Stock Review: BHEL

 

BHEL a public-sector entity that was incorporated in 1964, is India's largest manufacturer of power equipment (especially in the BTG segment, which stands for boiler, turbine and generator). It is also experienced in executing EPC (engineering, procurement and construction) orders. Some of the other industries besides power for which it manufactures equipment include transportation, manufacturing, telecommunication, renewable energy, oil and gas, and defence. While 67 per cent of its revenues come from the power sector, 27 per cent comes from other industries, and 6 per cent from export orders. The company manufactures over 180 products and has 15 manufacturing facilities spread across the country.

 

Sector prospects

About 55 giga watts (GW) of generation capacity is expected to be added in India during the 11th plan, entailing an investment of Rs6,60,000 crore. Of this, around 65 per cent or more will be through thermal power plants. This is a positive for BHEL as its strength lies in setting up coal-based power plants (though now it also has the ability to set up hydroelectric power plants).
In the 12th five-year plan, it is expected that about Rs14,60,000 crore will be spent on the power sector, of which Rs8,20,000 crore will be spent by the public sector (if one goes by the public sector's percentage share of investment during the 11th five-year plan). BHEL is thus likely to be a key beneficiary of higher investment in the power sector in the coming years.

 

Positives

Capacity addition: BHEL currently possesses capacity to manufacture equipment (in a year) that can produce 15,000 MW. It is expected to augment its capacity to 20,000 MW by March 2012.

According to the company's management, its capex plan for FY11 stood at Rs1,500-1,600 crore. This is expected to rise to Rs1,700 crore in FY12.

Large order book: At the end of Q4FY11, the company's order book stood at Rs16,40,000 crore, an increase of 14 per cent year-on-year (y-o-y).
Order inflow in FY11 stood at Rs60,510 crore. The largest contributors to order inflows were the power sector (Rs46,900 crore), manufacturing (Rs11,400 crore) and export demand (Rs3,700 crore).

In FY12 also, order inflow is expected to be strong as it is the last year of the 11th five-year plan. The company's management expects the order book to grow by more than 10 per cent in FY12.

Another positive for BHEL is high visibility regarding order inflows. About 70 per cent of the order inflows that it expects in FY12 and FY13 will come from state electricity boards and NTPC, and the probability of these orders being awarded to it is high.

Diversifying its customer base: The company is now exploring opportunities to supply power plant equipment to African countries such as Nigeria and Congo and Asian countries such as Malaysia, Indonesia and Afghanistan.

 

Risks and concerns

Slowdown in power reforms: As we have discussed in our review of the power sector, while the generation side of this sector has undergone a lot of reforms, the distribution side lags behind. State electricity boards, which are the major consumers of power, are in bad financial shape for reasons such as inability (due to political pressure) to revise power tariffs in line with the growth in cost of power generation, electricity theft, and so on. If reforms are not undertaken on the distribution side, that will affect the generation side (say, due to possible payment defaults by state electricity boards).
Around 65 per cent of BHEL's revenues are derived from the domestic market. If power reforms are not accelerated, the company's earnings growth could potentially get affected.

Intensifying competition: BHEL currently faces competition from Chinese power plant equipment manufacturers who enjoy economies of scale as they supply power equipment to a large number of companies across the globe.
Among analysts who cover this stock, opinion is divided regarding the impact of competition. On the one hand, you have analysts who believe that competition will only get more intense within the BTG space and this will whittle away BHEL's high return ratios.

On the other hand, there are analysts who believe that faith in the quality of Chinese power equipment is eroding within the Indian market. They say that the time wasted on "forced outage due to equipment" and on "planned maintenance" is higher in the case of Chinese equipment than in the case of BHEL's equipment.

The quality of coal being used by power producers is also changing. With Coal India unable to meet many of its supply commitments, many power producers now have to depend on imported coal. Chinese equipment, these analysts say, is unable to cope well with a wide variety of coal.

Moreover, while Chinese equipment can be bought at lower cost and is also supplied within a shorter time frame, it is not certain whether its life-cycle cost will be lower than that of BHEL's equipment.

Finally, by adopting high-level technology, BHEL has managed to reduce its cost structure and improve its delivery schedule. All these factors, these analysts say, will enable it to gain the upper hand over both Chinese and other domestic competitors.

Slowdown in execution: In our country, actual capacity addition in the power sector has often lagged behind targets set for five-year plans. Delays in land acquisition and environment clearance, and an inability to acquire coal linkages are some of the reasons why development of power plants doesn't happen on schedule. Difficulty in accessing funds, both debt and equity, is another reason for delays. Delays in execution in future could have an adverse impact on BHEL's earnings growth.
Volatility in commodity prices: Around 50 per cent of its order book is based on fixed-cost price contracts. This renders the company vulnerable to increase in commodity prices. The company does try to hedge this risk by booking its raw-material requirements in advance, but anticipating and booking all its requirements in advance is not possible.

 

Valuation

BHEL's stock is reasonably valued at present. The stock is currently trading at a price to book value (P/BV) of 4.70. This is much lower than its five-year median P/BV of 7.32.

The stock is currently trading at a PE of 15.77, and its EPS has grown at a compounded annual rate of 29.05 per cent over the last five years. This gives it a price-earnings to growth (PEG) ratio of 0.54, which is quite attractive. You may purchase this stock with at least a three-year investment horizon.