power ful show

Jitendra Kumar Gupta / Mumbai January 14, 2008

Power utility stocks have seen good gains in recent months, further upside depends on their ability to deliver on promises.

Power utility stocks have been a hit with investors since the last few months with stocks of nearly all major companies beating the BSE Sensex by a good margin.

The outperformance comes as a surprise, considering that stocks of power utilities are typically valued on a price-to-book value basis, since they earn fixed returns and a steady or a predictable cash flow and, there has been no unusual jump in their earnings recently.

Traditionally, stocks of power utilities have been valued between 1-2 times their respective book values. In terms of costs, including fuel expenses, interest and depreciation, all of it is pass-through and are passed on to the consumers so as to ensure that power utilities earn the fixed rate of return of 14 per cent on the shareholders funds (return on equity or RoE).

The conventional method of valuations though now seem to have gone for a toss as most of these companies are trading at about 4-5 times their respective book value and, their PE multiples are now at over 30 times FY07 earnings.

What's changed? To know the factors responsible for this up move and to know if there is still power left in these stocks, read on. Much of the action was started with the announcement of ultra mega power projects (UMPP), followed by the controversy over nuclear power in the country.

By that time, the market was convinced that the government is not only aiming for the ambitious capacity additions of 78,577 megawatt (MW) during the Five Year Plan ending 2011, but also, a large part of it is very likely to be achieved.

Their belief was further fuelled by the government's initiatives such as allocation of coal mines and allowing merchant power. The listing of Power Grid at premium valuations instilled more confidence among investors.

However, the most recent trigger in the sector, says Deepak Jasani, head of retail research, HDFC Securities, "For the last few months, there has not been any fresh trigger for the re-rating of the power utility sector apart from the hype built over the Reliance Power IPO. Re-rating of stocks in this space is happening based on relative valuations with respect to various parameters like capacity (existing and planned), book value, etc, when compared with the Reliance Power valuations."

Relative parity The forthcoming IPO of Reliance Power (RPL) has had a big rub-off on valuations. To give some numbers, based on Reliance Power's IPO price, at lower-band, of Rs 405 per share, the market is valuing the company at Rs 91,530 crore, in terms of market capitalisation. At the IPO price, its price to book-value per share works out to over 7 times.

There is nothing exceptional in the case of RPL, which justifies a premium valuation over others. Analysts say, for the six projects totaling 7,060 MW and estimated to cost Rs 31,789 crore, for which the funds are being raised in the IPO, the RoE for RPL is unlikely to be significantly higher than the usual 14 per cent. That's even after considering some upside potential in the case of the 3,960 MW Sasan-based ultra-mega power project and merchant power capacity.

Now compare this with NTPC, India's largest power producer and the sixth largest coal-based producer in the world, which currently has an installed capacity of about 28,000 MW (including about 1,000 MW through joint ventures) and a RoE of 14.9 per cent (for FY07). For NTPC, the price to book-value works out to 4.6 times.

Notably, NTPC has already undertaken various projects, which will see its capacity increase to over 50,000 MW by 2012. And by 2016, its capacity should stand increased to over 75,000 MW. Notably, NTPC's cash generation too, estimated at over Rs 10,000 crore in FY08 (and likely to grow at over 10 per cent annually), is sufficient to fund its growth plans, with little contribution from loans.

This gap in the valuations not only exists vis-à-vis NTPC, but to a large extent with other players as well. So, either RPL is over valued or the other power utility stocks are under-valued. Notably, as other stocks are catching up, at this point in time, based on historical valuation methods (price to book-value), all of them appear to be over-valued.

Says Srinivas Macha, vice president, Aranca, a global investment and research service provider, "In India, there seems little justification for such rich valuations as there is very little to show by way of performance. All the issues that dog the power sector in India such as high technical and commercial losses at 50-60% -- among the highest anywhere in the world, less than 50% of realisation of all power that is generated, inept state-run utilities with poor record of recovery, populist measures such as subsidies and so on, persist." While things are improving, it's still a long way to go.    IN DEMAND Rs crore Company  Trailing 12 months  Returns in (%) M-Cap  PE (x) ROE (%) P/BV(x) Sales Net Profit EPS (Rs)  CMP 1 Yr 6 M 3 M CESC 2587 297 23 649 108 56 14 8105 28 16 3 Gujarat Ind Power 808 150 10 145 131 120 51 2198 15 18 2 Neyveli Lignite 2868 691 4 233 309 259 115 39015 56 7 5 Tata Power 5010 820 33 1458 158 117 34 31635 44 12 5 NTPC 33994 8133 10 272 98 76 22 224525 27 14 5 Torrent Power 3185 173 4 202 156 189 57 9567 55 5 4

Growth story There are other things that seem to partly support the rising valuations. For one, the power sector is now being perceived as a growth sector, especially after many power projects have started to roll. In each of the last three five-year plans viz. 1992-97, 1997-2002 and 2002-07, the average total capacity addition has been 51.33 per cent of targeted capacity.

But, in the current plan (2007-12), key plant equipment (boiler, turbines and generators) for over 60% of the planned addition of 78,577 MW has already been ordered. So, there is greater visibility in terms of what is aimed and what is likely to be achieved. These developments too are playing positively on stock valuations, as it should result in higher earnings growth for companies.

Among other key fundamental changes that are responsible for the rally in the stocks of power utilities, says Amitabh Chakraborty, president, equity, Religare Securities, "The power utility stocks have been re-rated because of huge demand-supply mismatch and increased attention from the government. Utility returns were earlier capped and linked to the bank rate. So, there were no incentives to perform. Now, there is potential to earn higher returns by setting up merchant plants. Secondly, the ultra-mega power plants provide scale of economies for new power generation companies, and gas availability has also improved. Overall, all this is good news."

Adds Krishna Kumar, fund manager and head of research, Sundaram BNP Paribas Mutual Fund, says "developments such as better fuel linkages, de-blocking of the coal mines for the private and public sector power generation companies and allowing merchant power generation, have improved the outlook of these companies."

Not to forget, India is a power deficit country, especially when it comes to the energy requirement of the country. In the light of rising GDP thus, there is a long way for power generation companies to scale up their businesses. This has also led the private players to share the growth, and their participation is seen rising.

Merchant power The focus on merchant power, where power producers can earn higher returns compared to the traditional 14 per cent RoE, is also viewed as a key development, as it provides greater incentives to set up capacities.

With respect to merchant power, power producers can sell power at market determined prices, which in current scenario, may go up to as much as Rs 7 per unit on spot-basis, as compared with Rs 1.50-2.50 per unit, thanks to the huge demand-supply gap.

On the flip side, while the equation looks favourable now, it could change in a situation where supply exceeds demand and, buyers refuse to pay a high premium. Secondly, since the profitability will depend on market dynamics, besides, offtake commitment and timely payment by the buyer (of power), the lending community (banks, institutions, etc) too needs to be comfortable with lending to such projects.

Simply because, in case of merchant power plants, the risk will tend to be relatively higher. And due to such reasons, analysts believe that it will be difficult for any company to have an exposure of more than 15-20 per cent of their power generation portfolio, in merchant power plants.

Says an analyst, "For a company like NTPC, dedicating a 2,000 MW plant on merchant basis seems possible, as it has a strong balance sheet and equally robust profits, which can be used to service the debt, should anything go wrong. But, for a smaller company, debt servicing could become an issue in such an event."

In the best case scenario (and considering a RoE of 25 per cent for merchant power plants), the blended RoE is unlikely to go beyond 17 per cent. In short, profits are unlikely to rise significantly, purely based on this factor alone and, will hinge largely on the fresh addition to existing capacity.

Is the power run over? While there's no doubt that these various developments are positive for the sector, the run up in share prices also suggests that the market seems to have already factored in the growth that is expected to accrue over three to five years from now.

But, there are many who continue to be bullish on the sector, Says Amitabh Chakraborty, "We are positive on the sector." While some others believe that current valuations are either fair or on the higher side, they also suggest that further moves will depend on the listing of RPL and subsequent moves.

As per analysts estimates, factoring in the future growth plans of the bigger companies, the price to book-value for NTPC works out to around 2 times, while for Tata Power its about 1.8 times and for Reliance Energy (only power business) its about 1.6. These are close to fair values as per traditional valuation methods.

To sum up, in the short-to-medium term, there is little upside, if any, left from here on. But, going forward (long run), further upsides should come based on events including companies securing new projects, companies reporting satisfactory progress with regards existing projects and the government continuing to give attention to the sector.