Suzlon: Regaining power

Suzlon's measures to enhance financial strength and customer confidence, if successful, should improve sentiments towards the stock.

The stock of Suzlon Energy underperformed the BSE Sensex significantly over the last one year as it fell almost 80 per cent as compared to 33 per cent decline for the Sensex. Surprisingly, over the last one month, Suzlon has risen 65 per cent and outperformed the market (Sensex is up 32.4 per cent). Among key reasons include the flow of new orders, lower commodity prices, talks of restructuring foreign debt and attractive stock valuations.

Regarding orders, in the last 45 days, Suzlon has procured new orders worth Rs 2,200-2,500 crore or 400 mw. This includes a repeat order (announced on April 1) from Duke Energy, US for 42 mw to be supplied by July 2009 and another order (on March 31) worth 132.3 mw from AGL Energy, Australia. Similarly, a 100 mw order was also received from a World Bank funded project in China (on March 3). These have together enhanced market confidence about the prospects of its US business, which was earlier in the limelight due to product quality (blade cracking) issues and had suffered loss of business.

Global woes
Suzlon is the world’s third largest wind-turbine manufacturer with a market share of 13 per cent (including the share its European subsidiary, REpower). It has over 55 per cent share in India. The US and Europe, which are the largest markets, account for over 55 per cent of Suzlon’s revenues.

The global wind-power generation capacities have grown at about 25 per cent annually in the last five years to over 120,000 mw currently. However, off late, the challenging economic environment and global credit crunch has led some of the fast growing markets like the US and Europe to go slow in terms of new capacity additions. Also, as Suzlon faced customer complaints in the US regarding the crack in blades and quality of its equipment, there were concerns if it will be able to bag new orders in these two key markets.

All these factors had led to its order book declining by 42.5 per cent in Q3FY09 to 2,000 mw as compared to Q4FY08. The order backlog is quite low when compared to Suzlon’s current expanded capacity of 5,700 mw, reflecting significantly lower utilisation in the near-term. For companies like Suzlon, order backlog (and flow of new orders) is most critical as it reflects business conditions and revenue visibility. Although Suzlon has been getting new orders of late, analysts say the order backlog is still far from comfort levels. Notably, Suzlon is eyeing about 600 mw of new orders by H1CY09 (excluding 400 mw already received), which if procured should have a positive impact.

Improving finances
As a part of its growth strategy to gain access to global markets and technology, Suzlon had acquired several global companies. Its biggest acquisition was of REpower in June 2007, which is well known for its superior technology and strong position in Europe (particularly Germany) and China, has helped in terms of extension of products and new technologies besides, providing access to these markets. But later, the same also became a cause of concern and was among reasons for the downgrading of Suzlon’s stock by analysts.

The company currently holds about 74 per cent in REpower. However, to acquire the remaining stake (till 91 per cent), Suzlon will have to make a payment of Euro 30 million in April 2009 and Euro 175 million in May 2009. But, given the limited funding options in view of the current market conditions and an already leveraged balance sheet, it could put pressure on Suzlon’s financials. The management however, is looking at various options, including reduction in working capital in Q3FY09, Suzlon had high inventory of Rs 5,500 crore and debtors of about Rs 5,000 crore. Even if it is able to improve the working capital, say by 10 per cent (Rs 1,050 crore), the same should enable the company to meet its payment obligations for purchasing the balance REpower stake.
 

INCHING UP
in Rs crore	FY08	FY09E	FY10E
Revenue	13,679	19,000	23,700
EBITDA (%)	14.5	12.6	13.0
Net profit	1,181	1,200	1,350
EPS (Rs)	7.7	8.2	9.2
PE (x)	7.4	7.0	6.2
E: Analyst estimates

However, analysts believe that shrinking debtors’ cycle is going to be a difficult task, whereas reduction in inventory is possible to some extent. In this case, the company might also need to resort to other options. The company has already initiated a programme to restructure debt covenants on its FCCBs (or buy-back the same at a discount) equivalent to $500 million to bring its net debt-equity to less than one time and a probable fund raising through working capital debt. Meanwhile, if these measures flow smoothly without putting any constraints on Suzlon’s financials, it could result in further re-rating of the stock.

Integration benefits
To improve its working capital, Suzlon has already taken steps like restricting fresh purchases while simultaneously utilising existing inventory. Also, the reduction in commodity prices (account for 25-30 per cent of production costs), logistic costs and lower inventory levels should partly help the company. Besides, the company will increase REpower’s volumes and improve its margins by way of backward integration to reduce its dependency on outsourced materials like rotor blades, gear box and other turbine components.

The latter will be partly achieved through another subsidiary, Hansen Transmissions (71.3 per cent stake), which is into manufacture of gear boxes and is doubling its capacity to 14,600 mw by FY13. Additionally, Suzlon plans to leverage its in-house forging and foundry capacities, through SE Forge (a subsidiary) which has 1,20,000 tonne of annual casting and machining capacity. During Q3FY09, SE Forge has already started commercial production as well as supply to Suzlon and Hansen.

Overall, the company has taken various steps, which are very recent and might take some time to reflect in its margins. While Suzlon’s consolidated EBITDA margins dropped to 10.51 per cent in Q3FY09 (from 12.5 per cent in Q3FY08), analysts believe that with these initiatives margins should improve going ahead.

Investment rationale
The company was in the limelight for quite some time for concerns over revenue visibility, slowdown in overseas markets, funding of REpower acquisition, pressure on margins as well as issues regarding its product quality. Though some of the issues still exist and are reflecting in stock valuations, the company is taking appropriate steps to resolve the same.

Investors with a long-term perspective and some risk appetite could buy the stock. At Rs 57, it is available at 6.2 times the company’s estimated FY10 earnings, which is reasonable as compared to historical valuations. Also, Suzlon is a leading player in the domestic and international markets, where the potential for alternative energy is huge. In the long run, on the back of improvement in the demand (led by availability of funds), lower interest rate and recovery in global economic growth, Suzlon can offer good returns.