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Thursday, May 23, 2019

The Next Sector to help you make Alpha

Power sector broadly can be categorised into four segments starting with companies like BHEL which constructs power plants. The valuations of these kind of companies depend on their order books/capex cycle. Then comes the power generation companies such as NTPC and JSW Energy for whom profitability primarily depends on utilization given for PPAs. One major advantage for such companies now is that coal prices are getting passed on which wasn’t the case earlier. Third segment consists of the grids such as Power Grids of the world which are like the nodal distributors from state to state. Last segment belongs to guys like Tata, CESC and Adani (earlier Reliance Energy) which manage last mile distribution. It would be prudent to note that the Grids get a stable ROE kind of return however the last mile guys basically get an upside on volume growth.

Basic Thesis: It takes 3-4 years to set up a new power plant. Demand has been growing steadily at 7-8% a year, which is in line with real GDP growth. Capacity addition was growing at around ~15% for 3 years in a row i.e. FY11 to FY13 that lead to overcapacity and supply glut. Post that supply addition over the past 6 years has slowed to 2-3% so utilizations are inching higher for power generation companies.

PSU companies get preference in PPAs hence the PLF for them would always be higher than that of their private counterparts and on an average would be close to 80%. Which is why PSU generation companies have higher utilization rates. Let us consider a simple back of the envelope 3 year thesis on any operational power generation private company assuming PLF at 60% and no increase in tarrifs. So revenues and EBITDA can go up by 50% for private sector power companies on the exact same capacities with interest and depreciation either reducing or remaining constant. So JSW Energy for example by FY21 sees revenues at ~13500cr and EBITDA at ~4000cr minimum. Interest @800cr given debt repayment schedule and constant depreciation @1100cr giving a PBT of ~2100cr and PAT of ~1500cr. If valued at ~7x EBITDA, marketcap automatically doubles. That's the broad thesis for all such companies in the Power Sector. The same model can be applied to any power generation company.

First to benefit will be the power generation companies over the next 2-3 years. Post which next round of capex starts then it will be guys like BHEL which benefit. For distribution and grid companies it will be business as usual with steady growth. As in no earnings inflection. They should see steady 6-8% growth on existing assets. New assets of course will come in at a 14-16% ROE.

As a thumb rule for thermal power generation plants it costs 4.5-5cr for each MW capacity. So a 1GW plant will have a capex of 4500-6000crs. So if you notice a capex of say 7500-8000cr per GW just understand that it is capex gold plating. Interesting choice if asked to name, could be Gujarat industrial Power Ltd. Company with 800MW is quoting at around 1700crs Enterprise Value. Replacement cost of assets would be like 4000-5000crs. So in good times we might see a much higher valuation as the capacity gets utilised. As it is a PSU we can assume there are no management concerns. In the private segment, Jindal Steel and Power or JSW Energy may offer higher upside because of higher leverage.

Empirical evidence shows us, barring the commodities, no sector which created wealth in the previous bull cycle got repeated in the later bull markets. Power as a sector in living memory hardly created any wealth over the past 15-18 years. Let alone creating wealth, they have been wealth destroyers. Most of the companies are quoting at a huge discount to their replacement costs of assets. They are severely under owned and hated bets. But things are changing operationally for sure. The next 5 years can well belong to some of these quality stocks. Few of the companies even come with highly attractive dividend yields which protects their downsides. Valuations look pretty attractive and with clear signs of early tailwinds we should definitely watch out for some of these power stocks.

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