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Utilities and the three demons: Sector Outlook
We continue to have an underweight position on power utilities into the next quarterly results
3Q11 due to ongoing pressure on merchant power prices, tight fuel supply and rising inflation.
We therefore prefer a more defensive stance, opting for exposure to Tata Power and NTPC
for outperformance over the next few months. We also like Adani Power due it stronger fuel
position.
Throughout the first quarter of FY12 we expect the merchant power price scenario to improve
due to tight fuel supplies. Therefore we would be poised to buy merchant power exposures
with competitive fuel positions post the 3Q11 results that have been sold on the back of
merchant power weakness such as Jindal Steel and Power and Adani Power. Still wary of
those open to both merchant and fuel risk such as JSW Energy.
Rising inflation and bond rate pressure
Rising inflation is a headwind for most equities, but especially regulated earnings with subsector
growth such as NTPC and Power Grid. As shown below any climb in the long-term
bond rate translates to underperformance from utilities with long-tail cash flows that have
valuations (more than other stocks).
Fuel supply: CIL could further disappoint, while import prices go through the roof
We expect the Indian thermal coal scenario to further tighten. As at 31 December 2010, the
Central Electricity Authority (CEA) expects a total of 30GW of new power plant capacity to be
added by the end of FY12. Of this, around 15.6GW will rely on linkage coal (this doesn’t
include some imported or captive coal based plant that claim to have tapering linkages with
CIL). If these capacities come in we’d expect a further supply shortfall of 42mt for the power
sector based on our forecast of CIL production.
Even if we assume 50% of the state and central plants don’t get commissioned in this timeframe
(although this will just be a delay), there will still be a further supply gap of at least
13mt.
In our view, those plants dependant on linkages and with PPA’s that don’t allow cost passthrough
could suffer margin loss. Therefore we prefer those with competitive fuel positions
(Jindal Steel and Power, Adani Power) or those who have the ability to pass through higher
fuel costs (NTPC, Tata Power).
Power Prices: monsoon pessimism
3Q11 results are likely to again reflect soft merchant power prices and therefore we don’t
suggest playing any merchant rebound until post the results. The current forward curve
implies pricing of between Rs.4.00-4.50/kWh over the next few months in line with guidance
from the listed power companies.
However into 1Q12 we see power prices strengthening. The recent weakness in pricing has
been driven purely by weakening demand (supply is only up ~5% yoy – similar to the
previous year), as the northern region states of Rajasthan and Haryana have procured
significantly less volume via bilateral contracts than in the previous year. However, we are
already seeing sizeable volumes coming from the southern states of Tamil Nadu (upcoming
state election in FY12) and Karnataka vs. this time last year – more relevant for merchant
demand over the next six months.
Also, in an environment on rising coal prices, imported-based coal-fired plant remains the
marginal cost generator, setting a longer term base (over the next year or two) for merchant
power prices. The impact of higher coal prices on power prices are shown below and also
support power prices in the Rs.4.00-4.50/kWh range.
Sector Top Picks
Buy Recommendation
Adani Power (ADANI IN) (Outperform; TP: Rs146; Potential upside: 19%)
Ongoing volume growth the catalyst: With the first 660MW supercritical unit anticipated
to hit begin commercialisation over the next couple of months and a total capacity addition
of 2,640MW in FY12.
Captive coal source a competitive advantage: After visiting the Bunyu mine in
Indonesia we are more confident of the ability for the Adani Group to profitably mine the
low cost coal to provide a competitive source of fuel for the Mundra Project.
Potential return in confidence to merchant and valuation: Concerns over low merchant
power prices in our view are near a low. On our forecasts the stock is trading on 11x PER
in FY12 (merchant price of Rs.4.50/kWh) and 9x PER FY13 (merchant price of
Rs.3.50/kWh).
Buy Recommendation
Tata Power (TPWR IN) (Outperform; TP: Rs1,627; Potential upside: 20%)
Catalyst is thermal coal price: ongoing thermal coal price strength over the next few
months and a better than anticipated settlement for FY12 over the next few months.
Coal price leverage: 30% ownership in KPC/Arutmin coal mines gives TPWR a 20mtpa
net long coal position, therefore leverage to the thermal price which has climbed >40%
over the past six months.
Coupled with regulated business: the bulk of TPWR’s other earnings are regulated
assets, which give a high level of earnings stability.
NTPC (NATP IN) (Outperform; TP: Rs248; Potential upside: 30%)
Near term earnings improvement could help the stock: 3Q11 result improving on
seasonality and capacity additions.
Valuation suggests stock is oversold: The stock appears competitive on valuation,
trading at a 10% discount to its peers vs. ~10% premium a few months ago, and a 20%
discount to its historical 1yr fwd PER. In our view, fuel risk is becoming priced in.
Low-risk: Regulated, safe earnings and leverage to volume growth without merchant risk,
while the company is well funded (US$3.2bn cash) with the ability to self-fund capex for a
number of years.
Sell Recommendation
Reliance Power (RPWR IN) (Underperform; TP: Rs127; Potential downside: 15%)
Execution risk still very high: Project execution capabilities, considering early stage of
the execution cycle for some of its key projects and hence higher risk profile.
Coal price exposure in the longer-term: UMPPs present margin risks given their inability
to pass through costs; while coal production will have to ramp up significantly to create
material value.
Price captures much of the value: An enviable captive coal position, but on our
numbers, much of this value is already captured in the price
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