited risks to bounce back in the next two quarters.

We continue to prefer players with: (i) strong growth potential over the next five years; (ii) power contracted for significant capacity?not less than 80%; (iii) the least uncertainty about fuel, both quantity as well as price, or the option to pass through fuel costs.

We prefer Power Grid and Tata Power in the large-cap space as we expect both to report strong EPS (earnings per share) growth over FY11-13 (17% and 21%, respectively) with limited fuel and operational risks. In the mid-cap space we prefer PTC and CESC for their strong growth potential [EPS CAGR (compound annual growth rate) of 41% and 51%, respectively]. We do not favour NTPC as it offers limited growth (9%) and expect it to fall short of its own capacity addition targets.

Our analysis suggests that concerns about the increase in interest rates will not impact the progress of projects of our top picks or have any significant impact on their profit before tax. One company whose PBT could be affected is Lanco, for which any 100 bps increase over and above our estimate of interest cost (12%) could negatively impact PBT to up to 5% for FY12-13.

?HSBC Global Research