BHEL, battling falling margins & orders, hopes worst is over

Bharat Heavy Electricals Ltd (BHEL) is feeling the pinch of being the largest power equipment maker in the country. With a crippling slowdown facing the sector, its order book has dried by half and its investors have given it a thumbs down, with share prices at a seven-year low. Slowdown in demand, a lower order book and implementation issues due to payment delays by customers, deteriorating working capital, depleting cash in the books and falling operating profit margins are dragging the company down - signifying the ills now gripping the capital goods sector.

"A host of infrastructural bottlenecks related to power shortages, mining ban in many states and delays in commissioning of large projects are key headwinds for recovery in industrial production. We are currently operating in a difficult business environment," said B Prasada Rao, chairman and managing director, in a recent investor conference call.

Power, which contributes almost 80 per cent of BHEL's revenue, has been the biggest worry. The company used to win about Rs 60,000 crore of orders in a year. This has come down to Rs 25,000-30,000 crore. Once an order is booked, it takes two to three years for BHEL to make the equipment, making it important to keep the project pipeline moving. To combat this, the company is looking for other opportunities, particularly from the state and central utilities, which continue to invest in new projects as compared to private sector power companies.

Analysts have their doubts. "Although BHEL's management has guided (forecast) order visibility from state and central utilities, the inflow is not expected to keep pace with the execution run rate, which will lead to further deterioration of order backlog coverage and limit revenue growth," said Amit Patil of Angel Broking. They have less hope about revival of orders this year. "We expect a revival in the order outlook in 2014-15, when we expect domestic coal supplies to improve," says Girish Nair, analyst at BNP Paribas Securities in a note on June 24. The good news is depreciation of the rupee versus the dollar, which has increased BHEL's competitiveness compared to the import threat from its Chinese competitors. In recent years, many private sector companies ordered equipment from Chinese companies, due to lower cost. With the dollar now shooting up versus the rupee, Chinese companies have lost the price cut advantage.

BHEL is also looking at railway projects as a new growth engine. It has signed a joint venture each with Alstom and GE to make engines, which over a period will allow it to diversify and help mitigate a slowing in the power segment. It has also started to focus on exports, winning several orders.

The company is also looking at operational improvement. Almost 80 per cent of its money is employed as working capital and that has pulled down its return ratios and impacted free cash flows as clients delayed payments. Analysts say its return on equity is expected to fall from 32 per cent in FY12 to around 16 per cent in FY14.

The company is also trying to reduce debtors and inventory. "The working capital has been comfortable as compared to last year. It has been largely attributed to the better internal working capital management. The company has reduced its inventory days from 107 days to 96 days," said Rabindra Nath Nayak, analyst, SBICAP Securities.

Recent government policy initiatives on power rate revision, passing on of the higher cost of imported coal and increase in coal availability for about 78,000 Mw (existing and upcoming plants) is positive because that will speed implementation of projects and clients will pay dues as projects reach completion and funding starts. Besides, BHEL's timely capacity expansion from 10,000 Mw to 20,000 Mw today is helping it to speed execution. It put through 16,000 Mw worth of equipment in FY12. This financial year, it expects to put through work for about 20,000 Mw. This will also help arrest its falling operating margins, a key worry. "The noteworthy achievement has been that we have managed to control our direct material cost at 57.7 per cent (in FY13) compared to 59 per cent achieved in 2011-12," said Rao. This was partly possible because of its initiatives that emphasised on localisation of some imported components, helping it to bring down cost. It also reduced staff cost in 2012-13; on a net basis, it cut its employee count by about 1,000 people. Though these cost reduction initiatives and managing of working capital are key, analysts say the entire process of implementation and synergies could take another 12-18 months.

The company itself is confident. "I think our worst economic slowdown in a decade has bottomed out. Growth is expected to pick up and business prospects could improve," hopes Rao.