BHEL: Alstom-Shanghai JV: Top-end technology with low-cost manufacturing :: Kotak Securities

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Bharat Heavy Electricals (BHEL)
Industrials
Alstom-Shanghai JV: Top-end technology with low-cost manufacturing. Alstom
and Shanghai Electric have formed a 50:50 JV combining the boiler manufacturing.
business of two entities, combining the top-end technology of Alstom with the large
and low-cost manufacturing base of SEC. This JV would improve credibility of SEC, a
negative for BHEL which already faces intense Chinese competition. We retain our
REDUCE rating on concerns regarding coal availability, this may affect orders and
execution in the midst of increasing competitive intensity
Alstom-Shanghai Boilers Co.: Global pooling of boiler capacities; EPC, service kept separate
Alstom and Shanghai Electric (SEC) have signed an LoI to form a 50:50 JV, combining the global
manufacturing capacities of Alstom and Shanghai Electric. The EPC and services business of the
two entities will remain outside the JV. The JV would sell boilers as an independent supplier.
Alstom gets a play in China + low-cost supply; SEC gets credibility + global market + technology
The JV would combine Alstom’s technology capabilities with SEC’s low-cost manufacturing base.
The JV would provide Alstom a play in the Chinese market and a source of low-cost boiler supply.
SEC with this JV would get access to international market (its current agreements may have limited
participation in intl. tenders), key-technology license and improve credibility of its products.
Credible Chinese supply is –ve; India is big catch for JV; may impact BHEL-Alstom tie up as well
The JV may have following consequences: (1) Provide credibility to SEC’s boilers; catalyzing
more customers to evaluate that option positively. While SEC is already present but with lots of
questions on reliability etc. (2) JV would scale up presence of SEC and Alstom here as India is
a big catch; India is potentially larger than all other markets combined (leaving China apart). The
JV would potentially help scale-up the existing presence of SEC and Alstom in India as competitors
to BHEL. JV would have a manufacturing base in Durgapur which can be scaled up to do
supercritical manufacturing. (3) Technological support for BHEL may wane over time, though
BHEL may have indigenized to a large extent by then. Alstom has a technology tie up with BHEL
for boilers and Alstom would address adjustments, if required, in due course of time.
Retain REDUCE of sedate inflows and deteriorating competitive and coal position
We revise our estimates to Rs134 and Rs150 from Rs140 and Rs156 for FY2012E and FY2013E
and target price to Rs2,275 (from Rs2,400) based o\n 15XFY2013E (17X FY2012E earlier)
earnings. We reiterate our REDUCE rating on accounts of concerns regarding coal availability
(linkages and captive block based orders) affecting execution and order inflows sharply over the
next two years in addition to increasing competitive intensity from domestic and Chinese players.


Alstom-Shanghai Boilers Co.: Global pooling of boiler capacities; EPC, service
kept separate
Alstom and Shanghai Electric (SEC) have recently signed an LoI to form a 50:50 joint venture
company, Alstom-Shanghai Boilers Co. The deal encompasses the combining of the global
manufacturing capacities of Alstom and Shanghai Electric into the joint venture. This
company would primarily be involved in the manufacturing and supply of boilers for coalfired
power plants. The EPC business of the two entities will remain outside the joint venture;
Alstom and Shanghai Electric will continue to compete for EPC and service contracts globally,
the boiler for which would be sourced from the JV - the JV to sell boilers to the companies
as independent supplier. Other key terms of details of the deal include:
􀁠 Both companies would have an equal representation on the board of the JV
􀁠 The board would have a rotating chairman – with the shift every two years
􀁠 Management would be appointed by the board
􀁠 The JV will be registered in Shanghai and will have its headquarters in Singapore
􀁠 Boiler technology would be the property of the JV


Creation of the Rs160 bn strong boiler business
Alstom’s power sales for new equipment represent about Euro10 bn. Roughly on-third of
this business (Euro3.5 bn) is from coal. Taking out the turnkey, turbine/generator and
auxiliary equipment sales, Alstom’s boiler sales amount to about Euro1.3 bn. This combined
with Shanghai Electric boiler business results in JV having consolidated sales of Euro2.5 bn
(Rs161 bn; FY2010 numbers).


Matching Alstom’s technology with SEC’s manufacturing capability
The Alstom management believes that the joint venture would be an ideal combination of
Alstom’s technology capabilities and Shanghai Electric’s large and low-cost manufacturing
base. The JV would also aid Alstom to penetrate into the Chinese market where it has been
relatively weak so far - Alstom’s Wuhan unit is #4 player in the Chinese market.
For Shanghai Electric, the company would get access to Alstom’s technology, but more
importantly would improve credibility of its products in the market. We highlight that
presently 18% of Shanghai Electric’s total sales comes from overseas business. This segment
could potentially increase if customers perceive Shanghai Electric product to be reliable.
Coal to lead capacity addition; India-China combined have majority share of global
demand
Alstom management believes coal is likely to continue to be the most used fuel over the
next five years.
Furthermore, Asia (specifically India and China) are very important markets (and likely to
remain so) for coal based power equipment. According to Alstom, their combined share in
the coal based power plant orders would exceed the combined share of the rest of the
world over the next five years


Key benefits for Alstom
􀁠 Access to low-cost manufacturing base of Shanghai Electric leading to very competitive
boiler supply to support its turnkey and service businesses
􀁠 Potential access into the large Chinese and Indian markets where it has been a relatively
small player so far
Key benefits for Shanghai Electric:
􀁠 Access to top-class technologies of Alstom; would help improve credibility of equipments
􀁠 Increased penetration into other global markets for direct boiler sales



JV provides credibility to Shanghai Electric’s boilers; negative for BHEL
Although Chinese manufacturers have a strong presence in the Indian power equipment
supply market, there was some uncertainty regarding reliability and quality of these
equipments. The JV with Alstom would provide credibility to Shanghai Electric’s boilers. We
believe that this would be a negative development for BHEL which already faces tough
Chinese competition.
Earlier, with and aim to reduce Chinese competition, BHEL had objected against bids from
Chinese players with technological sourcing from Alstom (Alstom-BHEL alliance) as it had
entered into a technological tie-up with Alstom. BHEL also raised questions regarding
reliability concerns on Chinese equipments. The credibility of Alstom name to the Shanghai
Electric product is likely to lay rest to most of these concerns. This development would make
competition for BHEL more intense.
Shanghai Electric already has a strong presence in India
We highlight that Chinese companies including Shanghai Electric, Dongfang and Harbin
have been keen competing and winning power based orders in India over the past five years.
Shanghai Electric has been particularly active in the thermal (Reliance Power) and wind space
(KSK Energy). The company recently entered into a supply contract with Reliance Power Ltd
of India to provide 36 sets of 660 MW supercritical thermal power units with a contract
amount of US$8.29 bn, the largest import contract ever signed in the history of India


Alstom-Shanghai Electric JV to bid for Indian projects; technological agreement with
BHEL to continue
Alstom cited that Shanghai Electric is already selling in India and future bidding may happen
through the JV (particularly for pure boiler supply). The company has a number of
technology agreements with BHEL (including supercritical equipment) and these agreements
shall continue. Alstom would address adjustments, if required, in due course of time.
Coal availability issues may affect incremental order inflows and execution of
current book
We believe that current issues on coal availability may affect order inflows as developers take
a cautious view on developing incremental power projects. This is accentuated by lower
merchant power rates and large amounts of capacity already under construction.
Pending coal linkage and dependence on captive blocks weakens order book
To determine the strength of BHEL’s order book, we tracked its power orders for the past
two years (execution base). We categorized the coal based power orders into (1) captive
orders (including tapering linkage orders), (2) orders having coal linkage and (3) orders with
pending coal linkage. Of the total domestic coal based power awards of Rs840 bn, about
Rs353 bn (42%) worth orders await coal linkage from Ministry of Coal. A similar scenario
exists of the MW share of orders with pending coal linkage (38% or 12.5GW).


Revise estimates and target price to Rs2,275/share; reiterate REDUCE
We revise our earnings estimates to Rs134 and Rs150 from Rs140 and Rs156 for FY2012E
and FY2013E based on lower industrial segment order booking in FY2011E and potentially
slower execution of the current order backlog on back of issues of coal availability. We have
correspondingly revised our target price to Rs2,275/share (from Rs2,400) based on 15X
FY2013E earnings versus 17X FY2012E earlier.


We retain our REDUCE rating on the stock based on likely headwinds in maintaining order
inflow and execution traction as (1) domestic competition scales up even as Chinese stay
strong contenders, (2) likely increase in competitive intensity from Alstom-SEC JV, (3) XIIth
plan ordering and private sector utility gold rush abates and (4) other segments potentially
unable to scale up, (5) execution traction is likely to be weaker than market expectations as
some of the orders won in the last two years are from weaker players and do not have
requisite coal linkages etc. Lower inflows traction may reduce visibility and revenue growth
post FY2013E. Aggressive price competition in boiler bulk tender may be a near-term
negative catalyst. Order inflows have primarily come from relatively smaller utilities (Adhunik,
DB Power, Visa power etc.), potentially exposing BHEL to higher execution risks.