Q3 reconfirms low gross margin trajectory; BHEL likely to report losses till FY18
Our concerns on gross margin contraction driving losses for Bharat Heavy Electricals Ltd (BHEL) are accentuated post Q316 results. With increasing evidence, we lower our FY16-18 gross margin estimates by 260-340bp. These lower gross margin estimates, coupled with a cut in revenue estimates and the consequent negative operating leverage, drive our negative Ebitda estimates for BHEL over FY16-20. We estimate profit after tax (PAT) to turn positive in FY19, helped by other income. If execution in Telangana and stalled projects does not pick up by FY18e, net losses could persist beyond FY18e.
Revenues to remain muted in FY17; increase in fixed costs to hit in FY18
We have been concerned about the execution of Telangana orders being booked without the requisite approvals in place. Our analysis suggests that the 4GW Nalgonda and the 1.1GW Manuguru projects are unlikely to receive approvals before H2FY17. So, we think revenues will likely remain muted in FY17. The revenue boost from Telangana projects in our FY18 estimates could be offset by large increases in fixed costs, driven by the wage reset due in Q4FY17e.
Project pipeline looks long prima facie, but unlikely to drive order book growth
Management has highlighted 9GW worth of projects where it is favourably placed. This would translate into an order inflow of ~R180 bn. Our channel checks suggest that SOEs could award an additional 13-14GW of orders. Finalisations of these orders should help BHEL achieve our order inflow estimates of ~R330 bn/year over FY17-18– broadly in line with our FY17-18 revenue estimates. As a result, BHEL’s order book could stagnate. The order finalisation timelines could surprise negatively. Many of the 9GW projects, where BHEL emerged as the lowest bidder, have not been finalised for more than a year. Even SOE utilities are in no hurry to expedite orders, given limited ‘unmet’ demand and the power market’s significant overcapacity.
Valuation: cut PT to R70.00; we reiterate our Sell rating
Given we forecast BHEL’s first consistent loss in history, we move our valuation methodology from a PE (price-earnings ratio) multiple to a P/BV (price-to-book ratio) multiple. Given that our forecast ROEs remain significantly below the cost of equity, even in the medium term, we value BHEL at 0.5x FY17e P/BV, translating into a price target of R70.
Can BHEL’s order book grow in the next 3-4 years?
Not likely in the medium term. The oversupplied Indian power market implies private companies are not likely to invest in new capacities. SOEs could continue to order, based on long-term projections, resulting in the order book stagnating at current levels.
Can BHEL reduce fixed cost base to contain margin erosion?
Difficult. Gross margins have now moved to a downward trajectory and the wage reset is also due. Put together, we believe it will more than offset the positive impact of marginal reduction in employee count every year.
Can BHEL diversify into new areas to offset a lack of opportunities in the power sector?
Theoretically yes; but practically difficult. New segments like defence and railways present new avenues of growth but actual opportunities would take time to crystallise.
BHEL’s order book will stagnate around current levels over the medium term. This could result in mild revenue growth at best. Given BHEL’s inflation-linked fixed cost base, this would be insufficient to arrest current margin erosion and could translate into losses over FY16-18e. After the re-set in salaries, we think even marginal revenue disappointments could push the company to losses even beyond FY18e.
The Indian power market is clearly oversupplied. Our survey of 150 cities and towns indicates that ‘unmet’ demand is, at best, 10%. With current coal-based power plants’ capacity utilisation at 61% and another 100GW of capacity under construction, coal plants’ utilisation is likely to be sub-70% over the next five years, even in a scenario where power supply growth is 1.3x the historical highs. This will likely constrain order book growth.
WHAT’S PRICED IN?
Shares are pricing in a gradual recovery in order inflows and earnings. BHEL’s current ROE (return on equity) is less than the COE (cost of equity). As per the residual income model, 27% of the current stock price is attributed to long-term growth post the third forecast period. This implies that shares are pricing in a significant expansion in ROE in the medium term. As profitability is dependent on revenue recovery, we think investors are not factoring in the constraints on growth over the medium term, given the significant overcapacity.