IL&FS Investsmart : Buy BHEL The Power Monarch

Aided by substantial volume-driven growth and capacity expansions, BHEL is expected to deliver strong set of numbers going forward. We estimate the Net sales, EBITDA and PAT to grow at a CAGR of 31%, 35% and 33% respectively through FY2007-10E. The stock today quotes at a PER of 30x FY09E and 23xFY10E earnings. We initiate coverage on BHEL with a ‘BUY’ recommendation and DCF based target price of Rs3331.

Ministry of Power expects the generating capacity in India to be increased by another 150,000+ MW over the next ten years. BHEL being market leader in power generation equipment market is well placed to capture this opportunity. BHEL’s present order book stands at Rs726bn (3.2x FY08E Sales) executable in 30-36 months, gives it a clear visibility in its earnings. BHEL is expanding its capacity by 150% from 6,000MW to 15,000MW in two stages, which is likely to result in faster execution of the present order book Despite huge capex outlay, BHEL is expected to generate cash in excess of Rs101 bn through FY07-10E, with core business ROE expanding from 63% to 97%.

Valuations BHEL is quoting at PE multiple of 30xFY09E and 23xFY10E earnings and EV/EBITDA multiple of 20xFY09E and 15xFY10. At 30X FY09 earnings, BHEL is quoting at a premium to the sensex valuations. However, in our view, BHEL is expected to continue its premium valuations due to 1) strong macro economic fundamentals in the power sector2) continuing dominant leadership in the domestic market, 3)visibility and certainty in earnings due to a strong order book 4) core business ROE expanding from 63% to 97%.

Investment positives Undisputed King in Indian market BHEL commands the Indian power generation equipment sector with a 65% market share. Over 50 years since its establishment, the company has emerged as a leader in up to 500MW generation sets in India. BHEL’s strong position in the domestic market is highlighted by the following: 3 The company has installed 65% (88781 MW) of India’s total power generation capacity (136,901 MW) through supply of equipment such as boilers and turbines. 3 In the 10 th five-year plan (2002-07), BHEL has supplied equipment of 13,515MW, out of total installations of 21,095MW across the country. 3 During 2002-07, BHEL executed total orders of Rs643bn; these forms roughly 35% of the total power sector spend of Rs1870bn in the country. Over the next decade, India is likely to more than double its existing power generation capacity from 1,36,901MW to 300,000MW. In such a scenario, the above mentioned credentials reinforce our belief in BHEL’s strong prospects in bagging incremental orders going forward, resulting in stronger earnings growth beyond FY10. Strong order book: Visibility at its best Huge investments across the power sector enabled BHEL to record an order flow of Rs1 trillion in the 10th five-year plan. In the first 6 months of 11 th five year plan, the order flow was even stronger and touched the Rs256bn. Though the company is scaling up its operations to cater to the buoyant demand, surge in order flows has inflated the company’s outstanding order book to Rs 726Bn (3.2x FY08E Sales). The execution period for this order book stands at 30-36 months. We expect a further order in flow of 350bn during the next 6-8 months and the company is likely to end up with an order backlog in excess of Rs1trillion by FY2008. We believe that the magnitude of the current order book and near term strong order inflow puts continuing visibility and certainty in revenues and earnings for the next four years.

Order flow and opportunity According to the Ministry of Power, out of 78,577MW capacity addition planned under 11th five year plan (2007-12), orders for 53899MW have already been placed and are under various stages of implementation. In our understanding, orders for remaining 22,232MW are likely to be placed within the next six-eight months, and we believe that BHEL is well-placed to secure majority of these orders, mostly placed by SEBs and CPUs. Thus, we expect the order flow for BHEL to remain strong for the next six-eight months. Capacity expansion from 6,000MW to 15,000MW Currently, BHEL has a capacity of manufacturing equipment of 6000MW. The company is expanding this facility to 10,000MW by incurring a capex of Rs12bn; this capacity is likely to become operational by December 2007. To benefit from the emerging opportunities in the power generation sector and to ensure faster execution of the current order book, BHEL is further enhancing its capacity to 15,000MW by December 2009; the company is likely to incur an additional capex of Rs20bn for this expansion. With this capacity addition, we expect to see a faster execution cycle for BHEL; moreover, the expansion would also enable the company in attaining critical mass vis-à-vis its Chinese and Korean counterparts.

Collaborations with Siemens and Alstom for super-critical technology Till recently, addition of power generating capacity in India was through generation sets of 300-500MW. However, due to higher thermal efficiency, the MOP has given thrust on adding fresh generation capacity at supercritical level i.e. above 500MW (800MW and 1000MW capacity).

Having established itself as a leader in the category of 300-500MW generation sets, BHEL is now gearing up for the production of 800MW sets of supercritical thermal power equipment. For this purpose, it has entered into technical collaboration with Alstom, France, for boilers and with Siemens, Germany, for turbines.

In the initial phase, BHEL would procure some of the critical components from Alstom and Siemens. Over a period, however, the technology for the production of these components would be transferred to BHEL. We believe

that through these collaborations, BHEL would be well-poised to capitalise on the emerging opportunities in super critical components.

Supported by these collaborations, BHEL recently entered into the execution of supercritical thermal power projects; the company signed a MoU with Tamil Nadu Electricity Board (TNEB) to float a JV company that would set up the first

2x800MW supercritical power project in Tamil Nadu. Equity stake in projects: New mantra for securing orders Recently, BHEL signed a MoU to form a JVC with TNEB for a 1600MW project. Under the agreement, BHEL is likely to acquire an equity stake in the project by subscribing for 26% of the equity capital of the project cost. For the first

time, BHEL would be acquiring a stake in a power project. We believe this a strategic move, as acquiring an equity stake in a power project would translate into securing order inflow for entire EPC work. Also this will help the

Company to absorb the technology for supercritical generation sets. For a 1600MW plant to be set up under the JVC, the project cost would be around Rs80bn; this is likely to be funded through a debt: equity ratio of 80:20. BHEL is likely to invest Rs4.2bn in this project. Thus, by investing this amount, BHEL is expected to secure orders worth Rs60bn for EPC work where it could generate an EBITDA of over Rs11bn (according to current margins). Also, once the project becomes operational, BHEL would be in a position to capitalize its investments by cashing out either by selling this stake to TNEB or to a private entity. We understand that BHEL is already in touch with various SEBs for signing similar contracts to secure project orders.

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