The Hindu Business Line : Power stocks: Caution, high voltage

Power stocks have been generating a lot of heat in the last few weeks. They seem to be caught in a tidal wave that has boosted their valuations to stratospheric levels. So much so, these companies are now burdened with turning in exceptional earnings, quarter after quarter, for at least the next two years to justify these valuations. The rising tide has also lifted stocks of companies that are connected to the power sector, such as Power Finance Corporation, power equipmen t manufacturers such as BHEL and even PTC India, the lone listed power trading company.

Consider this. Reliance Energy (REL), the stock leading the action, is valued at 41 times its annualised sustainable earnings for the first half of this fiscal. PTC India is valued at 47 times by the same yardstick, while newcomer to the market Power Grid Corporation is valued at 37 times. Tata Power, which is comparable to REL in profile, is valued at a relatively sedate 31 times, which by itself is not cheap.

So, what’s driving all the action in these stocks? Are these valuations justified? Or is there a risk of short-circuit round the corner?

BS and AS

The story of price movement in power stocks in recent times has to be analysed in two parts — Before Sasan (BS) and After Sasan (AS). Sasan, in Madhya Pradesh, is where the second of the ultra mega power projects (UMPP) is to be located, and this project was awarded to REL after the original winner, Lanco Infratech, was disqualified. REL was formally awarded the project in early August.

Call it coincidence or otherwise, but power stocks surged after this. By early October, when its subsidiary, Reliance Power, filed an IPO document with SEBI, the REL stock had almost doubled from levels of Rs 750-760 in early August.

Tata Power, which bagged the first UMPP early this calendar year and followed it up by acquiring equity interest in two Indonesian coal mining companies in March, was trading in the Rs 500-600 band until July. By early October the stock shot past the Rs 1,350 mark.

The story is much the same for other power stocks, such as Neyveli Lignite Corporation (NLC), Gujarat Industries Power Company (GIPC), Lanco Infratech and GVK Power, to name just a few.

The Sasan award to REL and the IPO plans of Reliance Power appear to have suddenly opened the eyes of investors to the potential in the power sector. Interestingly, in the last three months when these stocks have been flying high, there has been no change in the fundamentals of the power sector whatsoever. And importantly, none of these companies whose stocks have been re-rated, have achieved anything spectacular in this period.

What they have done, though, is announce ambitious plans to expand generation and transmission capacity over the next 3-5 years. REL announced at its annual general meeting in July that it will be investing Rs 60,000 crore in the power sector in various projects that will take its generation capacity to 15,000 mega watts in five years’ time. Tata Power is on its own capacity expansion programme that will see it add 10,000 MW over the same period, including the UMPP at Mundra. Others, such as NLC, GIPC and Lanco, are either into expansion activity already or have announced plans for the same.

These plans appear to have fuelled the rally across the sector. The IPO of Power Grid Corporation and the big response it got only added further impetus. The second quarter performance of some of these companies was impressive, fuelling the rally further, and the market “discovered” the bright prospects for the sector.

Sustainable valuations?

That’s the big question. The last few days have seen most of these stocks retreat from their respective peaks but their valuations are still high. (see Graphic). There is no doubt about the potential the sector holds. An industry with a demand-supply gap of more than 12 per cent certainly offers its players good prospects. The regulations that govern the sector also afford excellent earnings visibility with a promised return on equity of 14 per cent. Of course, this will come up for review in 2009, when the current tariff policy expires.

The Eleventh Plan document envisages a capacity addition target of 68,869 MW, half the entire capacity of the country now.

Party-poopers

Yet, it is not as if everything is hunky-dory at the moment. There are several potential party-poopers lurking round the corner. Let us start with the basic issue of fuel. The UMPPs are well-conceived pit-head projects that also give the successful bidder the right to mine coal itself. While this assures fuel security, the fact remains that pure generation companies, such as Reliance Energy or Tata Power, have no expertise whatsoever in the complex business of mining. Tata Power may be relatively better off in this respect, as its UMPP is based on imported coal and half its requirement has already been covered by the Indonesian deal.

For the others dependent on domestic coal supplies from Coal India and its subsidiaries, the key issue is whether the latter can sustain uninterrupted supplies in the long term. Recent experience of coal shortages experienced by major power plants that depend on domestic supply certainly does not lend confidence.

For projects that depend on gas, there is the challenge of tying up supply at a price that will make the power generated affordable. Though Krishna-Godavari Basin gas will begin to flow by mid-2008, there are some knotty issues that could well set back those dependent on it for their upcoming projects. The Ambani brothers will have to sort out their differences over gas supply as mandated by the Bombay High Court.

Pending a settlement of the issue, other prospective buyers will have to wait as the final settlement will determine how much of gas will be available for the market. The settlement is also important for REL, which has planned a 5,600 MW project at Dadri to be fuelled by KG Basin gas. Work on this project, though announced three years ago, has yet to begin following uncertainty over gas supply. Things could get worse for REL if the settlement plan does not work out in Mr Anil Ambani’s favour.

Meanwhile, project planners are grappling with long lead times for equipment supply. BHEL, despite increasing its capacity, has a long waiting period for delivery which some in the power sector say is responsible for delays in their projects. L&T, sensing the opportunity, has now jumped into the fray in a joint venture with Mitsubishi that will manufacture super-critical boilers and turbines but supplies are not expected before 2009.

Some power companies have settled for Chinese or Korean equipment. Such equipment is relatively new in India and untested. This enhances the execution risks of these projects significantly. Issues with equipment supply could potentially hold back the capacity addition plans for the industry. Tata Power, for instance, has chosen South Korea’s Doosan Heavy Industries to supply boilers for the Mundra UMPP, while turbine generators will be supplied by Toshiba.

Finally, there is a significant regulatory risk in the sector. Tariff-based competitive bidding — as in the UMPPs — is likely to soon become the norm, and this will bring in a fresh set of challenges for generation companies. Financial closure will be the biggest challenge here as the security of a PPA will be absent in these projects. Companies will have to fall back on the strength of their balance-sheets to secure funding, and not too many companies — save the established ones — can do that comfortably. The market will have to factor this in its valuations because the advent of competitive bidding will create some level of fog in earnings visibility. It is not easy to control costs and cash-flows over a 20-25 year period when the tariff remains fixed. The UMPPs will be the first test of these regulations.

Valuations stretched

Whichever way you look at it, current valuations do appear stretched and these companies have to deliver exceptional growth rates of 30-40 per cent over the next 2-3 years to justify the valuations. The question is whether this is possible, especially as most of these companies will be in the investment phase over the next 3-5 years. This is a period when finance costs and depreciation will increase and cash-flows will be stretched.

Stocks such as REL, Tata Power, NLC, PTC India, Power Grid Corporation and Jaiprakash Hydro appear richly valued now and some correction appears inevitable once the euphoria surrounding the sector fades. REL’s foray into infrastructure projects such as building toll roads and the Mumbai MRTS diversifies its earnings stream but also enhances the risk profile in the medium term till the projects are executed and earnings kick in.

GVK Power and Lanco Infratech’s valuations also appear to be influenced by the infrastructure projects they are involved in, such as the Mumbai airport in the case of the former, and the Hyderabad real estate project of the latter.

Stocks such as NTPC, CESC, GIPC and Power Finance appear fully valued but shareholders can continue to hold on to them. Suryachakra Power, which shot up on news of a proposed joint venture with a Chinese company for a coal-fired project in Orissa, appears overvalued at the current price.

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