Bharat Heavy Electricals Ltd (BHEL), key beneficiary of an upturn in the power sector, is now in the news due to headwinds facing the sector, including delay in implementation of existing and new projects, lack of clarity over fuel supply, etc. These events have not only hit demand for power equipment but threaten cancellation of existing orders.
This is also why analysts expect a decline in the company’s earnings over the next two years and, consequently, have downgraded the stock, already down 15 per cent to Rs 198 in the past two weeks. In the worst case scenario, Macquarie Capital Securities India puts the stock’s value at Rs 100. Though other analysts might not agree to such low valuations, a few term BHEL a ‘potential value trap’. The probability of such a scenario increases if the concerns highlighted recently become reality, thereby impacting earnings in the coming years.
In simpler words, though on the basis of the current financial year’s earnings the stock might look reasonably valued at 8.5 times, if one considers the potential negative impact on earnings over the next two years, the valuations might not look as attractive.
| CONCERNS OVER PROFITABILITY | |||
| In Rs crore | FY12 | FY13E | FY14E |
| Sales | 47,979.0 | 47,528.0 | 47,285.0 |
| Ebitda | 9,722.0 | 8,407.0 | 7,426.0 |
| Ebitda (%) | 20.3 | 17.7 | 15.7 |
| Net profit | 6,874.0 | 5,683.0 | 4,985.0 |
| EPS (Rs) | 23.6 | 23.2 | 20.4 |
| RoE (%) | 30.2 | 20.9 | 16.2 |
| PE (x) | 8.4 | 8.5 | 9.7 |
| RoE is return on equity Source: Macquarie Research | |||
“With the prospect of earnings declining another 50 per cent from FY13 estimated levels, the stock’s current price could be at 20 times FY15 worst-case earnings. We would stay clear of BHEL until there’s concrete evidence of a turnaround in thermal generation award activity,” says Inderjeet Singh Bhatia, who tracks the company at Macquarie Capital.
The brokerage on September 6 came out with an ‘Underperform’ report on BHEL, with a 12-month price target of Rs 186. Besides earnings, analysts also see a possibility of a 1,500-basis points reduction in RoE (return on equity), to about 15 per cent over the next two years.
Visibility concerns
Back in 2010 and 2011, BHEL had an order book to sales ratio of over four times (on an average). This is now around 2.9. Even the current order book (partly) of the company at Rs 1,39,000 crore is at risk, believe analysts. This, they believe, is consequent to about 35 per cent of BHEL’s orders being accounted by private sector clients. “We estimate a total of 28 per cent of the existing order backlog (as of June) is at risk of cancellation or deferment due to either non-availability of coal linkage or cancellation of existing coal mines or linkage due to the coal allocation scam,” says Amar Kedia of Nomura Equity, in a note on the company.
Apart from cancellation risk, there is a risk of delay in projects. “With 46,000 Mw of power capacity struggling for long-term fuel supply, the pace of project execution would be delayed. This will result in a slower pace of project executions across the existing order book. We do not expect pick-up in ordering activity in FY13, considering the macro issues related to fuel supply,” says Rabindra Nath Nayak, lead research analyst, tracking the power sector at SBICAP Securities.
Hit on earnings
The combined impact of these issues is expected to result in lower revenue visibility, wherein analysts are expecting BHEL’s order book to sales ratio to fall to 1.8 times by FY14. As the average project execution cycle in the industry is around three years, this means pressure on revenue, at a time when the company’s capacity stands increased from 15,000 Mw to 20,000 Mw.
Analysts are expecting a contraction in revenue in the next financial year, which would also mean lower capacity utilisation, leading to higher pressure on margins and earnings. “Capacity underutilisation shall also aid margin contraction, in our view. Over FY12-15, we model a 480-basis points margin contraction to 16 per cent and EPS (earnings per share) fall of 25 per cent,” says Sumit Kishore, analyst at JP Morgan, in a recent note.
The expected contraction in margins is also due to increase in domestic competition from companies such as Larsen & Toubro. “In the second half of FY13, boiler factories of some of the smaller players would become operational, which would increase competition from smaller and more aggressive players from India,” says Rabindra Nath Nayak.
“In our opinion, many a private sector power project that BHEL is executing may go slow in the backdrop of growing uncertainty around fuel availability. This will adversely impact BHEL’s earnings growth for FY14 and beyond,” say analysts at Antique Stock Broking. “We believe the working capital environment will remain challenging. Declining earnings, coupled with adverse working capital, will drive down return on equity to 15 per cent in FY14 (the lowest since 2002-03; it was about 28 per cent in FY12),” add Antique’s analysts.
