Bharat Heavy Electricals Ltd - Stock Valuation and Financial Performance

2Q slips into a loss

While in first quarter BHEL reported a loss at the EBITDA level, second quarter went even further with a net earnings loss of Rs 200 Cr. EBITDA loss widened sequentially by 55% to Rs 700 Cr on the back of a 3% fall in sales and 10% fall in gross margin (high cost components sourced from technology partners).

Record EBITDA losses, highlighting cost pressure

Management has highlighted that the quarter was characterised by lower price realisations owing to higher execution of super-critical project contracts. This higher super-critical execution has led to higher import content leading to higher costs. Costs are expected to remain high as super-critical orders dominate the current order book. Super-critical boilers now constitute around 65% of the order book of INR1.12trn, while orders under execution have only 45% super-critical.

Order book stagnant

Order inflow fell ~80% year over year to Rs 2300 Cr; total order book at Rs 1.12 lac Cr.

BHEl has seen Rs 4600 Cr of orders from APGENCO (unlisted) at the start of 3QFY16, but it appears that large-scale revival in capex is still some way off.

Unexecuted slow moving orders, which contributed ~26% of the outstanding power sector order book, have increased to ~33% (Rs 3700 Cr.) with additional projects. We think, such a large share from slow moving orders is a precursor to order cancellations.

New concerns have emerged

BHEL has been plagued with structural low industry growth outlook and weak receivables cycle. Plus, the order book carries cancellation and margin risk.

There is now a new negative added to the list. BHEL now has to comply with sourcing critical components from its technology partners (Siemens and Alstom) for contracts where it has furnished Joint Deeds of Undertaking (JDU). Central and State Utilities are insisting on JDU commitments to safeguard product warranties. About 65% of the existing order book has JDU commitments and hence will hurt gross margins for BHEL as they source imported content.

Outlook

• Management maintains FY16 order inflow pipeline at 17GW (~Rs 50000 Cr), of which 9.7GW (Rs 28000 Cr) were received by 1HFY16. Of the 9.7GW of orders BHEL was L1 in 8.3GW, while the rest were received on a nomination basis.
• BHEL has witnessed some traction in Railways with its JV with foreign partners emerging as L1 for establishing locomotive factories at Madhepura and Marowra and for qualifying for supply of high-speed EMU train sets to Indian Railways (Speed 160-200kmph).
• BHEL expects to be able to rein in its employee costs at flat levels compared with FY15. Per head employee salary hikes are expected to be between 8-10% p.a. but upcoming retirements are expected to offset this increase.

Thus, we are expecting much slower earnings growth rate going forward. We expect earnings to grow by ~17% from a lower and a new normalised base EPS of 12.5. This is due to the lower gross margin and slow moving order book.

Earlier our valuations assumed that with economic revival, order book will move faster. However, looking at the stress in power sector companies (especially SEBs pan India that are BHELs major clientele), we do not expect order execution pace to improve anytime soon.

Given the low visibility and high volatility in near term earnings, we have cut down our valuation. Due to different variables involved we should ensure margin of safety of 45%.

For those already own BHEL shares, can consider partially selling of their holding, such that BHEL should not form more than 3% of your portfolio.

Post June quarter result announcement, BHEL’s stock price saw a huge fall. We feel this should be the last one of such huge corrections for BHEL.

The rationale:
Looking for newer markets: After quite a many years, the Order book has become weak at just equivalent to 2 years forward sales. This typically points to a scenario when order trickle down has nearly stopped. This means there would be strong pressure on the management to look for jobs across the globe. BHEL is generally strong in Gulf and has good export orders from this area, historically. However, the turmoil in major countries (Gulf ex Saudi-Kuwait-UAE) has significantly dented investment climate over there. This being the case, BHEL will be hard pressed to look for orders. Somewhere around 2007-08, BHEL simply stopped bidding for CPP (which became the forte of Thermax later on) and any power plants below 500 MW capacity (mostly CPP and brown field orders for power plants). We feel over the next two years, BHEL will try and focus on this market.

However, this would still lead to 25-30% lower sales or 43-56% lower profit, compared to its March 2013 numbers.

15 GW of Order Pipeline: The Company is expecting orders worth 15 GW to tender out in FY14, out of which it expects to bag orders worth 10 GW Given company’s strong track record in receiving government orders, this seems achievable. However, policy issues may lead to certain delays.

Strong demand for the power sector: India being a power deficient country, the demand for power is expected to grow at a much faster rate. However, the major issue remains that SEBs have to be made profitable in order to create a stable demand in the country.

Difficult to replicate BHEL’s scale and technology base: BHEL has recently ramped up its capacity to 20 GW, fully absorbed the supercritical technology and brought down its raw material requirements. Also, the company’s equipment’s enjoy a higher efficiency as compared to its peers. This puts the company at a favourable position to benefit from the next up-cycle.

And finally Logic from the Sands of Time…

If BHEL sees further lowering of sales and profits over next few quarters, we would see BHEL tripping toward P/B of 0.8 to 0.6.

1. These numbers have been reached historically over last two cycles (1995-2002 and 2005-2013).
2. Interestingly the period in which these numbers were reached, the company saw its sales collapse which led to losses in June quarter, low profits in Sept quarter and March been the major profit generator. (While this is not expected to play out exactly: we think that investors will have to start building expectations that losses less than 1% margins will occur in some quarters.)

The pullback in the stock prices is expected be massive, just like it was in the past (to give an idea 2002 was still a bear market; within a year, an Investor made 100% profit).

Key monitorables going ahead:

Under these conditions we need to keep an eye out for policies governing power sector more closely. There are three main things that require clarity:
1. Land Reforms (which we feel only a new government may take).
2. Captive Coal Mining but surplus coal production (in process).
3. Gas Pricing decision (done).

What should Investors do?

BHEL enjoys leadership amongst peers, enabling it to maintain its market share of more than 50%. We feel the company stands to benefit the most as and when the power sector revives. We believe the stock is at a discount to its intrinsic worth. However, the stock may still have short term pains left and could see a correction post the quarter results. Thus, investors could start accumulating the stock in tranches as the price sees further correction.

Weak results, but management positive on demand: The company reported poor numbers in Q3. We feel, this is already priced in the low valuations of the company. However, the management is more optimistic on demand and thus expects potential new order booking.

Subdued order inflow, but expected to improve: In Q3 BHEL received order inflows of Rs. 19,8 bn, which brings the order backlog to Rs. 1137 bn. Though this reduces the revenue visibility, the next quarter is expected to fare better. It has already received Rs. 50 bn orders in the month of January and also is the L1 bidder for orders worth Rs. 90 bn. Revenues from these projects are thus expected to come in next financial year, thereby reducing risks of further earnings deterioration.

Chinese competition overhyped: Though the fact remains that Chinese competition has been increasing, BHEL has continued to maintain its preferred supplier (thus market leader) with domestic manufacturers. Also, superior quality of the company’s equipment’s augments its position while maintenance costs of Chinese OEMs continues to remain a concern, As, cost advantage of Chinese players deteriorates, this will mean lesser trouble for the company.

Finally…
As positives outweigh the negatives, we continue to remain positive on the stock. However, the stock continues to remain risky as any positive change in capex cycle, power reforms, etc can provide a huge upside trigger, while slow order inflow, order cancellations and delay in payments can lead to further fall (though limited).

Investors should take into consideration that the stock may not give near term returns. Investors can look into buying the stock in tranches and look for good returns in 2-3 years.

Post Dec ’11 results, the share prices of the state owned BHEL have been under pressure. This was mainly due to negative growth in its order book.

1. Strong sales growth on strong execution: For the quarter, BHEL’s total sales increased by 19% to Rs 10,743 Cr. from Rs 9,023 Cr. Y-o-Y basis. Growth in sales was mainly due to strong order execution during the quarter.

2. Flat Profits due to declining margins: It has reported a net profit of Rs. 1433 Cr., a growth of 2.14% as compared to Rs. 1403 Cr. in FY 10. Profits were flat on account of a 3.5% decline in operating margins from due to high raw material costs (25% increase) and other expenses (65% increase). Rise in other expenses was due to provisioning of Rs. 380 Cr and high freight costs.

3. Deteriorating working capital condition: Being in the capital intensive industry, the company has a history of high working capital. But, the situation has worsened with working capital deteriorating further, due to rising receivables and declining advances from customers.

4. Negative order inflow:  The surprise in BHEL’s result came in at the order front. For the first time in 10 years, BHEL saw a net reduction in its order book. Orders worth Rs. 5840 Cr. (1.5 GW) were cancelled as the customers were unable to make significant progress in getting clearances. Further order inflows situation remained dismal.  As a result, there was a negative order inflow of Rs. 3500 Cr. in Q3FY12. Consequently, BHEL's order backlog declined 9% qoq and 7% yoy to Rs. 146500 Cr. from Rs. 161000 Cr. last quarter. Also, for the nine months ending December 2011, the order inflow for BHEL stood at Rs 10,000 crore against a guidance of Rs 55,000 crore for FY12.

5. Declining order backlog/revenue ratio: Order backlog/revenue ratio is likely go down from 4 times at FY11-end to 2.4 times by FY14.

What do we expect for the future?

1. The order cancellations have raised new concerns over the company’s revenue visibility and the quality its current order book. The company may witness more order cancellations in the coming quarter.

2. Additionally, order intake for the next few quarters may be dismal, given that ordering for the 12 year plan is complete.

3. The current problems in the power sector viz. environmental and regulatory clearances, coal linkages, rising completion and poor investment scenario will add to it woes.

4. Also, the proposed divestment will add to the pressure on the stock prices.

However, BHEL will see incremental order inflow once the 13^th five year plan ordering starts. But this is not expected for the next 2-3 years. Also, with easing monetary policy, the investment scenario is expected to improve, which will be a positive for the company.

So, what should investors do?

We expect BHEL’s prices to remain under pressure for the next 4-6 quarters. However, investors with a long term perspective (2-3) years can buy the stock on further declines.