Powershift: Will The Gains Sustain?

Power companies are all charged up on the bourses. No prizes, though, for guessing why. The Electricity Bill passed in June this year promises a bundle of goodies for the sector, breathing new life into the business.

Over the six months ended October 16, 2003, 15 power companies have collectively gained Rs 17,814 crore in market-cap, a gain of 92 per cent - that's much faster than the Sensex's gain of around 60 per cent.

Three large-cap power generation companies - the state-owned Neyveli Lignite Corp, Reliance group company BSES and Tata Power - and one power equipment and projects company, Bhel, hogged the lion's share of the value created - about 82 per cent of it.

BSES and Tata Power gained 91 per cent each, but some of their small-cap brethren reported more spectacular returns.

While the RP Goenka-owned CESC, a power generation and distribution company in West Bengal, rose 423 per cent in the six-month period, Ahmedabad Electricity, Surat Electricity, and Gujarat Industrial Power Company gained in the range of 70-125 per cent.

Among power equipment companies, Siemens, Asea Brown Boveri (ABB) and Alstom Projects gained an average 80 per cent, while small-cap stocks like Bharat Bijlee, Asian Electronics and Lakshmi Electricals saw sharper appreciation.

Evidently, these stocks have outpaced the Sensex substantially, making for a power-packed past. Can they continue their scorching pace, or is it time for load-shedding?

Quite a few equity analysts say there's life yet in power stocks. The power sector is likely to go through a structural change and, hence, stocks are getting re-rated.

But there are pessimists, too. They believe it is time to switch-off as the recent rise in power scrips is unsustainable. Power stocks, they say, have risen too much, too early.

Says Sandeep Shenoy, head, equity research, at Pioneer Intermediaries, a brokerage house, "The prices (of power scrips) have to correct and, in some cases, it could be very sharp." Nobody, though, questions the fundamental reasons for the re-rating.

What has changed

In a nutshell, the Electricity Bill seeks to give the power sector a new lease of life by doing away with licensing, revitalising cash-strapped state electricity boards (SEBs) and encouraging them to upgrade their infrastructure, thereby reducing losses in transmission and distribution (T&D).

In what is expected to be a free-market system, power producers will be free to determine their own charges and there will be no assured return - currently 16 per cent.

Clearly, power generating companies will gain from free market access. They can expand their capacities or set up power plants wherever they wish to and there will be no curbs on supplies. They could literally supply to anyone, anywhere.

That's a big positive for generating companies like BSES and Tata Power which can afford to expand capacities and push up their toplines.

Power equipment manufacturers and companies involved in power projects - Bhel, ABB, Alstom and Siemens - will gain significantly as capacity expansion takes off.

Besides, the sector has other positives. In a report on the Indian power sector, Fitch Ratings says there is "significant pent-up demand due to continuing power deficits...".

The report also says that economic growth and infrastructure upgrades, coupled with changes in the current regulatory framework, will fuel demand and improve the sector fundamentally.

Where the risks lie

The biggest risks stem from implementation hurdles. Industry sources and analysts agree that implementation of the Electricity Bill is still a long way off.

Says Urmik Chhaya, power sector analyst with Karvy Securities and Broking, "No major changes will take place for the next two-three years. The centre can only pass these laws, but implementation lies with the states."

The government is in the process of writing up a power policy which is expected to be released over the next few months. The Electricity Act will be implemented only after that.

Moreover, a number of finer details are yet to be dealt with. For instance, contentious issues like tariffs are still not addressed.

With elections on the horizon, tariff structures are unlikely to witness any change as the government will face high resistance from subsidised customers - including farmers.

"Tariff rationalisation will take at least four-five years to fructify," says Arun Tirumalai, research analyst with B&K Securities.

Currently, there is a huge differential in the rates at which power is sold to agriculture, domestic consumers and industries. "Tariff increase has not kept pace with the increase in input costs," says Srinivas Rao, power analyst with Motilal Oswal Securities.

About 60 per cent of the power supplied is either free (in case of agriculture) or is supplied at rates below the cost of production (as in the case of domestic consumption).

The remaining 40 per cent is supplied at a very high cost for industrial and commercial purposes. This has induced the latter to set up their own captive power plants.

"The first step in tariff rationalisation is to phase out subsidies - but this has to be decided by individual states and the respective electricity regulatory commissions (SERCs). To support the subsidies there will be surcharges and the whole exercise could take about three-five years," says Chhaya.

Over the long haul, it is certain that tariffs will come down and rake in a lot of revenues for private sector power companies who are under a differential tariff regime.

Overall, analysts expect huge upsides in the power sector once the reforms finally get implemented. But then, stocks are already discounting three-year forward earnings.

"Power companies have already started discounting the good news and prices are moving up on expectations," says Chhaya. That's not very healthy, say some analysts.

The fundamentals of many power companies have been improving with the economy looking up. But that is not enough reason to justify the steep rise in stock prices. Some of the highest gainers in terms of prices have been the worst performers in terms of fundamentals.

For example, CESC, the highest gainer in stock prices over a six-month period, has recorded a loss of Rs 30 crore for the year ended 2003.

Among equipment manufacturers, many small and mid-cap stocks have seen big gains but there is not enough growth visible to justify the manic rise in prices.

Power-gen Vs power equipment

Analysts are divided when it comes to choosing between power generation and distribution companies and equipment manufacturers.

"Equipment manufacturers like ABB, Alstom and Bhel will be the biggest beneficiaries. Generation companies, however, may take time to see revenues on the profit-and-loss statements till the Act gets implemented," says Chhaya.

Tirumalai also shares this view: "Around 70 per cent of the targeted capacity addition (42,000 mw) is expected to be achieved by 2007, unlike around 50 per cent in the previous plans. The clear winners will be equipment manufacturers like Bhel, ABB and Alstom."

But there are others who say that investing in equipment manufacturers may be fraught with risks. Says Shenoy, "The run-up in the prices of equipment manufacturers is unjustified. The primary reason is that their receivables will be hit when it comes to receiving payments from the SEBs."

There is another problem with equipment manufacturers. Says Manish Turakhia, equities manager, Gandhi Securities, "While the increase in the prices of generating and distribution companies looks genuine, the equipment manufacturers have seen increases in prices because of under-ownership."

Barring the large companies, many small-sized equipment manufacturers like Havell's India, Jyoti Structures, Lakshmi Electricals and Asian Electronics have seen sharp rises in prices purely because of low floating stock.

In such counters, the prices may not reflect true demand potential. "Retail investors should be careful with such stocks," warns Turakhia.

The underlying message: power is in, but there could be many a slip between the cup and the lip.

BSES Vs Tata Power

They are not exactly identical companies, but have similar business models and operate in the same business environment. Yet, when it comes to the way the stock markets value the shares of Tata Power and BSES (being renamed as Reliance Energy) the difference is stark.

Based on trailing 12-month price-earnings (P/E) ratios, Tata Power trades at 8.9x, while BSES enjoys a significantly higher multiple of 31.8! Even based on one-year forward earnings estimates, the former is only half as expensive as the latter.

Says Shilpa Krishnan, research analyst with Prabhudas Lilladher, "We expect a one-year forward P/E of 10 for Tata Power and 18 for BSES."

Why this discrepancy? "The valuation gap between Tata Power and BSES is because the former has issues regarding cross-holdings while the latter is expected to gain over the next few years with Reliance's new gas find," says Turakhia.

But, more importantly, analysts say there is a lot of bullishness surrounding BSES simply because of Reliance's ownership.

"After Reliance acquired BSES, people seem to have raised their expectations on the stock," says an analyst. Net-net, the market expects the power policy to benefit BSES more than Tata Power.

Ever since Reliance took over BSES in early 2003 (the first open offer was made in May 2000 and the second one this year), the stock's P/E multiple has jumped from ranges of 12 to 32.

During the same period Tata Power's valuations have risen from three to around eight. Analysts also point out that Tata Power's valuations have suffered in the past due to concerns about its investments in other Tata group companies, particularly telecom.

On the other hand, there has been a flurry of good news for BSES. The company recently bought a plant in Goa and announced plans to expand its generation capacity by 3,000 mw.

This is, obviously, bad news for Tata Power as BSES may further cut down on power purchases from Tata Power after the additional capacities come up.

Currently, BSES purchases 40 per cent of its power from Tata Power. Curiously, despite all the positives analysts are talking about, BSES is conspicuous by its absence in mutual fund portfolios. Except for Reliance Vision Fund, BSES rarely figures in any of the top mutual fund portfolios as on September 30, 2003.

On the other hand, DSP ML Equity, Franklin India BlueChip, Franklin India Growth, Kotak K-30 and Templeton India Growth Fund held Tata Power shares.

However, volumes at the BSES counter have been increasing steadily. Around six months ago, BSES used to see average weekly volumes of around 10,000 which is now about a lakh plus.

However, some analysts feel that the valuation gap is unjustified. Says Sandeep Shenoy, head, equity research, Pioneer Intermediaries, "BSES's valuations definitely looks stretched. Tata Power looks like a better bet compared to BSES especially after the clean up of its balance-sheet."