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The government is planning a massive investment in the power
transmission sector in the XI-XII Plans to meet the requirements of the
higher power generation capacity and historical neglect of the sector.
This translates into an investment opportunity of | 3,80,000 crore
(US$84.4 billion) in 2008-17. Transmission sector stocks have
underperformed the Nifty in the past year due to the subdued tendering
activity by PGCIL and state utilities. With the expected pick-up of
tendering activity by PGCIL and state utilities to meet their plan targets
and with ordering for mega projects expected to commence, we believe
the sector is due for a re-rating. With reasonable sales visibility, positive
outlook for new orders and stable margins, we project revenues and
PAT of our coverage companies (Jyoti Structures [JSL]; Kalpataru
Power Transmission [KPTL]; KEC International [KEC]) will grow at
16.3% and 16.8% CAGR in FY10-13E, respectively. We are initiating
coverage on JSL and KPTL with ADD rating and KEC with a BUY rating.
Our top pick is KEC due to its strong sales visibility, high RoNW, stable
margins and attractive valuations.
Strong tendering opportunity in next two or three years…
The government has lined up investments worth | 3,80,000 crore ($84.4
billion) during 2008-17 in the transmission sector. We believe PGCIL and
the state utilities will significantly step up their ordering activity over the
next two or three years driven by mega transmission projects like the nine
high capacity power transmission corridors (HCPTC), and planned
expansion of national and state grids. This translates into an ordering
opportunity of ~| 180,000 crore ($40 billion) during FY11E-13E.
…translates into reasonable earnings growth for companies & competition
We believe our coverage companies will be the key beneficiaries of the
huge domestic opportunities due to their strong execution capabilities
and diverse client base (PGCIL, state utilities and private sector). We
project domestic order backlog of ~| 22,000 crore ($5.5 billion) during
FY11E-13E for our coverage companies. Additionally, KEC and KPTL have
a sizable international presence (mainly Africa, Middle East and CIS
countries). Our coverage companies’ earnings are projected to grow at
17% CAGR in FY10-13E fuelled by their robust order book position and
stable margins expected.
Risks exist
The key risks to our call include lower-than-expected tendering of orders
by PGCIL and state utilities, delays in power generation capacity addition,
execution slippages by coverage companies, etc.
Recommendation
Power transmission sector stocks have underperformed the Nifty in the
last year. We believe the primary reason for the underperformance has
been the subdued ordering activity by PGCIL and state utilities, rising
competitive intensity as compared to 2005-08, slower execution, rising
capital intensity of the business (exposure to BOOT projects). Our three
coverage companies are currently trading at a substantial P/E discount
to their five year average one-year forward P/E (discount of 56% for
JSL, 40% for KPTL and 36% for KEC). We are valuing stocks on P/E as
well P/BV basis. We are initiating coverage on JSL and KPTL with ADD
rating and KEC (Top Pick) with a BUY rating.
Investment Rationale
Massive investment targeted in XI and XII Plans
Aggressive power generation capacity addition targets…
India’s rapid economic growth during the last decade (8.2% CAGR) has
placed tremendous pressure on the existing infrastructure base (power,
roads & highway, airports, telecom, etc). The power sector has witnessed
a significant demand-supply gap due to the sustained growth of power
demand (4.8% CAGR in FY00-10), historical shortfalls in generation
capacity addition (53% and 49% in the IX and X Plans, respectively) and
high transmission and distribution (T&D) losses. Consequently, the peak
load deficit in India has been in the 11-17% range in FY00-10. This has
constrained the economic growth of the country.
With the GDP expected to grow at 7.1% CAGR in FY12E-22E, power
demand is estimated to increase at 7.8% CAGR (as per Central Electricity
Authority [CEA]). This is likely to place a further strain on power
infrastructure. The government has aggressive investment plans for the
sector, with ~62 GW of generation capacity targeted to be added as per
the mid-term appraisal (MTA) of the XI Plan. The scale of opportunity
becomes even larger in the XII Plan (100 GW capacity additions targeted).
This is a quantum leap from the capacity addition since India’s
independence (126 GW generation capacity at the end of the Xth Plan).
The aggressive power generation capacity targets will entail massive
investment estimated at | 410,900 crore ($91.3 billion) in the XI Plan and |
495,083 crore ($110 billion) in the XII plan as per CEA. Additionally, this
will require an equally large investment in T&D infrastructure.
With a decade of underinvestment in the T&D space, the XI Plan and XII
Plans are more progressive for the T&D segment. This is clearly evident
from the fact that the share of expenditure on T&D in the XI and XII Plans
is 51% and 56.4%, respectively, as compared to the 44.2% share in the X
Plan. Like the generation segment, there is a structural change in the onus
for expenditure in the XI and XII Plans in terms of private sector
participation. The recent foray of private companies to build T&D
infrastructure is a sign of huge quantum of capex to be committed by
them in the next couple of years.
…translates into transmission sector investment of | 380,000 crore ($84
billion) in XI-XII Plans
One of the primary reasons for high T&D losses in India has been the
historical neglect of the sector in the previous five-year plan periods.
Majority of the investment was directed towards power generation while
ignoring the T&D sector. According to internationally accepted
benchmarks, an equal investment ratio should be maintained between
power generation and T&D. Recognising this, the government has
stepped up T&D spending in the XI Plan (51% of the total power sector
investment) creating attractive opportunities for companies catering to
this sector.
Our power transmission coverage universe (JSL, KPTL and KEC) primarily
focuses on the transmission sector (33% of T&D investment in XI Plan).
With an aggressive XI Plan physical targets for power transmission
capacity addition (88,515 ckm during XI Plan vs. 41,374 ckm added during
X Plan) and substations (157,691 MVA during XI Plan vs. 76,892 MVA
added during X Plan), an investment of | 1,40,000 crore is expected in
FY08-12. The scale of opportunity becomes even larger in the XII Plan,
which is pegged at | 240,000 crore.
Transmission orders of | 180,000 crore expected in FY11E-13E
Transmission sector orders largely depend on the power generation
capacity being added in the country and are generally placed two years
before the actual date of commission of generation capacity. With
significant power generation capacity expected to be added by FY15E and
remaining XI Plan orders, we estimate a transmission sector ordering
opportunity of ~| 180,000 crore in FY11E-13E.
Out of the ordering opportunity of ~| 180,000 crore over FY11E-13E, we
estimate that total opportunity for our coverage companies in the
transmission line packages and substation segment would be at |70000
crore and ~| 62700 crore, respectively.
PGCIL and state transmission utilities (STUs) will continue to lead
investments with ~85% share in both XI and XII Plans. PGCIL has recently
announced the creation of nine high capacity power transmission
corridors (HCPTC) linking independent power producers (IPP) plants in
several states including Orissa, Chhattisgarh, Jharkhand, Sikkim, Andhra
Pradesh, Tamil Nadu and Madhya Pradesh to different regions of India.
This presents an opportunity of | 49,633 crore (| 58,061 crore including
IDC). Ordering for this mega project is expected to pick up pace over
FY12E-FY13E. Below are the capacity expansion targets of key players in
the sector (detailed information on all agencies is provided in the
following sections)
• PGCIL: PGCIL plans to expand the capacity of the National Grid (interregional
transmission system) to 32.6 GW by the end of the XI Plan
(vs. 14.6 GW at the end of X Plan). Investment targets stand at |
55,000 crore (over and above HCPTC spending). In the XII Plan, the
government plans to further raise National Grid capacity to 75 GW.
We have assumed that approximately 10% orders for the XI Plan and
the entire XII Plan orders remain to be tendered. This translates into
an ordering opportunity of approximately | 31,100 crore during
FY11E-FY13E.
• State transmission utilities: Fuelled by power sector reforms
(unbundling of state utilities - separation of generation, transmission
and distribution functions) in recent years, and focus on reducing T&D
losses, state utilities have significantly stepped up spending in the
transmission sector. State utilities plan to invest | 65,000 crore in the
XI Plan to expand intra-state transmission network (from 131,828 ckm
at the end of X Plan to 175,869 ckm in the XI Plan). In the XII plan,
state transmission utilities are expected to invest approximately |
100,000 crore. We have assumed that ~70% of XI Plan orders have
been placed by FY10-end and entire XII Plan ordering remains to be
tendered. This translates into an ordering opportunity of ~| 74,250
crore during FY11E-FY13E.
• Private sector: In the XI Plan, investment of | 20,000 crore has been
envisioned from the private sector directed towards expanding interstate
transmission network. Several PPP projects have been awarded
by state utilities including Haryana, Rajasthan, Maharashtra, etc. Of
the XI Plan investment target, we have assumed that 50% of the
orders have been placed by FY10-end. In the XII Plan, the quantum of
private sector investment is expected to increase to | 30,000 crore.
PGCIL – HCPTC
Order tendering to pick-up in FY12-FY13E
With the higher share of private sector in incremental power generation
capacity (57% in XII Plan vs. 14% in XI Plan), we expect strong growth in
capacity of IPPs over the next few years (15 GW at present). This will
necessitate the need for an inter-state transmission network linking IPPs
to various parts of the country. In January 2010, PGCIL announced the
creation of nine HCPTC projects at an estimated capex of | 58,000 crore (|
49,633 crore excluding IDC). The identified projects will transfer ~50 GW
of power generated by IPP plants.
Based on our analysis of commissioning schedule of various IPP projects,
we expect ordering for this mega project to get completed by FY13E
(assuming an average execution period of two years). However, order
tendering by PGCIL has been behind target in H1FY11. Though there may
be some ordering for HCPTCs that will be done in FY11, the major pick
will be witnessed over FY12E-FY13E.
PGCIL – National Grid
Aggressive XI plan targets to expand National Grid…
At the end of the X Plan, the capacity of the National Grid stood at 14.6
GW dominated by transmission lines and substations in the 400 KV
capacity range. Expansion of inter-regional transmission networks is
required due to the uneven distribution of power generation capacity
across India and need to transport power to areas where high demand
exists. Consequently, the government plans to expand the National Grid
capacity to 38.2 GW by FY12E.
…translates into high capex for PGCIL
In the XI Plan, | 55,000 crore is planned for investment by PGCIL, India’s
inter-state transmission utility of which only ~| 26,000 crore has been
spent by PGCIL by FY10. The government’s emphasis on reducing
transmission losses will lead to significant investments to be made in high
capacity transmission lines (765 KV, +/- 500 kV HVDC Lines). According to
the MTA of the XI Plan, transmission capacity of 18.5 GW is likely to be
added by FY12E (shortfall of 24% vis-à-vis planned targets).
Eastern region to account for majority of capex on surplus power availability
Of the XI Plan target for the National Grid, the north-east and eastern
regions will account for majority of investment due to the surplus power
generating capacity. With more power generation projects expected to be
commissioned in the north-east region (mainly hydro power), surplus
power from these projects will need to be transferred to energy deficit
regions of the country – driving the need for a larger transmission
network.
State transmission utilities
Substantially higher spending by state utilities in XI Plan
For the XI Plan, the aggregate investment by state transmission utilities
was | 65,000 crore (plan target). Fuelled by power sector reforms
(unbundling of state utilities - separation of generation, transmission and
distribution functions) in recent years, and focus on reducing T&D losses,
state utilities have significantly stepped up spending in the transmission
sector (| 25,285 crore in the X Plan). The scale of investment becomes
even larger in the XII Plan (| 100,000 crore).
Maximum incremental investment in the XI Plan is targeted by power
hungry states, including Maharashtra (19% share of incremental
spending), Tamil Nadu (9%), Chhattisgarh (9%), Andhra Pradesh (6%),
Delhi (4%), etc.
Large order tendering for XI Plan still needs to be done
Despite the aggressive investment targets, actual transmission capacity
added by state utilities is behind schedule (~65% of 44,041 ckm planned
in XI Plan capacity has been added by Q3FY11). On the tendering front,
we have assumed that 30% of XI Plan orders still need to be done. This
has created a large opportunity for power transmission companies
catering to this space as state utilities step up tendering activity over the
next few quarters to meet their plan targets.
220/132 KV projects to dominate state utilities’ orders
State utilities will continue to rely on transmission lines and substations in
the 220 KV capacity range in the XI Plan. Although the share of higher
capacity transmission projects will increase, going forward, they are likely
to have a small share in total capacity added by state utilities.
For the XI Plan, approximately 80% of the capacity added by the state
utilities till date has been at the 220 KV and 132 KV level while only 4% of
the capacity added has been at the 400 KV level.
Private sector projects
Higher private sector investment expected in XII Plan
Although the sector was open to private sector investment since 1998,
there was only one operational PPP project prior to the XI Plan. In the XI
Plan, an investment of | 20,000 crore has been envisioned from the
private sector directed towards expanding the inter-state transmission
network. Several PPP projects have been awarded by state utilities
including Haryana, Rajasthan, Maharashtra, etc.
We expect private sector contribution to increase, going forward, driven
by expected bids from UMPPs in the XII Plan period and financial distress
faced by several state utilities.
Private sector participation in power generation projects expected to
provide further opportunities
The high share of the private sector in generation capacity addition in the
XII Plan could translate into private sector transmission utility orders. For
example, Adani Power has recently awarded a 1,000 km dedicated HVDC
power transmission line contract worth ~| 1,380 crore to Siemens for
evacuating power from the Mundra power plant in Gujarat to
Mohindergarh in Haryana. Similarly, Essar Power Transmission Co.
received a captive order to construct and maintain the transmission line
from the power plant at Mahan in Madhya Pradesh being installed by
Essar Power.
Intense competition…but have to live with it going ahead
Intense competition in recent years…
Attracted by the massive government investment and onus of PGCIL to
increase its vendor base so as to step up the growth rate of T&D
infrastructure (relaxation in bidding norms), competitive intensity in the
transmission sector has substantially increased in recent years. This has
led to new players bidding aggressively for PGCIL projects (sometimes
15-20% lower than our coverage companies). Unabated continuance of
this situation could result in margin contraction for our coverage
companies.
…however situation could improve…
We believe the margins could be sustained at current levels due to the
large tendering activity expected by PGCIL and state utilities over the next
two or three years. Additionally, with majority of smaller players already
operating at near full capacity, we believe these players will find it difficult
to bid for new projects in the near future. Thus, this is positive for overall
industry margins. Lastly, the two step bidding procedure being followed
by PGCIL (financial bids following results of the technical bids) will bring
some sanity to the bids being placed by suppliers.
…but focus on international markets is gaining prominence
Over the past few years, markets like Africa, Middle East, US and Latin
America have become key markets for the coverage companies. Both
KEC and KPTL have been executing orders in more than 20 countries. The
prominence of international orders in the backlog provides growth to the
coverage companies and cushion against the competitive intensity in the
domestic markets (specifically in the case of PGCIL orders), in our view.
As of Q3FY11, the share of the international order book stood at 54%,
36%and 18% for KEC, KPTL and JSL, respectively. Apart from these, KEC
and JSL are expanding their footprints in the US markets via acquisitions
(SAE Tower acquired by KEC in Q2FY11) and setting up greenfield
capacity (JSL likely to commission a 30,000 MT tower manufacturing
capacity in the US by December 2011)
Coverage companies command reasonable share in transmission line PGCIL
orders along with competition…
Based on the market share for PGCIL orders, JSL, KPTL, KEC, EMC and
Tata Projects are the major contenders for transmission tower orders.
Also, an erstwhile marginal player i.e. SPIC has been gaining market share
(37.7%in 9MFY11 vs. 6.5% in FY10) via consortium bidding (JV with BS
Transcomm, SMO and Aster). As of Q3FY11, our coverage companies i.e.
KEC, KPTL and JSL commanded a market share of 12.8%, 13.1% and 0%
respectively in Q3FY11. Though JSL has not won any orders in 9MFY11 it
commanded a market share of 14.9% and 11.1% in FY09 and FY10,
respectively.
…but have limited capabilities to undertake high capacity substation
projects
With PGCIL expected to award EPC orders for higher capacity substations
(765 KV) in the future, we believe that companies with capabilities to
undertake high capacity transmission and substation orders will enjoy a
strong competitive advantage. Among the companies in our coverage
universe, capacity to undertake substation projects stands at 500 KV
(KEC), while it is 400 KV (each for JSL and KPTL).
For the substation and transformers and reactor segments, MNC players
ABB, Areva T&D, Siemens, Hyosung (South Korean player) and Crompton
Greaves enjoy a high market share for PGCIL orders.
Operating Metrics
Strong sales visibility for coverage companies; robust order intake expected
in FY11E-12E
Our coverage universe companies enjoy strong sales visibility with a TTM
book-to-bill ratio in the 1.6-2.0x range. With the subdued tendering
activity by PGCIL and state utilities in 9MFY11, the order-book-to bill ratio
of our coverage companies has marginally declined (e.g. KEC, which has
secured some large overseas orders). However, we expect the domestic
ordering activity to pick up strongly in Q4FY11E and FY12E-FY13E driving
growth of order backlog growth (~16% CAGR in FY10-13E to ~| 22,252
crore at an aggregate level).
Additionally, a reasonable global macroeconomic outlook, stable
commodity prices and higher funding allocation by donor countries and
multilateral agencies for new projects are likely to drive overseas orders
(mainly from Africa, Middle East and CIS countries). Overseas orders are
an important component for two of our coverage companies (KEC and
KPTL).
With the positive outlook for order intake and higher execution rate by
companies (to meet contractual obligations), we project robust growth of
revenues for our coverage companies in FY10-13E (16.8% CAGR at an
aggregate level). In 9MFY11, project execution was adversely impacted
by the severe monsoon season and slower order inflows.
KPTL most diversified in terms of business vertical; KEC geographically
diversified
On closer inspection of our coverage companies, KPTL enjoys highest
order book diversification with 67% stake in its civil engineering
subsidiary, JMC Projects, having an order book of | 4,300 crore (Q3FY11)
in addition to the | 5,000 crore order book of the standalone entity.
Additionally, oil & gas pipeline projects (high growth potential) account for
approximately 3% of the consolidated order book, providing the company
further diversification. Lastly, with domestic transmission orders
constituting 33% of the consolidated order book, KPTL is substantially
exposed to the attractive domestic opportunity.
On the other hand, KEC has maximum exposure to the overseas
transmission sector (54% of order book). The company has recently
increased its focus on the lucrative American market with acquisition of
SAE Towers, expanding the scope of operations from the earlier focus
areas of Africa, Middle East and CIS countries.
JSL is least diversified and primarily caters to the domestic T&D sector
(82% of order book as of Q3FY11). Going ahead, we believe JSL will
incrementally gain on the international business as it is commissioning a
30000 MT capacity in the US so as to capture the opportunity in the US
and Canadian T&D market.
EBITDA margins of JSL least vulnerable to higher commodity prices
JSL has been successful in generating stable EBITDA margins even in
periods where commodity prices have been high. This is largely due to
the dominance of domestic projects in the order book (mainly with a price
variation clause). On the other hand, the EBITDA margins of KPTL and
KEC contracted substantially in FY09 due to their high overseas exposure
(fixed price contracts mainly) and the impact of the global economic
slowdown.
As of Q3FY11, KPTL’s 75-80% standalone order book is based on the
price variation clause. We believe it will be able to maintain its EBITDA
margins in the range of 11-11.5% over FY11E-FY13E. In terms of order
book, international orders comprise 38% of the overall order book.
Nevertheless, we believe the margins of KEC are most vulnerable to
higher commodity prices (high share of fixed price contracts in order
book). However, an upside case also exists from higher margins from
SAE Towers (14% EBITDA margins generated vs. ~10% for KEC). Hence,
we expect KEC’s EBITDA margins to hover around 10.4-10.6% levels over
FY11E-FY13E.
We have modelled stable EBITDA margins for our coverage companies in
FY11E-13E despite the high industry competition. The reasons for our
margin assumptions are margin visibility on the current order book, likely
reduction in bidding intensity (saturation of manufacturing capacity of
marginal players and two-stage bidding process by PGCIL) and the
companies’ management focus on bidding for only those projects that
fulfil certain minimum return criteria.
High working capital requirements
The working capital requirements of KPTL are highest among our
coverage companies (155 days in FY10) while it is lowest for KEC (78
days). The number of debtor days remains high for all companies at 160-
185 days due to retention money and back payments in domestic and
international government contracts. With power transmission
manufacturers actively scouting for BOOT projects, we expect working
capital requirements to increase further in future. KPTL has recently
achieved financial closure of BOOT power transmission projects from
Haryana Vidyut Prasaran Nigam
KEC has high leverage levels
Despite higher working capital requirements, JSL and KPTL have
managed to keep leverage at comfortable levels (0.6-0.7x range in FY10).
On the other hand, KEC’s leverage was higher at 1.0x in FY10. It is
expected to rise to 1.4x in FY11E (due to borrowings to fund the SAE
Towers acquisition).
JSL generates highest RoCE among peers
In FY06-10, JSL has generated strong RoCE in the 25-33% range driven
by the robust topline growth (30% CAGR), stable operating margins and
high asset utilisation. We expect the company to continue to generate
robust return ratios in FY11E-13E.
On the other hand, KPTL has generated the lowest return ratios among
peers in FY06-10. In our view, a major factor responsible for this is the low
utilisation of asset base (KPTL had sales/assets ratio of 1.7x in FY10 vs.
2.5x for JSL and 2.8x for KEC). Both KEC and JSL have access to large
third-party tower manufacturing capacity at 60,000 MT/annum (dedicated
value-added partners) and 50,000 MT/annum (Gulf Jyoti JV plant),
respectively. We expect KPTL’s return ratios to deteriorate further in
FY11E due to higher borrowings for working capital requirements (higher
due to power transmission BOOT) and the equity dilution through QIP
route in Q1FY11 (| 450 crore raised).
For KEC, the return ratios are expected to decrease in FY11E due to an
increase in borrowings to fund the acquisition of SAE Towers.
Exposure and focus on BOOT projects to increase equity intensity
The Government of India (GoI) is now laying greater emphasis on private
participation in building T&D networks. It is expected that both central
(PowerGrid) and state utilities (state transmission companies) would be
placing transmission line and substation contracts only on a BOOT basis
in the coming years. Going ahead, this may be equity dilutive in nature for
funding the projects.
KPTL has recently bagged a BOOT project in the transmission and road
segment (JMC Projects). The company had also raised | 450 crore for
funding the subsidiary and meeting the working capital needs. Also, JSL
has recently come out with an NCD issue with warrants attached to it. On
conversion of warrants (price of | 120 per share) equity dilution will
happen to the tune of 20% on a post conversion basis. We believe the
increasing equity intensity of the EPC companies may add to investor
scepticism and cap the valuation multiples of the coverage companies.
All the coverage companies are trading in the range of 7x-11x on FY12E
earnings. This, we believe, is a substantial discount to their historical one
year P/E averages of 13-16x for all three companies.
Risks and concerns
Lower order tendering due to economic slowdown
In case of an economic slowdown, order tendering by PGCIL, state
utilities and private sector could be significantly lower. With the growing
share of private sector investment, order inflows are especially vulnerable
to an economic slowdown.
Delays in power capacity addition
Since transmission orders depend on generation capacity addition, lowerthan-
expected generation capacity addition could result in lower order
inflows for our coverage companies. Historically, India has been plagued
by shortfalls in generation capacity addition vis-à-vis planned targets
(53% in IX Plan and 49% in X Plan). The situation has somewhat
improved in the XI Plan but the likely shortfall is still high at ~24%.
Execution delays
Execution of several transmission projects could be delayed due to
political unrests, terrorism, etc. With some HCPTC projects planned in
politically sensitive states, including Andhra Pradesh, Jharkhand,
Chhattisgarh, Orissa, etc, these projects could face execution delays. This
could result in lower-than-expected revenues for our coverage
companies.
Additionally, execution slippages could happen due to manpower
shortages, delays in receipt of environmental and land approvals, natural
calamities, etc.
Geopolitical tensions
Since companies are geographically diversified beyond India, any
geopolitical crisis may lead to slippages in execution and hamper order
inflow growth for the coverage companies. For instance, the recent
ongoing crisis in the MENA region may lead to minor slippages but may
hamper the order inflow growth from this region in the medium-term.
Higher commodity prices
Commodities (steel, zinc, etc) constitute a high proportion of raw material
costs. With a positive outlook for the global economy, commodity prices
are on an upward trend. Significantly higher commodity prices could
result in lower margins for our coverage companies. KEC and KPTL are
especially vulnerable due to the high share of fixed price contracts in the
order book.
Higher interest rates
Our coverage companies are significantly leveraged due to their high
working capital requirements. The leverage levels could increase further
due to BOOT projects that could be secured in the future. With the RBI
struggling to contain domestic inflation, interest rates could be raised
(resulting in lower profitability for our coverage companies).
Margin contraction due to intense competition
Entry of new players (domestic and international) attracted by the high
government investment has led to fierce bidding for PGCIL and state
utility orders. Continued aggressive bidding could lead to margin
pressures for our coverage companies.
Valuation
Underperformance to Nifty in past year; sector due for re-rating driven by
robust tendering activity expected in next two or three years
Power transmission sector stocks have underperformed the Nifty in the
last year. We believe the primary reason for underperformance has been
the subdued ordering activity by PGCIL and state utilities, rising
competitive intensity as compared to 2005-08, slower execution and
rising capital intensity of the business (exposure to BOOT projects).
Going ahead, the T&D companies may not get the multiples that they
used to enjoy during 2005-08, in our view. During the last five years, our
coverage companies use to trade in a one year forward P/E multiple of 14-
16x vs. current range of 7-10x. Our three coverage companies currently
trade at substantial P/E discount to their five year average one-year
forward P/E (discount of 39% for JSL, 36% for KPTL and 35% for KEC).
What would be an appropriate way to value T&D EPC companies?
Conventionally the companies should be valued on earnings multiples
(P/E multiple) as the business model is not capital intensive and mainly
dependent on the order inflows and timely execution of the same. The
current macro headwinds that the companies are facing at this point in
time are slow ordering activity of the CTUs and STUs, relatively higher
competitive intensity, liquidity pressure to combat working capital
management and exposure to BOOT projects in future. This will increase
the capital raising intensity, which will make these companies look highly
attractive in terms of forward P/E multiples when compared with historical
averages. Whether these multiples do capture the future in terms of an
anticipated pick-up in ordering, pick-up in generation capacity, rising
market shares vs. competition, pick-up in execution rates and decline in
commodity prices is tough to answer given the volatile local and global
macroeconomic backdrop at this point in time.
Hence, in order to capture the various “ifs and buts” surrounding the
sector, we have tried to capture the uncertainties by constructing three
scenarios wherein we try to value the T&D companies using P/E multiples
(assuming things improve and pick up from hereon) and also P/BV
multiple (if the macro backdrop worsens we believe that companies in the
sector will trace back to their book values and capture the negatives).
Top pick KEC with CAGR of 22% for revenues, 19% for PAT over FY10-FY13E
Our top pick is KEC due to its strong sales visibility, robust order flows,
relatively better return ratios, stable margins and attractive valuations.
KEC is currently trading at 7.5x and 6x its FY12E and FY13E earnings,
respectively.
If one is a believer of the efficient market hypothesis then the above
chart depicting the price trends of T&D EPC companies and construction
stocks says it all. The recent brutal decline in stock prices has certainly
discounted the following negatives pertaining to both sets of business
models and the environment:
• Tepid order flows are affecting both T&D EPC companies (PGCIL
and SEBs have delayed ordering in FY11) and construction stocks
(lack of order inflows from the road and irrigation sector)
• Execution has been disappointing: For T&D companies,
execution to a great extent depends on the progress of the related
generation project, which is not as per schedule due to various
regulatory hurdles and clearances not coming in time. Also, the
extended monsoon was one of the key reasons for slippages. The
same is almost similar to that of construction companies.
• Tight liquidity and high working capital requirements: A rising
rate environment and tight liquidity conditions are negative for
T&D EPC and construction companies. This makes working capital
loans dearer and, hence, has a negative impact on profitability.
• Rising competitive intensity: Irrational bidding by smaller EPC
companies in the T&D space have limited the order flows and put
a cap on incremental margin expansion. Competition has become
structural as PGCIL and SEBs want to diversify their vendor base
in order to accelerate their T&D infrastructure. Similar is the case
for construction companies where irrational competition exists in
the road segment.
• Rising capital intensity: Taking exposure to BOOT and BOT
projects has resulted in creation of separate SPVs and dilution of
stake in the SPV in order to gather capital for execution. This, we
believe, has not gone down well with investors and has resulted
into P/E de-rating. Similar are the trends emerging in the T&D EPC
space wherein many BOOT and BOT projects are in the offing.
Silver lining for T&D EPC companies:
If one looks at the capex cycle from an ordering point of view, it is
evident that the power sector has witnessed robust ordering activity
wherein ordering activity for sectors such as roads, ports, irrigation and
industrial sectors has been lacklustre. Given the huge power generation
ordering that has happened, a pick-up in T&D projects is inevitable
given that delays (regulatory, environmental and financial) do not
aggravate the generation side of the segment.
A pick-up in HCPTC ordering by PGCIL will be a huge kick for T&D
equipment players and will lead to a huge re-rating of earnings
multiples, in our view.
Other valuation multiples analysed
P/E multiple and earning CAGR: KEC has the best profile
We have analysed the attractiveness of the current valuations of our
coverage companies by comparing their estimated earnings CAGR in
FY10-12E with the current P/E valuations. Based on this analysis, KEC is
well placed with its reasonable P/E valuations and relatively high earnings
growth in FY12E-13E.
EV/EBITDA vs. order execution period
The comparison of the companies’ order execution period with their
EV/EBITDA multiples identifies KEC as a better stock due to a faster order
execution rate.
P/BV multiple vs. RoNW
We have further compared the coverage companies’ estimated RoNW (in
FY12E) with their current P/BV valuations. This analysis also identifies KEC
as a better pick among our coverage companies due to its attractive P/BV
valuation (1.6x) and high and stable returns (RoNW of 23%).
