Stock Review: Bharat Heavy Electricals’ (BHEL)

The impact of rising competition and the slow pace of new power projects has started to reflect on Bharat Heavy Electricals' (BHEL) financials, judging by its results for the June quarter. Revenue growth reported by BHEL, big daddy of the Indian power equipment industry, was the lowest in the past 13 quarters. Order inflows dived 75 per cent year-on-year to `2,500 crore — again, the lowest ever, amid subdued activity in the power sector and industrial capex.

While the order book is still robust at `1,59,600 crore or four times the company's 2010-11 sales, it has slipped marginally by three per cent sequentially; year-on-year growth at eight per cent touched a new fouryear low.

Not surprisingly, the stock fell close to nine per cent in the past two trading sessions and could correct further, as the outlook appears subdued. Analysts believe order inflows, order book, sales growth and margins are on the way down. Say Arun Kumar Singh and Murtuza Zakiuddin, analysts, HSBC Global Research, in their July 27 report, "Earnings growth should be flat in FY1314 versus a CAGR (compounded annual growth rate) of 30 per cent in the past five years." Analysts at Emkay Global expect BHEL's earnings growth to range five to nine per cent in FY12 and FY13. Most analysts believe the risk-reward equation is currently not favourable, despite the stock's underperformance in recent months.

OTHER INCOME BOOST

BHEL's revenues, or total operating income, grew just 10 per cent year-on-year in the quarter, half the pace as compared to analysts' expectations. Execution was weak due to delay in clearances at the ports (thereby impacting the company's plant commissioning) in particular and delays in progress of power projects in general. The company's power segment, which accounts for 80 per cent of total sales, reported a mere eight per cent growth in top line.

On the other hand, BHEL's industry division did better than expected, wherein profits jumped 120 per cent. This and operating leverage helped the company maintain its operating profit margin at around 15 per cent.

Net profit margin improved despite a higher base and a surge in depreciation, thanks to the 52 per cent jump in other income (to `249 crore).

MUTED OUTLOOK

In 2011-12, the company expects growth in revenues and order inflows to be 15-20 per cent and 10 per cent (Rs 66,000 crore or 1,600 Mw), respectively. Says B P Rao, chairman and managing director of the company, "We expect execution to pick up in coming quarters and thus maintain our revenue booking target of `50,000 crore in FY12." However, analysts expect things to remain tight in the medium term. They believe the impact of competitive pressures will become increasingly visible. Ordering activity is likely to be muted, as 90 per cent of 12th Plan projects have been awarded and Chinese players have already garnered asizeable share (above 50 per cent). Analysts expect the order book to remain flat in the current financial year after a 26 per cent CAGR between 2006-11. This will affect sales growth beyond 2012-13.

Margins, which peaked in 2010-11, are also expected to eventually come off the current levels due to competition and higher imported components for super-critical equipments initially. Emkay's analysts, in their July 26 report, estimate BHEL to report Ebitda (earnings before interest, taxes, depreciation and amortisation) margins of 19.7 per cent in 201112 and 18.6 per cent in 2012-13, as compared to 21 per cent in 2010-11l. Consequently, the return profile will deteriorate.

The stock currently trades at `1,825 levels. Even after correcting 25 per cent in the past year, touching a 52-week low in June, and trading at five year trough valuation of 14 times 2011-12 estimated earnings (below industry multiple of 16), analysts feel BHEL's stock will de-rate further, given the weak fundamental outlook of the power equipment sector.

Says Misal Singh of Religare Institutional Research in aJuly 6 report, "Valuation multiples are likely to trend lower, as the growth profile normalises beyond FY12." The upcoming follow-on public offer is also likely to put pressure on the stock.