Despite reasonable valuation, BHEL stock could give investors a shock

Fundamentals are improving, but managing working capital and order inflows will be tough

The good news for Bharat Heavy Electricals (BHEL) is that analysts are turning positive on the stock. 

The optimism is also backed by fundamentals — largely attributable to improved order execution and cost optimisation — which are, in turn, perking up operating profit margins for the coal-fed power plant maker. In addition, acting upon the need to diversify, BHEL is shoring up its presence in segments such as locomotives, railway electrification and emission control equipment, which contributed about 30 per cent to total order inflows (Rs 23,860 crore) in FY19. 

Further, with Rs 725 crore of orders from alternate energy (mainly solar), BHEL is making an attempt to reduce dependance on orders from coal plants, in the long run. 

Some of this worked well for the company in FY19, when its revenues grew 5 per cent year-on-year (YoY) and net profit doubled to Rs 1,215 crore. 

Operating margin also improved from 6.7 per cent a year ago to 7.1 per cent in FY19, with the March quarter number being the best in recent times, at 13.5 per cent. 

BHEL has also secured revenue of Rs 33,000 crore in FY20 — a 12 per cent YoY increase. 

However, that doesn’t take away some of the larger challenges the company is facing. 

Managing working capital will be a tight rope walk, given that the terms of payment for new orders have been modified recently to the advantage of customers, which will lead to an increase in debtors for BHEL. 

Analysts at ICICI Securities point out that as the current ratio — current assets as a ratio of current liabilities (a measure of liquidity) — has reduced from 1.92 times in FY18 to 1.66 times in FY19, it will put further pressure on working capital.

Further, BHEL’s efforts to diversify were not adequate to fill its order book (orders pending execution), which fell 8 per cent to Rs 1.1 trillion in FY19. 

“From peak inflow of 15-16 gigawatts (Gw) every year, we foresee BHEL struggling to receive even 7-8 Gw of inflows, despite assuming 90 per cent market share,” analysts at JM Financial have warned.

This could, as a result, limit operating margins and earnings potential. Slow traction in power plant refurbishment orders (with an opportunity size of 30 Gw) also substantiates the analysts’ pessimism.

This is why, even if the Street has incrementally turned positive, its faith is yet to reflect on BHEL’s stock price, which has  lost 6 per cent year-to-date. 

Despite reasonable valuations of 14 times its FY20 earnings, the intrinsic risk for investors is the weak outlook for thermal power plants. 

Therefore, until there is an on-ground improvement, the BHEL stock is best avoided.