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Bharat Heavy Electricals Ltd (BHEL.BO: Downgrade to Neutral from Buy)
Weakness in new orders from power industry to limit upside despite healthy order book coverage
We downgrade Bharat Heavy Electricals (BHEL) from Buy to Neutral on the back of order weakness in its core
power segment and relative outperformance of its peers since our upgrade in early May.
Since we added BHEL to our Buy list on May 3, 2011, the stock has fallen 12.3% vs. a 10% decline in the
Sensex and a 20% drop in our sector coverage. Over the past 12-months BHEL has declined 28% vs. the
Sensex which is down 8%. We mainly attribute the stock’s outperformance to its continued execution
delivery, a large order book that provides revenue visibility, and reasonable valuations.
Although the company has a strong order book with greater than 3X coverage, the momentum of inflows for
the company has remained weak over the past few years – limiting the company’s medium-term growth
prospects.
Weak macroeconomic conditions and a lack of new orders, as observed in the power generation industry,
limit the upside to BHEL’s numbers, in our view.
Increasing competition has resulted in margin pressure for BHEL, which remains a concern as more
production capacity comes on stream and order inflow is weak for newer supercritical equipment orders.
Meanwhile other power equipment companies in our coverage universe (L&T, Thermax, and BGR) have also
corrected and underperformed BHEL recently (by 11% since we upgraded the stock to Buy) – we believe the
opportunity for such relative outperformance is now limited.
We lower our FY12-FY14 EPS estimates by 0%-4% given that we now factor in slightly higher raw material
prices.
Valuation
BHEL currently trades at a 12-month forward P/E of 12.5X FY12E P/E and 3.3X FY12E P/B (vs. a 5-year mean
12-month forward P/E and P/B of 22.1X and 5.7X, respectively), at 5-year trough valuations. This discount to
historical valuations adequately prices in the risks from increasing competition, in our view.
We lower our 12-month target price on BHEL to Rs2,081 (from Rs2,365), based on a P/E multiple of 15X the
average of our new FY12-FY13 EPS estimates. Our P/E target multiple (down from 17.5X earlier) is at a 20%
discount to its historical median, which is in line with the 20% return compression we estimate over FY12-
FY14.
Key risks
Upside: (1) Uptick in award activity in the power space, and (2) any potential entry restriction to foreign
competition.
Downside: (1) Substantially increased priced-based competition from peers, and (2) volatile commodity
prices, especially steel.
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