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CESC Limited
Downside from retail priced-in
Initiating with Outperform and Rs384 TP, 30% potential upside
We initiate on CESC with an Outperform recommendation and a target price of
Rs384/share. Promoted by the RPG Group (53% holding), CESC is a miniconglomerate
consisting of a utility cash cow and a retail cash guzzler, Spencer’s.
The utility generates solid regulated cashflows, while, at current prices, there
appears to be little downside to Spencer’s. If management delivers on its
guidance, we see the potential for 70% share price upside. We also heavily
discount upside from CESC’s power generation growth portfolio. The stock is
trading at a 17% discount to regulated utilities based on a FY12E consolidated
PER of 10.6x and at a 50% discount to a FY12E consolidated P/BV of 0.7x.
Spencer’s risk in the price – a long-term catalyst
The management of both CESC and Spencer’s expect retail to break even on an
EBITDA basis by FY14 end, followed by a 6-7% EBITDA margin. This would
create more upside (~+70%) than downside in the stock price, we believe, if
current rates of corporate losses were protracted (-5%). We have adopted a
more cautious outlook, forecasting EBITDA to break even in FY16. From
speaking to some of Spencer’s competitors, their unanimous view is that a
strategic focus on growing food retail will produce profits sooner than this.
Cash cow supporting cashflow – integrated utility
CESC owns a vertically integrated utility in Kolkata that has 1,225MW of
generation (Rs11.4bn regulated equity) and 16,500km of Transmission and
Distribution (T+D) assets (Rs11.4bn regulated equity). We note the following:
Defensive: Earnings regulated using 14% ROE for generation and 15% ROE
for T+D. Regulatory risk may peak this year as regulator sets multi-year tariff.
Domestic: 100% of earnings are domestic, with a forecast growth rate of 7%
pa for the regulated equity base.
Debt: 70% gearing structure (lower than that of peers) and strong interest
coverage of 3.5x lowers financial risk. Annual debt repayment is ~Rs.4bn.
High-risk return: capital allocation, dilution and acquisition
A turnaround in retail goes hand-in-hand with CESC’s capital position. Should the
turnaround be delayed for longer than we forecast, there may be a strain on equity
due to financing requirements for CESC’s Haldia/Chandrapur power assets (we
assume a 20% stake sale). We also think that Indian power utilities such as CESC
will acquire more global coal assets due to the widening coal shortage in India. We
therefore believe acquisition- and equity-raising risk remains.
Valuation: Rs384 target price, interesting mid-cap
CESC is trading at a 30% discount to our sum-of-the-parts (SOTP) valuation,
which includes a negative valuation of Rs52/share for Spencer’s. CESC looks
inexpensive based on earnings multiples, trading at consolidated FY12E and
FY13E NPAT of 11x and 10x vs 13x and 12x, respectively, for Indian regulated
utilities. CESC is trading at 0.7x FY12E price/consolidated book value vs 1.5x
P/BV for regulated utilities and 1.7x P/BV for the broader utility space.
CESC Limited
Company profile
CESC is the largest subsidiary of RPG Group. A mini-conglomerate, CESC
owns regulated utility assets in Kolkata as well as Spencer’s, an organised
retailer with stores across the country.
The utility, the cash cow: CESC owns an integrated, regulated utility in
Kolkata that has 1,225MW of generation (Rs11.4bn regulated equity) and
16,500km of Transmission and Distribution (T+D) assets (Rs11.4bn regulated
equity). The Kolkata T+D network is one of the most efficient operating
distribution assets in the country, with current T+D losses of 13.3%, 10% of
which we consider to be a technical loss.
Key economics of utility: Earnings are regulated by the West Bengal
Electricity Regulatory Commission (WBERC), calculated at a 14% after-tax
ROE for the generation assets and a 15% after-tax ROE for the T+D assets.
We expect regulatory risk to peak this year as the WBERC sets its five-year
multi-year tariff. Volume growth (MU) over the past 10 years has averaged
4.4%, while gross fixed assets have grown by 6%, with the recent capex for
Budge-Budge Phase II (250MW) providing a boost. We expect future
regulated capex of the business to be ~Rs5bn pa.
The retailer, the cash guzzler: CESC owns Spencer’s, a multi-format retailer
with 856k square feet of retail premises across the country and with hyper retail
stores (>15ksqft) making up ~50% of this area and small stores (<3ksqft) ~40%.
The company expects floorspace to increase by 2.5x by FY14, and to be
focused on larger format stores and a core strategy of boosting margins in food.
Key economics of retail: The retail business has been running with
operating losses for the past five years, funded by the utility business.
However, over the past 18 months, management has proven its ability to
improve margins and reduce losses, with earnings at the store level now
breaking even and gross margins of ~18%. Management’s strategy is to
increase top-line growth to dilute the effect of a high corporate cost-base,
thereby improving EBITDA margins.
Downside from retail priced-in
Retail downside priced-in – margin improvement a catalyst
The key risk for accumulating CESC at such low trading multiples (11x consolidated FY12
PER, 0.7x consolidated FY12 P/BV) centers around the loss-making retail business,
Spencer’s, and ongoing capital allocation to support these losses. While we believe they are
reasonable concerns, we make the following observations:
Downside factored in: At current prices, we think CESC is close to fully factoring-in
ongoing corporate losses from its retail business. If we use management’s guidance of
EBITDA breaking even by FY14 followed by a 6-7% EBITDA margin, we estimate 70%
upside to the stock price. Our forecasts are not as bullish as those of management,
however, and we assume breakeven in FY16. Still, we see material upside potential
(+30%) for the stock based on these estimates.
Evidence of turnaround: Over the past 18 months, CESC’s management has delivered
margin growth, and Spencer’s is now at breakeven (EBITDA) at the store level (shown
below). Margin improvement has been driven by cost management (note gross margins
have been constant at ~18%) via store closures, but we think ongoing margin improvement
will have to come from top-line growth in the larger format food-focused retail stores.
Cashflows supported by a solid utility valued at Rs411/share
CESC’s flagship utility business is a regulated cash cow. We make the following points:
Well integrated – from customer to fuel: The integrated structure of CESC’s utility
assets significantly lowers its risk from potential fuel/power price rises in addition to the
regulated return structure (cost pass-through).
West Bengal – a safer place to operate: The below data, backed by discussions with
industry contacts, suggest that West Bengal has a solid power sector, allowing power cost
pass-through to customers and a low base-load power deficit relative to other states.
Regulatory risk: For more risk-averse investors, we suggest waiting for the regulatory
decision on CESC’s Kolkata assets, due in the next few months, before accumulating the
stock. Even so, we don’t see much downside to the regulated ROE, which is currently 14%
for generation and 15% for T+D vs 15.5% from the Central regulator. We understand that a
decision is formally due before 31 March 2010, but that this could be delayed by up to
three months – perhaps to June/July.
Risks: capital allocation, equity dilution and acquisitions
In our view, the key risk for CESC is capital allocation and potential equity dilution. Based on
our forecasts, the standalone business generates enough free cash to cover the equity
requirements of retail and the power assets, although only in FY13-14. Therefore, the
turnaround in the retail business won’t just affect earnings, but also ongoing equity
requirements, as we see it.
It is also our view that Indian power utilities such as CESC will acquire more global coal
assets due to the widening coal shortage in India, leading to acquisition risk.
Valuation: Rs384/share, while trading at a discount to most indices
CESC is trading at a 30% discount to our sum-of-the-parts (SOTP) valuation, which we view
as the best valuation methodology considering the vastly different business units.
CESC clearly looks inexpensive based on earnings multiples, ie, trading at consolidated
NPAT of 11x FY12E and 10x FY13E vs 13x FY12E NPAT and 12x FY13E NPAT for Indian
regulated utilities. CESC is trading at 0.7x FY12E Price/Consolidated Book Value vs 1.5x
P/BV for regulated utilities and 1.7x P/BV for the broader utility space.
Valuation: Rs384/share
Sum-of-the parts (SOTP): Rs384/share
We use an SOTP valuation for CESC. In summary, cashflows from the utility assets create
more value than the consolidated group, and Spencer’s, the retail business, creates negative
value. We probability weight the generation growth, as <10% of the project capex has been
invested to-date, while both rely on coal linkages with Coal India (high-risk).
Kolkata utility: Rs411/share (P/BV, DCF)
We have valued the existing regulated utility on Price/Book and separately value growth and
incentives on P/BV and DCF. Our primary assumptions are:
Regulated return on equity: 14% for generation assets and 15% for T+D assets, as per
the WBERC regulatory decision for FY08-10.
Cost of equity: 12% for generation assets (beta: 0.8, Rf: 8%, MRP: 5%) and 11% for T+D
assets (beta: 0.6, Rf: 8%, MRP: 5%).
Regulated equity base in FY12 of: Rs11.4bn (US$250m) for generation and Rs12.9bn
for T+D network (US$283).
Growth capex: We assume Rs5bn capex per annum according to company guidance
(realistic compared to historical capex), with 30% being added to the regulatory base. No
further growth in generation (separately modelled via its Haldia plant) forecast.
Incentives: We maintain a 1% spread between actual ATC losses (13%) and the
regulated target (14.25%) and a long-term Plant Load Factor of 90% (below recent
averages) for PLF outperformance.
Retail: -Rs52/share based on FY16 EBITDA breakeven
Retail is a loss-making business. Management currently expects the business to break even
at an EBITDA level by the end of FY14, and it is implementing strategies to reduce losses;
the lower losses have improved earnings over the last 18 months. We have taken a more
conservative view and believe that the retail business will only become EBITDA positive in
FY16.
Key assumptions we have applied to model the retail business earnings:
Store growth: From 0.9m sqft to 2.5m sqft by the end of FY14 at a cost of Rs1,300/sqft
Same store sales growth: +14% in FY12, +10% in FY13, +2% real growth afterwards
Gross margin: From 18% to 21% in FY14
Costs: Store opex growth of +3.5% per annum, corporate opex up by CPI, advertising at
2% of sales, distribution costs at 5% of sales.
Current share price assumes a bear case scenario
We have run a scenario analysis on the retail business, observing valuation impacts from
management guidance for a turnaround in profitability coming to fruition and from the worst
case – ie, no change to margins and ongoing losses. On these assumptions, the current
stock price appears to be pricing-in the worst case scenario (-5% to share price) and material
upside (+70%) if management is able to execute its strategy.
Worst case scenario: corporate level losses continue
The retail business is currently breaking even at a store level; however, corporate overhead is
still creating losses for the business. If we capitalise these losses, as per below, assuming
that they are ongoing, it would take Rs157/share from our valuation. This is also in line with
the business operating for another five years with growing losses and then being closed
down. This would be a complete failure of the retail business, and it appears that this is being
priced-in at current levels. This appears to be overly bearish, in our view, when we see
evidence of management improving earnings margins.
Fig 10 Ongoing losses for 10 years – an unlikely scenario
Current Corporate Costs 1,967
EV/EBITDA Multiple 8x
Enterprise Value -15,733
Net Debt 3,936
Equity Value -19,669
Shares 125
per share -157
Note: We have cross-checked the use of an 8x EV/EBITDA with NPV of corporate losses. An 8x multiple
equates to ~10 consecutive years of corporate level losses, growing with rising revenues.
Source: Macquarie Research, March 2011
Management guidance: FY14 breakeven, FY16 6-7% EBITDA margin
CESC’s management estimates that retail will reach breakeven at a corporate level by the
end of FY14 and will start realising EBITDA margins of 6-7% at maturity. This differs from our
current forecast, likely due to management’s more bullish store-on-store sales growth
projections. However, if we assume that guidance comes to fruition, then we estimate there
could be around 70% upside to our current share price target. We reach that forecast by
estimating a 1yr fwd EV/EBITDA multiple valuation of 8x in FY15, then discounting back to
current prices at 13%.
Fig 11 Turnaround scenario: Rs57/share
Turnaround Scenario
FY16 Revenue 45,124
FY16 EBITDA Margin 6.5%
FY16 EBITDA 2,933
EV/EBITDA Multiple 8x*
FY16 EV 23,464
Discounted at 13% WACC 12,656
less: losses to FY14 -1,636
less: Net Debt -3,936
Equity Value 7,084
Shares 125
per share 57
*EV/EBITDA multiple in line with Pantaloons, while EBITDA target margin in line with management guidance
and at a slight discount to the current EBITDA margins of peers (due to a greater focus on food than apparel)
Source: Macquarie Research, March 2011
Closing down business could be value accretive at current prices
Indeed, based on our back-of-the-envelope valuation, closing down the retail business would
yield a stronger valuation than the shares are currently trading at. We understand from
management, however, that this is an unlikely outcome and, therefore, we haven’t considered
it in our base-case valuation.
Fig 12 Closing down valuation –Rs79/share
12 month of fixed costs -4,911
Inventory sales @ 50% book value 610
Receivable @ 50% book value 93
Payables -1,711
Net Debt -3,936
Total -9,855
Shares on Issue 125
Valuation -79
Source: Macquarie Research, March 2011
Haldia and Chandrapur: Rs14/share (DCF – 50% probability)
We have valued both power projects using a DCF methodology on geared cashflows, with a
13.5% cost of equity, while assuming that CESC will sell 20% of its generation assets at book
value. This helps from an equity requirement perspective, not a value perspective.
Around two-thirds of the capacity of Chandrapur is expected to be sold into the merchant
market, while a quarter of Haldia’s capacity is expected to be merchant. Our merchant power
price forecasts are shown below.
Not pricing-in any upside from retail
While the RPG Group has owned Spencer’s for the past 13-14 years, it wasn’t until 2007 that
the company was moved into CESC. It has consumed capital ever since and has weighed
negatively on investor sentiment. However, at current prices, it appears that the market is
pricing-in the possibility that current losses for Spencer’s will continue for the next ten years,
while the business has proven to be an operational turnaround over the past 18 months. We
therefore think that, with a solid utility business providing cash support, a turnaround in retail
could add material value from current levels.
Evidence of a turnaround, with store EBITDA breaking even
Over the past 18 months, we have seen tangible evidence that CESC’s management has
improved margins, as shown below, with store level EBITDA (not including corporate
overhead, distribution, advertising) breaking even. This turnaround has been driven by cost
reductions, while gross margins have stayed at ~18%. Spencer’s has closed ~50 stores over
the past two years (currently 206 stores), while the number of distribution warehouses has
decreased from 21 to nine over the past year. Much of the low hanging fruit for cost reduction
has now been achieved.
Strategy is now about top-line growth and margin expansion
One of the key challenges for Spencer’s and its peers, in our view, is its large corporate cost
base. Management’s strategy to tackle this is clear: grow the absolute gross margin to dilute
the impact of the corporate costs and drive the business into positive EBITDA margins, which
it aims to do over the next 36 months, with the goal of achieving maintainable EBITDA
margins of 6-7%. Senior management of Spencer’s that we met in Kolkata noted that the
current corporate cost base could support a business with 3x the turnover. Therefore, the
value drivers would be three-fold:
1. Increase floor space from 0.9m sqft to 2.5m sqft by FY14 by adding larger-format
retail space. Currently, ~50% of floorspace is larger format hyperstores (>15k sqft), which
we expect to move up to ~85% of total floorspace. Spencer’s aims to be the leading food
retailer in India, with 75% of current turnover being food. The larger format store is
expected to increase the product range in food and in higher-margin offerings (see #3).
Senior management also noted that the larger format stores have lower opex of
~Rs100/sqft vs smaller format stores of Rs122/sqft, a positive for margins.
2. Same store sales growth of 14-15% in FY11/12: We visited Spencer’s largest
hypermarket (47k sqft) in South City Mall, Kolkata, and met with its operations manager
who noted that the store achieved 35% sales growth in 2010. Walking around the store, it
was clear that Spencer’s is still in a learning phase in regard to maximising floorspace
efficiency. For example, the manager noted that the apparel floorspace had been reduced
from 9k sqft to 6k sqft, with no change in sales.
3. Improving gross margin from 18% to 20% in FY12 and to 22% in FY14, in line with
some of Spencer’s competitors, such as Big Bazaar and Hypercity. Spencer’s senior
management that we met in Kolkata noted that improving margins in its food business is
core to Spencer’s strategy of improving profitability. Several ways to get there are:
⇒ Higher-margin offerings, such as a Gourmet food section (shown below), which
takes up 5-6% of store floorspace and yields a higher margin of ~24-25%. Other
additional offerings include bakeries/bottle shops in store. Fresh meat and fish are also
expected to improve current margins.
Regulatory earnings create the cash cow
CESC’s Kolkata-based utility is a strong cash generating business with annuity style
cashflows. With 1,225MW of regulated generation and a 16,500km T+D network, earnings
are typically driven by volume, capex and regulatory outcomes. CESC has been awarded the
power supply licence to 2020 in West Bengal.
Vertically integrated: long distribution, short-fuel
Similar to Tata Power, CESC has a reasonably strong integrated position. We expect it to
remain long-distribution until its power generation growth pipeline starts to kick in FY15 (we
estimate a 12-month delay vs the company’s target). Despite being short-fuel, its own mine
covers 50% of its generation requirement, which is high compared to that of its peers.
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CESC Limited
Downside from retail priced-in
Initiating with Outperform and Rs384 TP, 30% potential upside
We initiate on CESC with an Outperform recommendation and a target price of
Rs384/share. Promoted by the RPG Group (53% holding), CESC is a miniconglomerate
consisting of a utility cash cow and a retail cash guzzler, Spencer’s.
The utility generates solid regulated cashflows, while, at current prices, there
appears to be little downside to Spencer’s. If management delivers on its
guidance, we see the potential for 70% share price upside. We also heavily
discount upside from CESC’s power generation growth portfolio. The stock is
trading at a 17% discount to regulated utilities based on a FY12E consolidated
PER of 10.6x and at a 50% discount to a FY12E consolidated P/BV of 0.7x.
Spencer’s risk in the price – a long-term catalyst
The management of both CESC and Spencer’s expect retail to break even on an
EBITDA basis by FY14 end, followed by a 6-7% EBITDA margin. This would
create more upside (~+70%) than downside in the stock price, we believe, if
current rates of corporate losses were protracted (-5%). We have adopted a
more cautious outlook, forecasting EBITDA to break even in FY16. From
speaking to some of Spencer’s competitors, their unanimous view is that a
strategic focus on growing food retail will produce profits sooner than this.
Cash cow supporting cashflow – integrated utility
CESC owns a vertically integrated utility in Kolkata that has 1,225MW of
generation (Rs11.4bn regulated equity) and 16,500km of Transmission and
Distribution (T+D) assets (Rs11.4bn regulated equity). We note the following:
Defensive: Earnings regulated using 14% ROE for generation and 15% ROE
for T+D. Regulatory risk may peak this year as regulator sets multi-year tariff.
Domestic: 100% of earnings are domestic, with a forecast growth rate of 7%
pa for the regulated equity base.
Debt: 70% gearing structure (lower than that of peers) and strong interest
coverage of 3.5x lowers financial risk. Annual debt repayment is ~Rs.4bn.
High-risk return: capital allocation, dilution and acquisition
A turnaround in retail goes hand-in-hand with CESC’s capital position. Should the
turnaround be delayed for longer than we forecast, there may be a strain on equity
due to financing requirements for CESC’s Haldia/Chandrapur power assets (we
assume a 20% stake sale). We also think that Indian power utilities such as CESC
will acquire more global coal assets due to the widening coal shortage in India. We
therefore believe acquisition- and equity-raising risk remains.
Valuation: Rs384 target price, interesting mid-cap
CESC is trading at a 30% discount to our sum-of-the-parts (SOTP) valuation,
which includes a negative valuation of Rs52/share for Spencer’s. CESC looks
inexpensive based on earnings multiples, trading at consolidated FY12E and
FY13E NPAT of 11x and 10x vs 13x and 12x, respectively, for Indian regulated
utilities. CESC is trading at 0.7x FY12E price/consolidated book value vs 1.5x
P/BV for regulated utilities and 1.7x P/BV for the broader utility space.
CESC Limited
Company profile
CESC is the largest subsidiary of RPG Group. A mini-conglomerate, CESC
owns regulated utility assets in Kolkata as well as Spencer’s, an organised
retailer with stores across the country.
The utility, the cash cow: CESC owns an integrated, regulated utility in
Kolkata that has 1,225MW of generation (Rs11.4bn regulated equity) and
16,500km of Transmission and Distribution (T+D) assets (Rs11.4bn regulated
equity). The Kolkata T+D network is one of the most efficient operating
distribution assets in the country, with current T+D losses of 13.3%, 10% of
which we consider to be a technical loss.
Key economics of utility: Earnings are regulated by the West Bengal
Electricity Regulatory Commission (WBERC), calculated at a 14% after-tax
ROE for the generation assets and a 15% after-tax ROE for the T+D assets.
We expect regulatory risk to peak this year as the WBERC sets its five-year
multi-year tariff. Volume growth (MU) over the past 10 years has averaged
4.4%, while gross fixed assets have grown by 6%, with the recent capex for
Budge-Budge Phase II (250MW) providing a boost. We expect future
regulated capex of the business to be ~Rs5bn pa.
The retailer, the cash guzzler: CESC owns Spencer’s, a multi-format retailer
with 856k square feet of retail premises across the country and with hyper retail
stores (>15ksqft) making up ~50% of this area and small stores (<3ksqft) ~40%.
The company expects floorspace to increase by 2.5x by FY14, and to be
focused on larger format stores and a core strategy of boosting margins in food.
Key economics of retail: The retail business has been running with
operating losses for the past five years, funded by the utility business.
However, over the past 18 months, management has proven its ability to
improve margins and reduce losses, with earnings at the store level now
breaking even and gross margins of ~18%. Management’s strategy is to
increase top-line growth to dilute the effect of a high corporate cost-base,
thereby improving EBITDA margins.
Downside from retail priced-in
Retail downside priced-in – margin improvement a catalyst
The key risk for accumulating CESC at such low trading multiples (11x consolidated FY12
PER, 0.7x consolidated FY12 P/BV) centers around the loss-making retail business,
Spencer’s, and ongoing capital allocation to support these losses. While we believe they are
reasonable concerns, we make the following observations:
Downside factored in: At current prices, we think CESC is close to fully factoring-in
ongoing corporate losses from its retail business. If we use management’s guidance of
EBITDA breaking even by FY14 followed by a 6-7% EBITDA margin, we estimate 70%
upside to the stock price. Our forecasts are not as bullish as those of management,
however, and we assume breakeven in FY16. Still, we see material upside potential
(+30%) for the stock based on these estimates.
Evidence of turnaround: Over the past 18 months, CESC’s management has delivered
margin growth, and Spencer’s is now at breakeven (EBITDA) at the store level (shown
below). Margin improvement has been driven by cost management (note gross margins
have been constant at ~18%) via store closures, but we think ongoing margin improvement
will have to come from top-line growth in the larger format food-focused retail stores.
Cashflows supported by a solid utility valued at Rs411/share
CESC’s flagship utility business is a regulated cash cow. We make the following points:
Well integrated – from customer to fuel: The integrated structure of CESC’s utility
assets significantly lowers its risk from potential fuel/power price rises in addition to the
regulated return structure (cost pass-through).
West Bengal – a safer place to operate: The below data, backed by discussions with
industry contacts, suggest that West Bengal has a solid power sector, allowing power cost
pass-through to customers and a low base-load power deficit relative to other states.
Regulatory risk: For more risk-averse investors, we suggest waiting for the regulatory
decision on CESC’s Kolkata assets, due in the next few months, before accumulating the
stock. Even so, we don’t see much downside to the regulated ROE, which is currently 14%
for generation and 15% for T+D vs 15.5% from the Central regulator. We understand that a
decision is formally due before 31 March 2010, but that this could be delayed by up to
three months – perhaps to June/July.
Risks: capital allocation, equity dilution and acquisitions
In our view, the key risk for CESC is capital allocation and potential equity dilution. Based on
our forecasts, the standalone business generates enough free cash to cover the equity
requirements of retail and the power assets, although only in FY13-14. Therefore, the
turnaround in the retail business won’t just affect earnings, but also ongoing equity
requirements, as we see it.
It is also our view that Indian power utilities such as CESC will acquire more global coal
assets due to the widening coal shortage in India, leading to acquisition risk.
Valuation: Rs384/share, while trading at a discount to most indices
CESC is trading at a 30% discount to our sum-of-the-parts (SOTP) valuation, which we view
as the best valuation methodology considering the vastly different business units.
CESC clearly looks inexpensive based on earnings multiples, ie, trading at consolidated
NPAT of 11x FY12E and 10x FY13E vs 13x FY12E NPAT and 12x FY13E NPAT for Indian
regulated utilities. CESC is trading at 0.7x FY12E Price/Consolidated Book Value vs 1.5x
P/BV for regulated utilities and 1.7x P/BV for the broader utility space.
Valuation: Rs384/share
Sum-of-the parts (SOTP): Rs384/share
We use an SOTP valuation for CESC. In summary, cashflows from the utility assets create
more value than the consolidated group, and Spencer’s, the retail business, creates negative
value. We probability weight the generation growth, as <10% of the project capex has been
invested to-date, while both rely on coal linkages with Coal India (high-risk).
Kolkata utility: Rs411/share (P/BV, DCF)
We have valued the existing regulated utility on Price/Book and separately value growth and
incentives on P/BV and DCF. Our primary assumptions are:
Regulated return on equity: 14% for generation assets and 15% for T+D assets, as per
the WBERC regulatory decision for FY08-10.
Cost of equity: 12% for generation assets (beta: 0.8, Rf: 8%, MRP: 5%) and 11% for T+D
assets (beta: 0.6, Rf: 8%, MRP: 5%).
Regulated equity base in FY12 of: Rs11.4bn (US$250m) for generation and Rs12.9bn
for T+D network (US$283).
Growth capex: We assume Rs5bn capex per annum according to company guidance
(realistic compared to historical capex), with 30% being added to the regulatory base. No
further growth in generation (separately modelled via its Haldia plant) forecast.
Incentives: We maintain a 1% spread between actual ATC losses (13%) and the
regulated target (14.25%) and a long-term Plant Load Factor of 90% (below recent
averages) for PLF outperformance.
Retail: -Rs52/share based on FY16 EBITDA breakeven
Retail is a loss-making business. Management currently expects the business to break even
at an EBITDA level by the end of FY14, and it is implementing strategies to reduce losses;
the lower losses have improved earnings over the last 18 months. We have taken a more
conservative view and believe that the retail business will only become EBITDA positive in
FY16.
Key assumptions we have applied to model the retail business earnings:
Store growth: From 0.9m sqft to 2.5m sqft by the end of FY14 at a cost of Rs1,300/sqft
Same store sales growth: +14% in FY12, +10% in FY13, +2% real growth afterwards
Gross margin: From 18% to 21% in FY14
Costs: Store opex growth of +3.5% per annum, corporate opex up by CPI, advertising at
2% of sales, distribution costs at 5% of sales.
Current share price assumes a bear case scenario
We have run a scenario analysis on the retail business, observing valuation impacts from
management guidance for a turnaround in profitability coming to fruition and from the worst
case – ie, no change to margins and ongoing losses. On these assumptions, the current
stock price appears to be pricing-in the worst case scenario (-5% to share price) and material
upside (+70%) if management is able to execute its strategy.
Worst case scenario: corporate level losses continue
The retail business is currently breaking even at a store level; however, corporate overhead is
still creating losses for the business. If we capitalise these losses, as per below, assuming
that they are ongoing, it would take Rs157/share from our valuation. This is also in line with
the business operating for another five years with growing losses and then being closed
down. This would be a complete failure of the retail business, and it appears that this is being
priced-in at current levels. This appears to be overly bearish, in our view, when we see
evidence of management improving earnings margins.
Fig 10 Ongoing losses for 10 years – an unlikely scenario
Current Corporate Costs 1,967
EV/EBITDA Multiple 8x
Enterprise Value -15,733
Net Debt 3,936
Equity Value -19,669
Shares 125
per share -157
Note: We have cross-checked the use of an 8x EV/EBITDA with NPV of corporate losses. An 8x multiple
equates to ~10 consecutive years of corporate level losses, growing with rising revenues.
Source: Macquarie Research, March 2011
Management guidance: FY14 breakeven, FY16 6-7% EBITDA margin
CESC’s management estimates that retail will reach breakeven at a corporate level by the
end of FY14 and will start realising EBITDA margins of 6-7% at maturity. This differs from our
current forecast, likely due to management’s more bullish store-on-store sales growth
projections. However, if we assume that guidance comes to fruition, then we estimate there
could be around 70% upside to our current share price target. We reach that forecast by
estimating a 1yr fwd EV/EBITDA multiple valuation of 8x in FY15, then discounting back to
current prices at 13%.
Fig 11 Turnaround scenario: Rs57/share
Turnaround Scenario
FY16 Revenue 45,124
FY16 EBITDA Margin 6.5%
FY16 EBITDA 2,933
EV/EBITDA Multiple 8x*
FY16 EV 23,464
Discounted at 13% WACC 12,656
less: losses to FY14 -1,636
less: Net Debt -3,936
Equity Value 7,084
Shares 125
per share 57
*EV/EBITDA multiple in line with Pantaloons, while EBITDA target margin in line with management guidance
and at a slight discount to the current EBITDA margins of peers (due to a greater focus on food than apparel)
Source: Macquarie Research, March 2011
Closing down business could be value accretive at current prices
Indeed, based on our back-of-the-envelope valuation, closing down the retail business would
yield a stronger valuation than the shares are currently trading at. We understand from
management, however, that this is an unlikely outcome and, therefore, we haven’t considered
it in our base-case valuation.
Fig 12 Closing down valuation –Rs79/share
12 month of fixed costs -4,911
Inventory sales @ 50% book value 610
Receivable @ 50% book value 93
Payables -1,711
Net Debt -3,936
Total -9,855
Shares on Issue 125
Valuation -79
Source: Macquarie Research, March 2011
Haldia and Chandrapur: Rs14/share (DCF – 50% probability)
We have valued both power projects using a DCF methodology on geared cashflows, with a
13.5% cost of equity, while assuming that CESC will sell 20% of its generation assets at book
value. This helps from an equity requirement perspective, not a value perspective.
Around two-thirds of the capacity of Chandrapur is expected to be sold into the merchant
market, while a quarter of Haldia’s capacity is expected to be merchant. Our merchant power
price forecasts are shown below.
Not pricing-in any upside from retail
While the RPG Group has owned Spencer’s for the past 13-14 years, it wasn’t until 2007 that
the company was moved into CESC. It has consumed capital ever since and has weighed
negatively on investor sentiment. However, at current prices, it appears that the market is
pricing-in the possibility that current losses for Spencer’s will continue for the next ten years,
while the business has proven to be an operational turnaround over the past 18 months. We
therefore think that, with a solid utility business providing cash support, a turnaround in retail
could add material value from current levels.
Evidence of a turnaround, with store EBITDA breaking even
Over the past 18 months, we have seen tangible evidence that CESC’s management has
improved margins, as shown below, with store level EBITDA (not including corporate
overhead, distribution, advertising) breaking even. This turnaround has been driven by cost
reductions, while gross margins have stayed at ~18%. Spencer’s has closed ~50 stores over
the past two years (currently 206 stores), while the number of distribution warehouses has
decreased from 21 to nine over the past year. Much of the low hanging fruit for cost reduction
has now been achieved.
Strategy is now about top-line growth and margin expansion
One of the key challenges for Spencer’s and its peers, in our view, is its large corporate cost
base. Management’s strategy to tackle this is clear: grow the absolute gross margin to dilute
the impact of the corporate costs and drive the business into positive EBITDA margins, which
it aims to do over the next 36 months, with the goal of achieving maintainable EBITDA
margins of 6-7%. Senior management of Spencer’s that we met in Kolkata noted that the
current corporate cost base could support a business with 3x the turnover. Therefore, the
value drivers would be three-fold:
1. Increase floor space from 0.9m sqft to 2.5m sqft by FY14 by adding larger-format
retail space. Currently, ~50% of floorspace is larger format hyperstores (>15k sqft), which
we expect to move up to ~85% of total floorspace. Spencer’s aims to be the leading food
retailer in India, with 75% of current turnover being food. The larger format store is
expected to increase the product range in food and in higher-margin offerings (see #3).
Senior management also noted that the larger format stores have lower opex of
~Rs100/sqft vs smaller format stores of Rs122/sqft, a positive for margins.
2. Same store sales growth of 14-15% in FY11/12: We visited Spencer’s largest
hypermarket (47k sqft) in South City Mall, Kolkata, and met with its operations manager
who noted that the store achieved 35% sales growth in 2010. Walking around the store, it
was clear that Spencer’s is still in a learning phase in regard to maximising floorspace
efficiency. For example, the manager noted that the apparel floorspace had been reduced
from 9k sqft to 6k sqft, with no change in sales.
3. Improving gross margin from 18% to 20% in FY12 and to 22% in FY14, in line with
some of Spencer’s competitors, such as Big Bazaar and Hypercity. Spencer’s senior
management that we met in Kolkata noted that improving margins in its food business is
core to Spencer’s strategy of improving profitability. Several ways to get there are:
⇒ Higher-margin offerings, such as a Gourmet food section (shown below), which
takes up 5-6% of store floorspace and yields a higher margin of ~24-25%. Other
additional offerings include bakeries/bottle shops in store. Fresh meat and fish are also
expected to improve current margins.
Regulatory earnings create the cash cow
CESC’s Kolkata-based utility is a strong cash generating business with annuity style
cashflows. With 1,225MW of regulated generation and a 16,500km T+D network, earnings
are typically driven by volume, capex and regulatory outcomes. CESC has been awarded the
power supply licence to 2020 in West Bengal.
Vertically integrated: long distribution, short-fuel
Similar to Tata Power, CESC has a reasonably strong integrated position. We expect it to
remain long-distribution until its power generation growth pipeline starts to kick in FY15 (we
estimate a 12-month delay vs the company’s target). Despite being short-fuel, its own mine
covers 50% of its generation requirement, which is high compared to that of its peers.
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