Call it an error of judgement but the domestic mutual funds (MFs) have missed the boat when investing in India's leading PSU power companies. In the past 24 months, the MFs stuck to their higher portfolio allocation to NTPC while the rally in another PSU Power Grid Corporation took the markets by surprise.

Both Power Grid and NTPC had nearly a similar market capitalisation, but the former has outperformed NTPC by 33 per cent over the past 24 months. MFs hold 18.4 per cent stake in NTPC and just 8.2 per cent in Power Grid. MFs have 1.5 per cent of their portfolio invested in NTPC and just 0.7 per cent in Power Grid. As on date, Power Grid is valued at over ₹1.49 lakh crore and NTPC at nearly ₹1.25 lakh crore.

MFs and banking financial institutions have preferred NTPC over Power Grid. This despite NTPC facing significant disruption risks from transition to clean energy and Power Grid likely benefiting from the same shift to clean energy. Investors may be perhaps influenced by NTPC’s cheaper valuations versus Power Grid and hope of convergence in their valuations. (But) they may want to take note of the vastly different long-term prospects of the two," Kotak Institutional Equities said in its report.

Kotak's view on NTPC's transition to clean energy

India’s accelerated transition to clean energy will result in a meaningful negative shift in NTPC’s return and risk profile given low free cash flow (FCF) generation. NTPC will have to invest cash flows from extant coal plants into a new solar capacity to stay relevant and protect its terminal value. It will have limited growth in generation capacity, as new solar capacities incrementally substitute extant thermal powers over some time; solar tariffs are already cheaper than thermal, and higher risks to cash flows of solar assets given free-market tariffs versus extant guaranteed regulated returns of thermal assets.

"We note that solar plants generate high-single digit IRR under current tariffs, which are significantly lower than the guaranteed RoE of 15.5 per cent (of regulated equity) for NTPC’s thermal assets," the report said.

Power Grid's prospects

Kotak says that India’s accelerated transition to clean energy will offer new growth opportunities for PWGR after a slowdown in the pace of new capacity addition in recent years. Its core electricity transmission business will likely thrive as India makes large investments in new transmission capacity to modernise its national grid and connect to new solar electricity sources, which will largely be built in north and west India given favourable solar irradiance, away from the coal-based plants located in central and east India.

"Power Grid is indifferent to the generation mix and faces lower financial risks as it operates in a largely regulated industry with 96 per cent of its asset base being regulated as of September 2021.Power Grid deserves a larger valuation premium to NTPC," said the report.

Power Grid stock had traded at premium valuations to NTPC over the past 18 months, unlike when their valuations were very similar.

"In our view, Power Grid's relative premium to NTPC is justified, as NTPC’s return profile has deteriorated significantly compared to Power Grid in the past few years and it faces meaningful long-term disruption risks. However, relative investor positioning in the two stocks implies domestic investors’ belief that the valuation multiples of NTPC and Power Grid would converge (mean-reversion). In our view, this is unlikely given the vastly different fundamentals of the two businesses," Kotak said.

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