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Highlights
For an industry-leading, regulated utility in a market with a chronic electricity deficit, NTPC's third
quarter results (Q/E Dec 31) contained a lot of bad news. In this report, we detail why NTPC, the lowest
cost electricity provider in India, idled capacity in the third quarter because of lack of demand. We also
consider what is likely to change in 2011.
NTPC backed down its power stations in the third quarter because State Electricity Boards that are
contracted to buy the electricity are currently too poor – or too illiquid - to pay. India suffers a chronic
electricity deficit and NTPC offers the cheapest electricity supply in India. If State Electricity Boards
cannot afford to pay the variable cost component of NTPC's electricity (less than Rs1.50/KWh by our
estimate), the long-term prospects for IPPs building power stations that will import coal and are assuming
payment of Rs3.50KWh (at a minimum) are bleak.
NTPC's falling effective tax rate is, perversely, bad for earnings. The electricity regulation under which
NTPC calculates its permitted return on equity allows a gross-up for the applicable tax rate. As we
understand it, when the applicable tax rate for NTPC is the corporate tax rate of 33.99%, the company's
pre-tax return on equity is 23.5% even though its effective tax rate was less than the statutory rate. Use of
the MAT rate (which NTPC is now liable for) reduces this gross up and the delta between actual taxes
paid and the recovery of taxes that NTPC is permitted to embed in its power charges.
NTPC is likely to miss its reduced commercialized capacity additions targets. The bull thesis on NTPC
is that it is able to invest at a guaranteed 15.5% return on equity practically in perpetuity. All the
company needs to do is build power stations. In the third quarter, NTPC reduced its target for the year
from 4,150MW to 3,150MW. And NTPC may not be "commercializing" all of the 3,150MW this year in
order to avoid triggering tax benefits that will exacerbate its MAT problem. The stations will still be
commissioned. Regardless, a target of 3,150MW for FY2011 is 50% below the run rate required to hit
the company's stated target of 75GW by 2017.
The question is: which of these problems will persist into the fourth quarter and beyond. Arguably, the
bad news is all out. NTPC's earnings could surge in the fourth quarter if it can raise its effective tax rate.
The broader problem is the State Electricity Boards: NTPC has provided little comfort about why the
SEBs are instituting black-outs rather than buying the cheapest electricity in India. If this problem
persists, the long-term investment case for NTPC – and the sector – breaks down.
Investment Conclusion
We rate NTPC Marketperform (NATP.IN, Target Price INR190). Given NTPC's regulated rate of return
nature of the business and the company's reluctance to enter a competitive bidding process for its generation
capacity, we believe that the upside to current valuation is limited.
Details
NTPC's third quarter results were dominated by three problems. First, the company will fail to meet its own
reduced "commercialized" new capacity target for FY11. Second, State Electricity Boards are currently too
poor to pay NTPC for what is the cheapest electricity supply in India and are requiring NTPC to back down
its power stations instead. Third, NTPC's effective tax rate is falling, which means that perversely – through
a twist in Indian tax law and electricity regulation – earnings growth is flat.
Arguably, these issues are transitory. NTPC may delay commercializing some of its new capacity in order
to avoid exacerbating its Minimum Alternate Tax problem (details below). Further, the way that the CERC
regulations are drafted, NTPC should – theoretically – be indifferent to dispatch levels as it is paid based on
availability, not power generated.
However, the investment case for the entire sector is premised on chronic electricity deficits. Said
differently, the Indian economy is supposed to have load to meet almost any level of new capacity.
Structural problems within the distribution segment may be placing that assumption in doubt.
NTPC backed down its power stations in the third quarter because State Electricity Boards that
are contracted to buy the electricity are currently too poor – or too illiquid - to pay for it.
NTPC is the lowest cost provider of electricity in India. It is also the largest and the best operator in India
and has almost all of its capacity locked up in long-term power purchase agreements. India's electricity
deficit remains chronic.
Yet, in the third quarter of 2010, NTPC reported that several of its power stations were backed down
because of the refusal of various State Electricity Boards to pay for the electricity that would have been
generated. In the first nine months of the financial year (April-December 2010), NTPC estimates that it
could have generated an incremental 10,000 GWh or roughly 6% of gross generation over the period.
The problem here is potentially profound. NTPC offers the cheapest electricity supply in India. By virtue of
the regulations under which NTPC operates and the long-term power purchase agreements that it signs with
the State Electricity Boards ("SEBs"), the SEBs are liable for all of NTPC's fixed costs and a return on
equity of ~15.5% as long as NTPC is available for dispatch more than 85% of the time.
There are two implications here. First, as long as NTPC is available for dispatch, its earnings are largely
unaffected by the decision of a particular SEB not to purchase electricity. There are additional benefits to
NTPC from operating at high utilization because of the way the CERC regulations are drafted. Because it
is able to generate electricity at a heat rate that is lower than the nominal heat rate in the electricity
regulations, NTPC effectively gets paid for coal that it does not burn. However, if NTPC doesn't generate
the electricity, it cannot claim this benefit. And backing down and re-firing coal power plants is inefficient.
In short, the actions of the SEBs matter in terms of quarterly earnings – but only at the margin.
Second (and more broadly), if State Electricity Boards cannot afford to pay the variable cost component of
NTPC's electricity generated from domestic coal (by our estimate, less than Rs1.50/KWh), long-term
prospects for IPPs building power stations that will import coal based on business cases that assume a
payment of Rs3.50KWh (at a minimum) are bleak.
And the poor operating performance of NTPC's power stations is clear from a review of the rolling gross
generation growth over the last twelve months. Rolling annual gross generation growth is currently 1.4%
for NTPC (Exhibit 1). To put that in context, annual energy demand growth in India has been 5-7% in
recent years and installed capacity growth is 7-8% currently and trending higher. Low power consumption
growth rates in India are often attributed to a lack of capacity growth or a lack of coal. In this instance,
capacity is not the problem. For NTPC, utilization has fallen in two of the last three quarters and was flat in
the second quarter (Exhibit 2)
Coal provision from imports and Coal India has increased modestly over the last year. Total coal increased
from 98.58 million tons in the nine months to December 2009 to 100.44 million tons in the nine months to
December 2010 – a 1.8% increase.
In theory, it is possible that the lack of generation growth is a function of a lack of fuel supply growth rather
than a function of demand growth. But NTPC describes the fact that its availability is higher than its plant
load factor (availability – as NTPC measures it – requires access to domestic coal). In short, this is a
demand problem.
And not just for NTPC. Annual power demand growth for India has been below 5% for the last four months
(Exhibit 3). In fact, for NTPC this is less of a problem than for the rest of the industry. NTPC's fleet is
largely regulated and gets paid a return on equity for availability. For the rest of the industry, payment is –
largely - based on electricity supply. Certainly for the power stations that are being built currently by IPPs,
the base case scenario has involved the ability to sign long-term power purchase agreements at
Rs3.50/KWh or more and to sell power into the merchant market at Rs5-6/KWh or more
Except that – as we discuss above – it is not clear that NTPC can currently sell electricity even at
~Rs1.50/KWh and the merchant market has been trending down since 2008
The average price of merchant electricity since the middle of 2008 as reported by IEX India has been just
over Rs5/KWh. But the trend has been down the whole time. There is some seasonality involved: prices
tend to peak in the May-June time period and trough in January-February. We are currently therefore
emerging from a trough and the fact that the average three month price has been lower than the long-term
average since for the last six months is – in part – a function of seasonality.
But there is something else going on too. The peak in May-June 2010 was lower than the peak in 2009 and
the current trough is lower than the troughs in either 2010 or 2009. In short, merchant power prices are
falling.
The two primary explanations offered for the downturn in power demand growth suggest that the trend is
temporary. First, given that Indian GDP growth remains in the high single digits, it is unlikely that power
consumption growth can remain half of that level. The "classic" relationship between power consumption
growth and GDP growth suggests that developing economies use a lot of electricity for each additional unit
of GDP. The "power multiplier" doesn't generally fall below one unit the economy is heavily industrialized
and is transitioning to services, transport and higher value-added manufacturing for its sources of economic
growth (i.e., the United States in the 1970s; China today). To suggest that India can continue to growth at
9-10% with power consumption growth of 4-5% seems unlikely based on the state of the Indian economy
and this longstanding relationship between power consumption growth and GDP growth.
And yet, that is what we have documented previously. Notwithstanding the fact that India would not be
viewed by many as a post-industrial economy, its power multiplier has been below 1.0 since 2003 (viewed
on a rolling five year basis).
Looking at the difference between real GDP and electricity consumption cumulative average growth rates
over the period from 1976 to 2009 highlights this inflection point (Exhibit 5). In no period before 2003 was
real GDP growth (measured on a 5-year CAGR) greater than electricity production growth (measured on a
5-year CAGR). In no period since 2003 has the inverse been the case. And if we look solely at data since
2003, a new relationship between electricity production and real GDP growth appears to be emerging.
India's power multiplier has been ~0.7 for the past five years (Exhibit 6). Annual data has not yet been
released but the quarterly data suggests that the power multiplier for the five years ended December 2010
will be lower still.
Our expectation has been that power consumption growth will accelerate and the power multiplier in India
will increase over the next decade because of an increase in installed capacity and improved access to fuel
supply. Both of these things will, in our view, result in cheaper electricity that "funds" more powerintensive
activities. In short, the trend would be good news for India but not good news for the IPPs. We
didn't expect (and still don't expect) it to play out for several years. But a fall in merchant price of
electricity – like we are currently seeing – would certainly be the first sign that supply was outstripping
demand.
The more prosaic explanation is politics. The argument goes that, during election years, State Electricity
Boards buy more electricity. In short, political incumbents like to point to regional development and
progress as a sign of political success and therefore like to keep the lights on based on the assumption that
the electorate will link reliable power supply with economic progress. Politicians therefore pressure State
Electricity Boards to maintain supply and avoid black-outs in the run-up to elections, no matter what the
cost. In non-election years, these pressures dissipate. The explanation is widely told and a certain logic.
And the electricity deficit data backs up this explanation in only a minority of cases.
Looking at the gap between total electricity demand over the year and total electricity supply, there are
examples (Exhibit 7) at a state level where the deficit falls in an election year and then spikes back up the
following year – but not many. In fact, this pattern is the exception rather than the rule. We identified this
pattern in Haryana, Punjab, Uttar Pradesh, Mizoram, Nagaland and Tripura during their most recent
elections. Of those six states, only the first three are significant in terms of population or as a share of
national electricity consumption.
At a national level, the electricity deficit fell in India in 2009 (an election year) but also in 2010. In fact, that
observation – the fact that nationally the electricity deficit has fallen in the last two calendar years - may be
the more important fact to note.
Of course, the fact that the election year phenomenon is not observable in every instance based solely on
aggregated calendar year electricity demand and supply data does not mean that it does not exist. An
election early in a calendar year would mean the "election year" effect would bleed over into the prior year.
Further, there are a number of economic, weather and other patterns that will affect electricity consumption.
In addition, a greater willingness to purchase merchant power to address peak demand in the run-up to an
election may have a significant impact on perceptions about reliability of service without necessarily
dramatically changing total electricity consumption.
And that is, in the end, our point. We believe that it is possible to overstate the impact of the political cycle
on total electricity consumption patterns in India. The impact on merchant pricing may be real. However,
we are not sure how significant the impact on total consumption is.
Whatever the size of the "political effect", it is good news for IPPs in a country often accused of having too
much democracy in that it is always an election year somewhere. In 2011, there are five states holding
elections: West Bengal, Tamil Nadu, Pondicherry, Assam and Kerala. These states account for ~250 million
people or just under 20% of the population in 2009. While in 2010, only Bihar with a population of ~100
million people, had a state election. Accordingly, there may be an increase in electricity production growth
in 2011 if the election year phenomenon holds true.
The third explanation of the slowing on power consumption growth is structural. Put simply, the
distribution companies and State Electricity Boards simply do not have any money and therefore cannot pay
for electricity. If actual technical and commercial losses are so high (often thought of as half of all power
distributed is stolen) that distribution companies lose money, then the more power they supply, the more
money they lose. And – unless resolved - as the economy develops and becomes more power intensive, the
problem gets worse, not better.
Whatever the cause of the deceleration in power consumption growth in the last year, NTPC enjoys a level
of protection being the lowest cost provider of electricity in the country. Implications for the rest of the
industry are, in our view, more dire.
NTPC now qualifies for the MAT which, perversely, is bad.
For the last two quarters, there has been a lot of focus on the Minimum Alternate Tax ("MAT") for NTPC.
India – like the United States – has two-tiered income tax system. Indian companies calculate a corporate
income tax liability and a Minimum Alternate Tax liability. The company is liable for the higher of the
two.
The electricity regulation under which NTPC calculates its permitted return on equity allows a gross-up for
the applicable tax rate. When the applicable tax rate for NTPC is the corporate tax rate of 33.99%, the
company's pre-tax return on equity is 23.5% even though its effective tax rate may be far less than the
statutory rate of 33.99%. The use of the MAT rate of ~18% reduces both this gross-up and the delta
between actual tax paid and the level of permitted recoveries for taxes that NTPC embeds in its electricity
charges.
The company's preference is therefore to pay the corporate income tax. Mechanically, NTPC should be
able to manage this classification by the rate at which it qualifies for tax credits and other benefits that serve
to lower the company's effective tax rate.
As we understand it, the calculation of corporate income tax liability in India (like in most jurisdictions)
involves various adjustments to Net Profit before Tax as calculated for financial reporting purposes.
Depreciation is usually the most significant adjustment. Specifically, "book" depreciation is added back to
Net Profit before Tax and "tax" depreciation subtracted. In India, the "tax holidays" available to
commercialized power stations in their first 10 years of operation under Section 80IA of the Income Tax
Act mean that these profits are included within Net Profit before tax for financial reporting purposes but
excluded (permanently) from taxable income.
With those (and other) adjustments made to derive taxable income, tax is calculated at the corporate tax
rate. As we understand it, if the tax payable under this calculation is lower than the product of the MAT
rate and Net Profit before Tax, the company is captured within the MAT regime and pays that higher level
of tax.
This affects NTPC earnings because of the way that the company's tax rate is used to calculate the return on
equity that it may embed in capacity charges to State Electricity Boards. If NTPC is subject to the
corporate income tax rate, it grosses up the regulated return on equity of 15.5% by the corporate income tax
rate of 33.99% and embeds that amount in its calculation of capacity charges. This is the case even though
the company's effective tax rate (once permanent differences like the tax holidays are adjusted for) may be
significantly lower than 33.99%.
The problem is this: if NTPC is subject to the MAT rate, the gross-up for the purposes of calculating the
return on equity recoverable through capacity charges drops from the corporate income tax rate of 33.99%
to the MAT rate of 18%. And the benefit of recovering based on a statutory tax rate of 33.99% but paying
tax at the effective tax rate that may be up to ~1,500bps lower is reduced to almost nothing. And that is
why the fact that NTPC is subject to the MAT (on its face, a lower tax rate) is detrimental to earnings.
Of course, only earnings in the second and third quarter of FY2011 have been calculated using the MAT
rate. If the effective tax rate increases above the MAT rate because of events in the fourth quarter, income
tax for the year will be calculated based on corporate income tax and the gross up for the purposes of
calculating capacity charges will be at the higher rate.
We understand that the simplest way for NTPC to ensure that this occurs is to defer commercialization of
newly commissioned projects so that the income derived from these projects is captured within taxable
income, raising the company's effective tax rate.
Of course, there is a further wrinkle in all this. By paying corporate income tax, NTPC increases the size of
the capacity payments that it is permitted to charge State Electricity Boards. These are the same State
Electricity Boards that – in some instances – are so illiquid that they are unable to purchase electricity from
NTPC at Rs1.50/KWh. If capacity charges increase, at a minimum, the likelihood that the State Electricity
Boards instruct NTPC to back down its power stations increases.
NTPC is likely to miss its reduced capacity additions guidance.
The bull thesis on NTPC is that it is able to invest at a guaranteed 15.5% return on equity practically in
perpetuity. All the company needs to do is build and commission power stations. NTPC's target for new
installed capacity for the current financial year had been 4,150MW. That was reduced during the third
quarter to 3,150MW due to, among other things, heavy rain that delays construction at the Jhajjar and
Simhadri power stations. NTPC may miss its target of 3,150MW of newly commercialized capacity this
year in order to avoid triggering tax benefits that will exacerbate its MAT problem outlined above. But that
said, a target of 3,150MW for FY2011 is 50% below the run rate required to hit the company's stated target
of 75GW in 2017. In short, heavy rain and the MAT-inspired deferral are simplest the newest iterations of a
recurring problem
The question is: which of these problems will persist into the fourth quarter and beyond.
Arguably, the bad news is all out. NTPC could see a surge in earnings in the fourth quarter if it can raise its
effective tax rate. The delay of "commercialization" of some of the planned new capacity might assist in
this goal.
The broader problem is the State Electricity Boards: NTPC has provided little comfort about why the SEBs
are backing down cheap electricity and when this will stop. If this problem persists, the long-term
investment case for NTPC – and the sector – breaks down.
For NTPC, regardless of the current fluctuations in electricity demand from State Electricity Boards, the
answer remains the same: build new capacity. NTPC is paid based on availability of power stations, not the
amount of power that those power stations produce. Accordingly, whether power consumption growth
slows further or accelerates, the right answer for NTPC is: keep building. Until the company starts to
positively surprise on this score, we remain on the sidelines.
Valuation Methodology
We value NTPC on a two-stage dividend discount model. We base our estimate of growth in stage 1 of the
DDM based on the company's current dividend pay-out ratio and our estimate of return on book equity
given the regulations that prescribe NTPC's returns. The second-stage of the model assumes a steep
increase in the dividend pay-out ratio as capital spending falls once supply and demand within the Indian
power sector comes into balance in the latter half of the decade. Growth in the second-stage of the dividend
discount model drops as a result.
Our valuation for Reliance Power of INR 120.00 is based on a DCF valuation, adjusted downward to reflect
concerns about the terms on which the company may raise additional equity.
Reliance Power is still in the early stages of commissioning its fleet of power plants. Earnings are currently
dominated by interest and investment income and accordingly provide little guide as the company's core
business or sustainable long-term earnings power. Further, given our pessimism about the pricing power of
the non-regulated fleet in India, we have decided against using sales-based valuation metrics. Accordingly,
we are valuing Reliance Power as a "Start-up" on a DCF valuation methodology.
Risks
The primary risk to our thesis on the India utilities is that electricity demand growth may be higher than we
anticipate or the level of newly commissioned power stations may be lower than anticipated. In other
words, the long-term demand-supply imbalance may continue indefinitely.
In addition, for NTPC significant changes in the regulation of the power sector, or a statutorily required
reduction in Government ownership in NTPC over a short timeframe, or a significant investment in foreign,
non- regulated, non-generation assets (all floated in India in the last six months) would have negative
implications for NTPC valuation, in our view.
The primary risk to our thesis on Reliance Power is that if the long-term demand-supply imbalance
continues indefinitely, Reliance Power's IPP fleet – once built – will operate at higher than anticipated
utilization levels and sell electricity at higher than anticipated prices. In that circumstance, commissioning
the fleet in full and on time with minimal additional equity and through the use of large amounts of
inexpensive debt financing would create value over the long term that is not currently reflected in our
valuation.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Highlights
For an industry-leading, regulated utility in a market with a chronic electricity deficit, NTPC's third
quarter results (Q/E Dec 31) contained a lot of bad news. In this report, we detail why NTPC, the lowest
cost electricity provider in India, idled capacity in the third quarter because of lack of demand. We also
consider what is likely to change in 2011.
NTPC backed down its power stations in the third quarter because State Electricity Boards that are
contracted to buy the electricity are currently too poor – or too illiquid - to pay. India suffers a chronic
electricity deficit and NTPC offers the cheapest electricity supply in India. If State Electricity Boards
cannot afford to pay the variable cost component of NTPC's electricity (less than Rs1.50/KWh by our
estimate), the long-term prospects for IPPs building power stations that will import coal and are assuming
payment of Rs3.50KWh (at a minimum) are bleak.
NTPC's falling effective tax rate is, perversely, bad for earnings. The electricity regulation under which
NTPC calculates its permitted return on equity allows a gross-up for the applicable tax rate. As we
understand it, when the applicable tax rate for NTPC is the corporate tax rate of 33.99%, the company's
pre-tax return on equity is 23.5% even though its effective tax rate was less than the statutory rate. Use of
the MAT rate (which NTPC is now liable for) reduces this gross up and the delta between actual taxes
paid and the recovery of taxes that NTPC is permitted to embed in its power charges.
NTPC is likely to miss its reduced commercialized capacity additions targets. The bull thesis on NTPC
is that it is able to invest at a guaranteed 15.5% return on equity practically in perpetuity. All the
company needs to do is build power stations. In the third quarter, NTPC reduced its target for the year
from 4,150MW to 3,150MW. And NTPC may not be "commercializing" all of the 3,150MW this year in
order to avoid triggering tax benefits that will exacerbate its MAT problem. The stations will still be
commissioned. Regardless, a target of 3,150MW for FY2011 is 50% below the run rate required to hit
the company's stated target of 75GW by 2017.
The question is: which of these problems will persist into the fourth quarter and beyond. Arguably, the
bad news is all out. NTPC's earnings could surge in the fourth quarter if it can raise its effective tax rate.
The broader problem is the State Electricity Boards: NTPC has provided little comfort about why the
SEBs are instituting black-outs rather than buying the cheapest electricity in India. If this problem
persists, the long-term investment case for NTPC – and the sector – breaks down.
Investment Conclusion
We rate NTPC Marketperform (NATP.IN, Target Price INR190). Given NTPC's regulated rate of return
nature of the business and the company's reluctance to enter a competitive bidding process for its generation
capacity, we believe that the upside to current valuation is limited.
Details
NTPC's third quarter results were dominated by three problems. First, the company will fail to meet its own
reduced "commercialized" new capacity target for FY11. Second, State Electricity Boards are currently too
poor to pay NTPC for what is the cheapest electricity supply in India and are requiring NTPC to back down
its power stations instead. Third, NTPC's effective tax rate is falling, which means that perversely – through
a twist in Indian tax law and electricity regulation – earnings growth is flat.
Arguably, these issues are transitory. NTPC may delay commercializing some of its new capacity in order
to avoid exacerbating its Minimum Alternate Tax problem (details below). Further, the way that the CERC
regulations are drafted, NTPC should – theoretically – be indifferent to dispatch levels as it is paid based on
availability, not power generated.
However, the investment case for the entire sector is premised on chronic electricity deficits. Said
differently, the Indian economy is supposed to have load to meet almost any level of new capacity.
Structural problems within the distribution segment may be placing that assumption in doubt.
NTPC backed down its power stations in the third quarter because State Electricity Boards that
are contracted to buy the electricity are currently too poor – or too illiquid - to pay for it.
NTPC is the lowest cost provider of electricity in India. It is also the largest and the best operator in India
and has almost all of its capacity locked up in long-term power purchase agreements. India's electricity
deficit remains chronic.
Yet, in the third quarter of 2010, NTPC reported that several of its power stations were backed down
because of the refusal of various State Electricity Boards to pay for the electricity that would have been
generated. In the first nine months of the financial year (April-December 2010), NTPC estimates that it
could have generated an incremental 10,000 GWh or roughly 6% of gross generation over the period.
The problem here is potentially profound. NTPC offers the cheapest electricity supply in India. By virtue of
the regulations under which NTPC operates and the long-term power purchase agreements that it signs with
the State Electricity Boards ("SEBs"), the SEBs are liable for all of NTPC's fixed costs and a return on
equity of ~15.5% as long as NTPC is available for dispatch more than 85% of the time.
There are two implications here. First, as long as NTPC is available for dispatch, its earnings are largely
unaffected by the decision of a particular SEB not to purchase electricity. There are additional benefits to
NTPC from operating at high utilization because of the way the CERC regulations are drafted. Because it
is able to generate electricity at a heat rate that is lower than the nominal heat rate in the electricity
regulations, NTPC effectively gets paid for coal that it does not burn. However, if NTPC doesn't generate
the electricity, it cannot claim this benefit. And backing down and re-firing coal power plants is inefficient.
In short, the actions of the SEBs matter in terms of quarterly earnings – but only at the margin.
Second (and more broadly), if State Electricity Boards cannot afford to pay the variable cost component of
NTPC's electricity generated from domestic coal (by our estimate, less than Rs1.50/KWh), long-term
prospects for IPPs building power stations that will import coal based on business cases that assume a
payment of Rs3.50KWh (at a minimum) are bleak.
And the poor operating performance of NTPC's power stations is clear from a review of the rolling gross
generation growth over the last twelve months. Rolling annual gross generation growth is currently 1.4%
for NTPC (Exhibit 1). To put that in context, annual energy demand growth in India has been 5-7% in
recent years and installed capacity growth is 7-8% currently and trending higher. Low power consumption
growth rates in India are often attributed to a lack of capacity growth or a lack of coal. In this instance,
capacity is not the problem. For NTPC, utilization has fallen in two of the last three quarters and was flat in
the second quarter (Exhibit 2)
Coal provision from imports and Coal India has increased modestly over the last year. Total coal increased
from 98.58 million tons in the nine months to December 2009 to 100.44 million tons in the nine months to
December 2010 – a 1.8% increase.
In theory, it is possible that the lack of generation growth is a function of a lack of fuel supply growth rather
than a function of demand growth. But NTPC describes the fact that its availability is higher than its plant
load factor (availability – as NTPC measures it – requires access to domestic coal). In short, this is a
demand problem.
And not just for NTPC. Annual power demand growth for India has been below 5% for the last four months
(Exhibit 3). In fact, for NTPC this is less of a problem than for the rest of the industry. NTPC's fleet is
largely regulated and gets paid a return on equity for availability. For the rest of the industry, payment is –
largely - based on electricity supply. Certainly for the power stations that are being built currently by IPPs,
the base case scenario has involved the ability to sign long-term power purchase agreements at
Rs3.50/KWh or more and to sell power into the merchant market at Rs5-6/KWh or more
Except that – as we discuss above – it is not clear that NTPC can currently sell electricity even at
~Rs1.50/KWh and the merchant market has been trending down since 2008
The average price of merchant electricity since the middle of 2008 as reported by IEX India has been just
over Rs5/KWh. But the trend has been down the whole time. There is some seasonality involved: prices
tend to peak in the May-June time period and trough in January-February. We are currently therefore
emerging from a trough and the fact that the average three month price has been lower than the long-term
average since for the last six months is – in part – a function of seasonality.
But there is something else going on too. The peak in May-June 2010 was lower than the peak in 2009 and
the current trough is lower than the troughs in either 2010 or 2009. In short, merchant power prices are
falling.
The two primary explanations offered for the downturn in power demand growth suggest that the trend is
temporary. First, given that Indian GDP growth remains in the high single digits, it is unlikely that power
consumption growth can remain half of that level. The "classic" relationship between power consumption
growth and GDP growth suggests that developing economies use a lot of electricity for each additional unit
of GDP. The "power multiplier" doesn't generally fall below one unit the economy is heavily industrialized
and is transitioning to services, transport and higher value-added manufacturing for its sources of economic
growth (i.e., the United States in the 1970s; China today). To suggest that India can continue to growth at
9-10% with power consumption growth of 4-5% seems unlikely based on the state of the Indian economy
and this longstanding relationship between power consumption growth and GDP growth.
And yet, that is what we have documented previously. Notwithstanding the fact that India would not be
viewed by many as a post-industrial economy, its power multiplier has been below 1.0 since 2003 (viewed
on a rolling five year basis).
Looking at the difference between real GDP and electricity consumption cumulative average growth rates
over the period from 1976 to 2009 highlights this inflection point (Exhibit 5). In no period before 2003 was
real GDP growth (measured on a 5-year CAGR) greater than electricity production growth (measured on a
5-year CAGR). In no period since 2003 has the inverse been the case. And if we look solely at data since
2003, a new relationship between electricity production and real GDP growth appears to be emerging.
India's power multiplier has been ~0.7 for the past five years (Exhibit 6). Annual data has not yet been
released but the quarterly data suggests that the power multiplier for the five years ended December 2010
will be lower still.
Our expectation has been that power consumption growth will accelerate and the power multiplier in India
will increase over the next decade because of an increase in installed capacity and improved access to fuel
supply. Both of these things will, in our view, result in cheaper electricity that "funds" more powerintensive
activities. In short, the trend would be good news for India but not good news for the IPPs. We
didn't expect (and still don't expect) it to play out for several years. But a fall in merchant price of
electricity – like we are currently seeing – would certainly be the first sign that supply was outstripping
demand.
The more prosaic explanation is politics. The argument goes that, during election years, State Electricity
Boards buy more electricity. In short, political incumbents like to point to regional development and
progress as a sign of political success and therefore like to keep the lights on based on the assumption that
the electorate will link reliable power supply with economic progress. Politicians therefore pressure State
Electricity Boards to maintain supply and avoid black-outs in the run-up to elections, no matter what the
cost. In non-election years, these pressures dissipate. The explanation is widely told and a certain logic.
And the electricity deficit data backs up this explanation in only a minority of cases.
Looking at the gap between total electricity demand over the year and total electricity supply, there are
examples (Exhibit 7) at a state level where the deficit falls in an election year and then spikes back up the
following year – but not many. In fact, this pattern is the exception rather than the rule. We identified this
pattern in Haryana, Punjab, Uttar Pradesh, Mizoram, Nagaland and Tripura during their most recent
elections. Of those six states, only the first three are significant in terms of population or as a share of
national electricity consumption.
At a national level, the electricity deficit fell in India in 2009 (an election year) but also in 2010. In fact, that
observation – the fact that nationally the electricity deficit has fallen in the last two calendar years - may be
the more important fact to note.
Of course, the fact that the election year phenomenon is not observable in every instance based solely on
aggregated calendar year electricity demand and supply data does not mean that it does not exist. An
election early in a calendar year would mean the "election year" effect would bleed over into the prior year.
Further, there are a number of economic, weather and other patterns that will affect electricity consumption.
In addition, a greater willingness to purchase merchant power to address peak demand in the run-up to an
election may have a significant impact on perceptions about reliability of service without necessarily
dramatically changing total electricity consumption.
And that is, in the end, our point. We believe that it is possible to overstate the impact of the political cycle
on total electricity consumption patterns in India. The impact on merchant pricing may be real. However,
we are not sure how significant the impact on total consumption is.
Whatever the size of the "political effect", it is good news for IPPs in a country often accused of having too
much democracy in that it is always an election year somewhere. In 2011, there are five states holding
elections: West Bengal, Tamil Nadu, Pondicherry, Assam and Kerala. These states account for ~250 million
people or just under 20% of the population in 2009. While in 2010, only Bihar with a population of ~100
million people, had a state election. Accordingly, there may be an increase in electricity production growth
in 2011 if the election year phenomenon holds true.
The third explanation of the slowing on power consumption growth is structural. Put simply, the
distribution companies and State Electricity Boards simply do not have any money and therefore cannot pay
for electricity. If actual technical and commercial losses are so high (often thought of as half of all power
distributed is stolen) that distribution companies lose money, then the more power they supply, the more
money they lose. And – unless resolved - as the economy develops and becomes more power intensive, the
problem gets worse, not better.
Whatever the cause of the deceleration in power consumption growth in the last year, NTPC enjoys a level
of protection being the lowest cost provider of electricity in the country. Implications for the rest of the
industry are, in our view, more dire.
NTPC now qualifies for the MAT which, perversely, is bad.
For the last two quarters, there has been a lot of focus on the Minimum Alternate Tax ("MAT") for NTPC.
India – like the United States – has two-tiered income tax system. Indian companies calculate a corporate
income tax liability and a Minimum Alternate Tax liability. The company is liable for the higher of the
two.
The electricity regulation under which NTPC calculates its permitted return on equity allows a gross-up for
the applicable tax rate. When the applicable tax rate for NTPC is the corporate tax rate of 33.99%, the
company's pre-tax return on equity is 23.5% even though its effective tax rate may be far less than the
statutory rate of 33.99%. The use of the MAT rate of ~18% reduces both this gross-up and the delta
between actual tax paid and the level of permitted recoveries for taxes that NTPC embeds in its electricity
charges.
The company's preference is therefore to pay the corporate income tax. Mechanically, NTPC should be
able to manage this classification by the rate at which it qualifies for tax credits and other benefits that serve
to lower the company's effective tax rate.
As we understand it, the calculation of corporate income tax liability in India (like in most jurisdictions)
involves various adjustments to Net Profit before Tax as calculated for financial reporting purposes.
Depreciation is usually the most significant adjustment. Specifically, "book" depreciation is added back to
Net Profit before Tax and "tax" depreciation subtracted. In India, the "tax holidays" available to
commercialized power stations in their first 10 years of operation under Section 80IA of the Income Tax
Act mean that these profits are included within Net Profit before tax for financial reporting purposes but
excluded (permanently) from taxable income.
With those (and other) adjustments made to derive taxable income, tax is calculated at the corporate tax
rate. As we understand it, if the tax payable under this calculation is lower than the product of the MAT
rate and Net Profit before Tax, the company is captured within the MAT regime and pays that higher level
of tax.
This affects NTPC earnings because of the way that the company's tax rate is used to calculate the return on
equity that it may embed in capacity charges to State Electricity Boards. If NTPC is subject to the
corporate income tax rate, it grosses up the regulated return on equity of 15.5% by the corporate income tax
rate of 33.99% and embeds that amount in its calculation of capacity charges. This is the case even though
the company's effective tax rate (once permanent differences like the tax holidays are adjusted for) may be
significantly lower than 33.99%.
The problem is this: if NTPC is subject to the MAT rate, the gross-up for the purposes of calculating the
return on equity recoverable through capacity charges drops from the corporate income tax rate of 33.99%
to the MAT rate of 18%. And the benefit of recovering based on a statutory tax rate of 33.99% but paying
tax at the effective tax rate that may be up to ~1,500bps lower is reduced to almost nothing. And that is
why the fact that NTPC is subject to the MAT (on its face, a lower tax rate) is detrimental to earnings.
Of course, only earnings in the second and third quarter of FY2011 have been calculated using the MAT
rate. If the effective tax rate increases above the MAT rate because of events in the fourth quarter, income
tax for the year will be calculated based on corporate income tax and the gross up for the purposes of
calculating capacity charges will be at the higher rate.
We understand that the simplest way for NTPC to ensure that this occurs is to defer commercialization of
newly commissioned projects so that the income derived from these projects is captured within taxable
income, raising the company's effective tax rate.
Of course, there is a further wrinkle in all this. By paying corporate income tax, NTPC increases the size of
the capacity payments that it is permitted to charge State Electricity Boards. These are the same State
Electricity Boards that – in some instances – are so illiquid that they are unable to purchase electricity from
NTPC at Rs1.50/KWh. If capacity charges increase, at a minimum, the likelihood that the State Electricity
Boards instruct NTPC to back down its power stations increases.
NTPC is likely to miss its reduced capacity additions guidance.
The bull thesis on NTPC is that it is able to invest at a guaranteed 15.5% return on equity practically in
perpetuity. All the company needs to do is build and commission power stations. NTPC's target for new
installed capacity for the current financial year had been 4,150MW. That was reduced during the third
quarter to 3,150MW due to, among other things, heavy rain that delays construction at the Jhajjar and
Simhadri power stations. NTPC may miss its target of 3,150MW of newly commercialized capacity this
year in order to avoid triggering tax benefits that will exacerbate its MAT problem outlined above. But that
said, a target of 3,150MW for FY2011 is 50% below the run rate required to hit the company's stated target
of 75GW in 2017. In short, heavy rain and the MAT-inspired deferral are simplest the newest iterations of a
recurring problem
The question is: which of these problems will persist into the fourth quarter and beyond.
Arguably, the bad news is all out. NTPC could see a surge in earnings in the fourth quarter if it can raise its
effective tax rate. The delay of "commercialization" of some of the planned new capacity might assist in
this goal.
The broader problem is the State Electricity Boards: NTPC has provided little comfort about why the SEBs
are backing down cheap electricity and when this will stop. If this problem persists, the long-term
investment case for NTPC – and the sector – breaks down.
For NTPC, regardless of the current fluctuations in electricity demand from State Electricity Boards, the
answer remains the same: build new capacity. NTPC is paid based on availability of power stations, not the
amount of power that those power stations produce. Accordingly, whether power consumption growth
slows further or accelerates, the right answer for NTPC is: keep building. Until the company starts to
positively surprise on this score, we remain on the sidelines.
Valuation Methodology
We value NTPC on a two-stage dividend discount model. We base our estimate of growth in stage 1 of the
DDM based on the company's current dividend pay-out ratio and our estimate of return on book equity
given the regulations that prescribe NTPC's returns. The second-stage of the model assumes a steep
increase in the dividend pay-out ratio as capital spending falls once supply and demand within the Indian
power sector comes into balance in the latter half of the decade. Growth in the second-stage of the dividend
discount model drops as a result.
Our valuation for Reliance Power of INR 120.00 is based on a DCF valuation, adjusted downward to reflect
concerns about the terms on which the company may raise additional equity.
Reliance Power is still in the early stages of commissioning its fleet of power plants. Earnings are currently
dominated by interest and investment income and accordingly provide little guide as the company's core
business or sustainable long-term earnings power. Further, given our pessimism about the pricing power of
the non-regulated fleet in India, we have decided against using sales-based valuation metrics. Accordingly,
we are valuing Reliance Power as a "Start-up" on a DCF valuation methodology.
Risks
The primary risk to our thesis on the India utilities is that electricity demand growth may be higher than we
anticipate or the level of newly commissioned power stations may be lower than anticipated. In other
words, the long-term demand-supply imbalance may continue indefinitely.
In addition, for NTPC significant changes in the regulation of the power sector, or a statutorily required
reduction in Government ownership in NTPC over a short timeframe, or a significant investment in foreign,
non- regulated, non-generation assets (all floated in India in the last six months) would have negative
implications for NTPC valuation, in our view.
The primary risk to our thesis on Reliance Power is that if the long-term demand-supply imbalance
continues indefinitely, Reliance Power's IPP fleet – once built – will operate at higher than anticipated
utilization levels and sell electricity at higher than anticipated prices. In that circumstance, commissioning
the fleet in full and on time with minimal additional equity and through the use of large amounts of
inexpensive debt financing would create value over the long term that is not currently reflected in our
valuation.
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