BHEL: REDUCE with a PT of INR2,210:: Nomura

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 Action
We kick off a short series of research highlighting structural changes in BHEL’s
business outlook that have so far been ignored by the street. In this first note, we
highlight that near-term earnings strength is a myth, as is evident from the negative
operating cashflow in 1H FY11. We also highlight, contrary to market perception,
that pricing in the recent NTPC bulk tender implies substantial risk to BHEL’s
margins if it were to match L1 pricing. Reaffirm REDUCE and INR2,210 PT.


 Catalysts
Continued earnings and order flow disappointment compared with street
expectations are potential share-price catalysts for BHEL.
Anchor themes
We see a significant opportunity for India’s power equipment firms over the coming
years. However, rising competition bodes ill for margins and market share in the
generation segment.



Boiling issues (1)
 Near-term earnings strength a myth…
A sharp rise in working capital led by slowing customer advances and
orderbook growth should see disproportionate growth in profit and
operating cashflow. In other words, we believe BHEL has already
enjoyed the cashflow benefits on execution. Hence, despite
expectations of strong earnings growth until FY12F, this is unlikely to
be accompanied by commensurate growth in operating cashflow.
 … as rising working capital will offset earnings growth
This trend of slowing growth in operating cashflow is already evident
in the company’s FY10 and 1H FY11 results, and we expect it to
continue. In FY10, profit grew by 37% y-y, while operating cashflow
fell by 47% y-y. Similarly, 1H FY11 operating cashflow was negative
despite a better-than-consensus bottom line. We expect BHEL to
record an earnings CAGR of 31% over FY09-12F, versus an
operating cashflow CAGR of just 5% over the same period.
 Margins in NTPC bulk tender unlikely to exceed 6-7%
We find a large section of the street is not worried about pricing from
the recent turbine bulk tender by NTPC-DVC. However, we highlight
that if BHEL were to match L1 bids, it would hardly make a 6-7%
margin as compared to 18-20% margins it currently commands.
 Prices up since 2008, but so are commodity prices
While some suggest that the tender price has increased vs past bids,
we point out that commodity prices have also risen by 15-20%, thus
necessitating price rises to protect margin levels.

 Reaffirm REDUCE with a PT of INR2,210
Our DCF valuation yields a PT of INR2,210. We believe a sharp
earnings slowdown post FY12F justifies an FY12F P/E of 15.3x.