BHEL: Strong qtr but environment challenging:: Macquarie

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Bharat Heavy Electricals
Strong qtr but environment challenging
Event
 BHEL declared its 2QFY11 results which were ahead of our and street
estimates on earnings front due to higher revenues and lower other expenses.
 We believe FY11 will be the best year for BHEL in terms of margins and
earnings growth. Competition will likely hurt order inflows and margins for
BHEL going forward. We remain cautious on stock with an increased price
target of Rs2,315 with downside of 5%. Retain Neutral.
Impact
 Strong 2Q FY11 numbers; upside to earnings limited: BHEL reported
revenue and earnings growth of 26% and 33%, respectively in 2Q FY11. This
was mainly driven by stronger top line and staff cost operating leverage.
However, upside to FY11 EPS estimates from these levels is limited as gains
due to operating leverage will vanish in FY12 and lower than expected other
income as cash balance declines due to working capital pressure
 FY11 to be peak in earnings growth and margins, margin pressure from
FY12: We believe that earnings growth and margins will peak out in FY11 at
24% and 19.7%, respectively. We believe that in FY12 and beyond, revenue
growth will slow down as order inflows stagnate and margins will remain
under pressure due to lower margins in initial years of supercritical equipment
supply (which have high import content) and EPC contracts.
 Order inflow guidance to be met with EPC orders: We expect the company
to book Rs260bn of EPC orders of the total Rs600bn orders in FY11. These
orders will have 30–40% outsourcing content. This implies that BHEL’s order
inflow would decline 15–20% YoY on a comparable basis over FY10, where
most orders were BTG orders.
 Stock to remain subdued as concerns on competitive environment take
centre stage: The first true test of competitive intensity will be seen in 4Q
FY11 when boiler contracts for NTPC’s bulk tender are opened. Recall, it has
4 bidders for 2 slots. We believe that BHEL will remain under pressure as
competition heats up further in the space, impacting order inflow and margins
in the longer term.
Earnings and target price revision
 We are marginally increasing our FY11E and FY12E EPS by 1%. Our target
price has also increased by 1% to Rs2,315.
Price catalyst
 12-month price target: Rs2,315.00 based on a PER methodology.
 Catalyst: Lower pricing in the bulk boiler tender in 4Q FY11.
Action and recommendation
 Order inflow / backlog growth to stagnate, putting pressure on
sustainable revenue growth: We believe that annual order inflow for BHEL
is likely to stagnate at Rs600bn. A stagnating order book would likely lead to a
decline in revenue growth in FY12 and beyond, in our view.
 Remain cautious on the stock: BHEL is trading at 19.5x FY12 EPS despite
single-digit earnings in FY12 and beyond. We remain cautious on the stock as
we think competitive headwinds remain strong for the company. Retaining
Neutral with revised target price of Rs2,315.