The Hindu Business Line : It's boom time for equipment makers with the...<br> Power sector on high voltage

Power equipment trends suggest that big players have the edge in leveraging the power story, with their technical superiority, diversification strategy and careful capacity addition.

The stock market action over the last eight months may have led to load-shedding by power equipment company stocks, with key scrips under-performing the market. However, the power story is still far from being unplugged, considering the strong company fundamentals, the investment commitments across the power chain (generation, transmission and distribution) and the loaded order books.

Various factors are likely to keep this this long-term growth story live. Here is a look at where the listed players in the equipment space stand in terms of equipping themselves to ride the power wave. And a list of preferred stock-picks in the segment.

Policy initiatives

The Electricity Act 2003, the clean-up of State Electricity Board losses, and the implementation of the Accelerated Power Development and Reforms Programme (APDRP) to privatise, modernise and strengthen the transmission and distribution (T&D) network have played key roles in fast-tracking investments in the power sector.

Power Grid Corporation, for instance, is in the process of upgrading inter-State transmission capacity to 37,200 MW at a total cost of Rs 71,000 crore . Further, transmission capacities are being enhanced in the West Asian countries, where a number of Indian players now have a foothold. In the generation segment, the target is to increase the power generation capacity from 1,20,000 MW to 2,00,000 MW by 2012. This requires huge investments in generation equipment such as boilers and turbines, and the infrastructure to transport such power generated.

Further, the Tenth Plan is expected to achieve 80 per cent of the initial targeted capacity additions. This is much higher than the earlier Plan achievements of about 50 per cent. This vindicates the the reforms process.

The high level of capacity additions needed translates to order flows for power equipment makers. While these plans are showing up in equipment companies' order-books, at 1-2.5 times their last four trailing quarter revenues, investors need to take note of the following: The equipment-maker's ability to upgrade to higher-range solutions, improve execution capabilities, and ramp up capacity, while avoiding excess capacity situations, would be key factors to success. The challenges arise from the stiff deadlines for execution, increasing competition and the consequent pressure on margins.

Why bigger is better

An analysis of trends in the industry suggests that big companies such as ABB, Siemens and BHEL enjoy certain advantages over the others. With the reforms aimed mainly at ramping up power generation, improving shipment and reducing losses and theft, there will have to be a shift towards higher voltage T&D applications and super-critical boilers.

Three factors that support our conviction about big companies are their technological edge, business diversification and discretion in capacity addition. These factors not only augur well for such companies seeking to leverage on the power story but also suggest that they could join the league of global players.

For instance, after losing out to Doosan (Korea) and Power Machines (Russia) in the bid for NTPC's super-critical power projects, BHEL put in place tie-ups with global players Alstom and Siemens. ABB is increasingly into High Voltage Direct Current (HVDC) systems in the T&D space, one of the high-end products with few competitors; the company is also focussed on exiting low-value segments.

Apart from being in the high-end power equipment space, which is likely to see sustained demand, these companies have well-diversified business models to hedge against any slowdown in one segment. ABB and Siemens, for instance, derive about 60 per cent of their income from the power equipment segment and the rest from the automation and drives businesses. Thermax is involved in wastewater treatment solutions while Crompton Greaves is into electric motors, home electricals and agricultural pumps. Such diversification across various infrastructure areas forms a strong de-risking strategy.

In terms of expansion of production capacities, BHEL, although the largest in terms of outlays on expansion, is in line with others in terms of percentage of additional revenues. ABB and Siemens are expanding only in specific products, while Thermax is adding just one greenfield facility. Evidently the large companies want to avoid a repeat of the overcapacity situation of 1999.

While the large players are showing prudence in capacity expansion, smaller players, such as Emco, Voltamp Transformers and Bharat Bijlee, are on an expansion spree. Although the medium-term outlook for these companies is backed by good demand, investors need to keep in mind the following risk. As mentioned earlier, the reforms targets require higher voltage equipment. At the Central level, for instance, all the requirements are for the above 400 kV category, and at the State transmission level it has been enhanced to 132 kV.

This would necessitate constant upgradation to higher voltage segments by smaller players. Further, this move to high capacity lines may mean that the requirement for transmission towers and conductors will eventually decline, as the traffic is likely to be handled by fewer high-end equipment. So the way out for small companies will be to constantly upgrade and diversify product lines.

Emco and Areva T&D have proved their capability to quickly move up the value chain. A few, such as Voltamp Transformers, derive 95 per cent of their revenues from the industrial sector and hence are not particularly dependent on the reform process. For investors, a wait-and-watch approach may be the strategy in evaluating the mid-size players.

The "ultra-mega" story

While equipment makers in the mid-value segment are likely to profit from the implementation of ultra-mega power projects (UMPP), the gains may not be uniform for all players. Recent trends suggest that key bidders are going in for tie-ups with specific (domestic as well as overseas) vendors for critical components. In the recently won Sasan Project, Lanco Infratech has a tie-up with China's Dongfeng Electric for power equipment. NTPC, which had a tie-up with BHEL for equipment, lost the bid. Chinese equipment-makers may have an edge over the local players in terms of pricing and lead-time.

While there may be no threat to the revenue stream of such players as BHEL, there could well be some pressure on the pricing side for local players in the near term as Chinese companies such as Shanghai Electric and Dongfeng may adopt aggressive entry strategies into the Indian market, given its significant potential. This is evident from overseas vendors bagging various super-critical thermal projects from NTPC. Investors need to take note of these risks before estimating the revenues for equipment-makers from UMPPs.

Our stock picks: ABB, with a focussed strategy, steady margins and support from global parent, is our preferred pick in the power equipment space; its valuation appears justified in the face of good long-term prospects.

BHEL, a pure power play, is exposed to relatively higher risks from a slowdown in policy implementation. The company also faces the risk of competition from its own alliance partners and overseas vendors (bidding independently) in the super-critical projects space. A hold strategy appears appropriate now, given that the company is the preferred supplier for government projects.

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