Before going ON a power trip...

Investing in this capital-intensive sector calls for a close look at existing power purchase agreements and fuel supplies

Investors did not have a very good experience with some of the recent Initial Public Offers (IPOs), especially from companies in the power sector, as many of these in the recent past traded to below the issue price. Most market participants believe the investors completely ignored the fundamentals and just focused on opportunities in the power sector. 

SIZE OF OPPORTUNITY
The opportunities are definitely large, considering that India's per capita power consumption is amongst the lowest in the world. According to industry estimates, India's is about 650-700 units, compared to 2,000 in the case of China, 7,000 in Britain and 15,000 units in the US. The requirement for power grows along with the growth in the economy and that is also a reason why this sector has recently seen very high activity, particularly after the opening of the sector for the private players. Today, India has over 130,000 Mw of installed power capacity, expected to reach about 300,000 Mw by 2017 and 450,000 Mw by 2022. 

BUSINESS MODEL
While the opportunities in the sector should in the long run reward investors, one needs to be careful while investing in these companies. A company's business might comprise generation of power, transmission or distribution, or a combination of all the three. The sector has very high entry barriers, given the capital-intensive nature of the business. It requires about Rs 4-5 crore of investment for every Mw of generation capacity, the amount depending on the sourcing of equipment and type of fuel. A hydro power plant, run by tapping water from a river, might cost something like Rs 5-6 crore per Mw, whereas a coal-based station might cost less. 

However, more than the business model, investors need to understand the profile of the individual companies and projects. Some parameters are listed below.

KEY PARAMETERS
Funding 
Since the business requires huge debt financing, to the extent of 70-80 per cent of total project cost, funding is essential, without which no work can commence on projects. Investors should check at what rate the funding is being done. Also, in case of equity infusion, if this could result in dilution. 

Power purchase agreement (PPA)
Most of these companies generate power and supply to the grid. Which, in turn, transmits power to substations and to ultimate consumers. Its customers might include households and the industrial house. Investors need to check if the company has signed a PPA and at what rate for existing and upcoming power plants. 

Companies sign a long-term PPA, for about 10-30 years in advance. It is a critical parameter which gives an idea about whatever power the company produces being sold at a predetermined price. This is also why the cash flow of every power plant can be predicted and this helps in funding from banks. The companies sign a PPA at a price which may start from as low as Rs 1.5 per unit to Rs 10 per unit. The rates provide insight about its profitability and returns on investment. In the case of household customers, the companies charge rates which are relatively lower and determined by way of actual cost of generation and the required regulated return on equity (RoE)

Return on equity
Typically, companies generate an RoE between 12-14 per cent. But if the company is allowed to sell a certain or entire portion of its total generation through merchant power (selling power at Rs 6-10 a unit to industries or selling power in the open market at market-driven rates), the RoE could move to as high as 30-40 per cent. Also, in many cases, if the capacity utilisation or plant load factor (PLF, which may differ from 50-100 per cent) is higher, it results in a better RoE. One should also look at the PLF to gauge efficiency of a power plant.

Better RoE means better operational efficiency and higher returns on shareholder funds. This is also a reason that a company with higher RoE could command premium valuations in the market, compared to companies with lower RoE. 

Supply of fuel
Secured supply of fuel is critical, irrespective of the fuel type such as coal, gas or water. Reliance Power's Dadri plant of 7,480 Mw is a classical case where due to the hindrance over supply of gas from Reliance Industries' KG Basin, the plant has been delayed for a long time. Companies first secure the fuel, which accounts for a majority of the cost, that too for the long term, like acquiring coal mines or entering into a long-duration agreement with suppliers of coal or gas. 

Acquisition of land 
Every power plant requires a large amount of land. Companies sometimes face agitation from local residents. Typically, delays are more in hydro power projects, where the land is identified based on the availability of water; dam construction and evacuation of local residents become critical. A thermal power unit could be erected within 3-4 years, but a hydro power plant might take 5-7 years. 

Government and other clearances
Companies have to go through all the relevant clearances from government agencies, such as environment, forests, etc. Clearances are critical and these are assessed by individual agencies after all the due diligence. A power plant might get delayed in case of problems with regard to clearances such as forest or environmental. 

Procurement of equipments 
Investors also needs to look at the sourcing and time frame for supply equipment such as boilers, turbines and generators. Equipment accounts for almost 60 per cent of the total project cost. Sometimes, companies have been sourcing equipments from Chinese suppliers to save cost and time. However, there could be risks relating to performance of such equipment. Delay in placing or procuring equipment can lead to cost overrun. 

Valuation parameter
Finally, valuations are important. Considering the predictable future cash flow, most power companies are valued based on the discounted cash flow. Also, due to the large asset base, companies are also valued on the price to book value. A price to book value which is near 1.5-2 times is always good, considering that the company is expanding its capacities.

Alternatively, power companies are also valued in terms of market capitalisation per mega watt (Mw). As it requires about Rs 4-5 crore for every Mw, a company should ideally have the same market capitalisation as it spent on its power capacities. For 1,000 Mw capacity, the company should have a market cap of about Rs 4,000-5,000 crore. However, analysts also take into account the planned or upcoming capacities. However, in that case, the market capitalisation per Mw could be in the range of Rs 2-2.5 crore and considered to be reasonable. This ratio gives an indication of how much the company is asking for every Mw of its planned capacity and if the stock is overvalued.