Reforms are likely to be undertaken in FY13f to revive the Indian
power sector. If left unchecked, annual losses of all state‐level
distributing companies are likely to reach 1.2% of the GDP. Likely tariff
hikes by DISCOMs need to be supplemented by measures that would
ensure a steady coal supply to the new thermal generating capacity of
c7GW at a stable and reasonable price. The benefits of such reforms
and expected firming up of merchant tariffs are likely to improve
earnings from FY14. Even with the well‐known stress, the consensus
forecasts for the power companies’ FY13 and FY14 earnings growth
exceed that of the Nifty. This is likely to preserve the premium in the
P/E over the Nifty. We initiate coverage with Buy ratings on NTPC and
ADANI, an Add rating on TPWR and a Hold rating on JSW.
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Compelling case for next phase of reforms in FY13
If there are no reforms, DISCOM losses, as a percentage of the nominal GDP,
are likely to reach 1.2% by Mar14f, as was witnessed earlier between FY99 and
FY02. As of Dec11, cINR1,627bn, i.e., 32% of the banks, POWF and RECL’s
exposure to the power sector faces risk. As crisis reaches a tipping point, the
next set of reforms may be initiated; this is visible with the Shunglu
committee’s report submission, and the presidential directive to Coal India
(COAL IN, Add) to sign FSAs.
Tariff is likely to grow double digits, but breakeven may need more
DISCOMs of key states need to raise tariffs at a CAGR of 13%–58% in FY13f–
FY14f to bridge the net gap. DISCOMs may be able to raise the ARR per unit by
a CAGR of 11% in the next three years. While this may reduce losses to 0.8% of
the nominal GDP in FY14f from 1.0% in FY12f, the breakeven may need more.
Hurdles to captive mining lifting slowly; benefits after two years
Progress on mining at allocated captive coal blocks was slow due to the ‘go, nogo’
policy of the Ministry of Environment. The last six months reveal some signs
of the policy’s removal, but coal extraction may only begin after two years.
Capacity of 45GW was approved in 2006–10 with fuel supplies from these coal
blocks, and c7GW may be completed in FY13 and FY14.
Outlook likely to improve for earnings from FY14f
FY14f earnings of private utilities with large pipelines may improve due to the
likely increase of lower‐cost domestic coal supply and rise in merchant tariffs
for a small period due to the elections scheduled in 1H2014. Companies such as
NTPC and TPWR are relatively protected as a large part of their revenues are
shielded from cost increases. The structural improvement in profitability arising
from anticipated reforms may be visible after FY14f.
Higher earnings growth may preserve premium over Nifty
Consensus forecasts for the power companies’ FY13f and FY14f earnings
growth exceed those of the Nifty. This is likely to preserve the premium of the
power index over the Nifty. We initiate coverage on NTPC (Buy), ADANI (Buy),
TPWR (Add) and JSW (Hold). Risk factors include a higher‐than‐expected
domestic coal production.
Investment summary
Reforms that are necessary to rejuvenate India’s power sector may finally be undertaken in FY13. If left unchecked,
annual losses of all state‐level distributing companies are likely to reach 1.2% of the gross domestic product (GDP). The
need to defuse a looming crisis that could affect several sectors within the economy may catalyze a series of steps that
can restore the viability of producers and reduce risk to lenders with a low impact on consumers. Tariff hikes need to be
supplemented by measures that would ensure a steady coal supply to the new thermal generating capacity of c7GW at
a stable and reasonable price. Two elements in this effort are the supply from Coal India (COAL IN, Add) and
development of captive mines. The benefits of such reforms and expected firming up of merchant tariffs, are likely to
improve earnings from FY14. Even with the well‐known stress, the consensus forecasts for the power companies’ FY13
and FY14 earnings growth exceed that of the Nifty. This is likely to preserve the premium in the P/E over the Nifty.
Producers such as NTPC (NTPC IN, Buy) and Tata Power (TPWR IN, Add) with a high proportion of revenues at tariff that
provide pass‐through of fuel costs have more stable earnings. We initiate coverage with Buy ratings on NTPC and Adani
Power (ADANI IN), an Add rating on TPWR and Hold rating on JSW Energy (JSW IN).
Compelling case for next phase of reforms in FY13
Crisis in the power sector is reaching a tipping point with distribution companies (DISCOM)’s losses, as
a percentage of the nominal GDP, likely to reach 1.2% by Mar14f, if no reforms are implemented. Such
high‐level losses, as a percentage of the GDP, were earlier witnessed in FY99–FY02, when key reforms
pertaining to the bailout of state electricity boards (SEBs) and formation of the Electricity Act were
initiated. Also, the power sector crisis may impact other sectors such as banks. Of the total loans, 50%
loans to the WIP capacity and 90% to DISCOMs are likely to be at risk. As of Dec11, this amount was
likely to be cINR1,627bn, i.e., 32% of the banks, Power Finance Corporation (POWF IN, Buy) and Rural
Electrification Corporation (RECL IN, Buy)’s exposure to the power sector that faces risk. As the crisis
reaches a tipping point, the next set of reforms may be initiated, including: (1) permitting a passthrough
of imported coal costs; (2) increase in tariffs by DISCOMs; and (3) approvals for already
allocated captive coal blocks. Signs of a likely initiation of the next set of reforms are visible with the
following: (1) submission of the Shunglu committee’s report addressing measures to improve
DISCOM’s financial health; (2) removal of basic customs duty on imported coal; and (3) directing Coal
India (COAL IN, Add) to sign fuel supply agreements (FSAs) for power plants commissioned by 31Dec11.
Tariff is likely to grow double digits, but breakeven may need more
To bridge the widened net gap, DISCOMs of key states need to raise tariffs at a CAGR of 13%–58% in
FY13f–FY14f. However, the average realized rate (ARR) per unit is likely to have risen at a CAGR of
1.9%–7.0% in FY08–FY12f. Considering a maximum three‐year CAGR of c11% in ARR for Uttar Pradesh
over FY09–FY11, we expect DISCOMs to be able to raise their ARR by a CAGR of 11% in the next three
years. While this may help reduce losses to 0.8% of the nominal GDP in FY14f from 1.0% in FY12f, the
breakeven may need more. With a CAGR of 11% in ARR, it may take nine years to achieve PAT
breakeven. The 11% increase in power costs may impact the profits of companies in various sectors
such as manufacturing, textiles, automobiles etc., by c2.5%, as per our analysis of the relevant group of
BSE500 companies. Some steps were taken by non‐state entities to compel DISCOMs to improve
financial health such as preconditions for restructuring loans and a proposal to include DISCOM losses
into state government deficits as well as asking SERCs for a suo moto rise in tariffs.
Hurdles to captive mining lifting slowly; benefits after two years
Thermal capacity of about 45GW was approved in 2006–10 with fuel linkage to undeveloped coal
reserves. Progress on the development of these ‘captive mines’ has been very slow. The biggest hurdle
being the ‘go, no‐go’ policy that held up the Ministry of Environment’s approval. In the last six months,
there have been signs that the policy is likely to be removed. Even with this, coal extraction may only
begin after two years. Of the new capacity linked to ‘captive mines’, we estimate c7GW may be
completed in FY13 and FY14; companies may be compelled to operate by buying coal at market prices.
Some utilities such as NTPC and TPWR are likely to commence mining from ‘captive mines’ in FY15f. As
per our estimates, capacity of c41GW may be supported by coal from such ‘captive mines’.
Changes under way to expand profitability from FY14f
The FY13f earnings of private utilities with large capacity in the pipeline are likely to remain under
pressure due to INR depreciation against the USD as well as high interest rates and imported coal costs.
Larger and older companies such as NTPC and TPWR are relatively protected as a large part of their
revenues from PPAs are shielded from cost rises. However, the FY14f earnings of private utilities with
large pipelines may improve due to the likely growth in lower‐cost domestic coal supply and increase in
merchant tariffs for a small period owing to the elections scheduled in 1H2014. Supply from COAL
would support an additional c10GW by the end of FY14. Another driver of profitability is likely to be the
firming up of merchant tariffs preceding the general elections due in 1H2014. The structural
improvement in profitability arising from anticipated reforms may be visible after FY14f.
Higher earnings growth may preserve premium over Nifty
Consensus forecasts for the power companies’ FY13f and FY14f earnings growth exceed that of the
Nifty. This is likely to preserve the recent premium of the power index over the Nifty. The power
index’s relative underperformance to the Nifty reduced pace in the quarter ending Mar12 compared to
the five consecutive quarters, preceding the last quarter. The power index underperformed Nifty in
Apr12. Earlier underperformance may have been led by the significant drop in the y‐o‐y growth in
consensus PAT forecasts of the power index in FY12. This brought growth forecasts lower than that of
the Nifty. Our analysis indicates that with a change in merchant tariffs and coal availability from COAL,
the RoEs may reflect significant variance from ADANI and JSW’s base case forecasts. However, NTPC
and TPWR’s RoEs are less exposed to headwinds pertaining to coal availability and merchant tariffs due
to a large proportion of installed capacity under tariffs that enable pass‐through of fuel costs. We
initiate coverage on NTPC (Buy, INR208), TPWR (Add, INR118), ADANI (Buy, INR81) and JSW (Hold,
INR46). Risk factors include higher‐than‐expected domestic coal production and project delays.
Initiate coverage on NTPC, TPWR, ADANI, JSW
NTPC
Capacity addition is likely to accelerate to 2.6GW per annum during FY13–FY15, well above the 2.3GW
per annum in the last three years. By FY14f, CWIP, as a proportion of total assets, is likely to fall to 35%.
Over 98% of the revenues would be from assets with regulated tariff that provide full pass‐through of
higher fuel costs; this along with growth in the proportion of operating assets, is likely to expand the
consolidated RoE by 30bp to 14% in FY14f, despite a fall in the EBITDA margin on a rise in consumption
of higher cost coal. NTPC is likely to be the preferred power supplier to DISCOMs due to lower tariffs
compared to peers. Strong operating cash flows in FY13f–FY15f would support capital expenditure. We
value NTPC using the DCF method and initiate coverage with a Buy rating and a Mar13 TP of INR208.
TPWR
TPWR’s RoE is likely to bottom out by FY14f. Losses at the Mundra UMPP are likely to pull down the
consolidated RoE from 12.6% in FY12f to 8.6% in FY14f. However, from FY15f, losses at the Mundra
UMPP are likely to reduce leading to an improvement in the consolidated RoE even if the current PPA
remains unchanged. TPWR’s 30% stake in the Indonesian coal JV implies a positive correlation between
consolidated RoE and global coal prices. We have not assumed any rise in worldwide coal prices. Cash
profits of INR68bn are likely to be generated over FY13f–FY14f to support c4GW of projects under
planning. With likely decline in the RoE over FY12f–FY14f, the discount in the company’s P/B compared
to peers may extend. The stock amply reflects these weaknesses. We initiate coverage with a Mar13 TP
of INR118 and an Add rating. Risk factors include a decline in global coal prices.
ADANI
ADANI is likely to increase its installed power generation capacity by 2x over FY13f–FY14f. With lower
uncertainties on the power off‐take as well as fuel security imparted by coal linkages and parent – ADE,
ADANI’s RoE is likely to expand 17% over FY13f–FY14f. A potential rise in merchant sale realizations
driven by the elections in 1H2014, pickup in open access, and exposure to states such as Maharashtra
and Gujarat, are likely to enhance RoEs. Higher proportion of installed capacity, as of Mar14f, is likely
to be tied up under fixed tariffs. Hence, earnings and RoEs are sensitive to price of fuel sourced from
COAL and ADE. Our DCF‐based method pegs ADANI’s Mar13 TP at INR81. We initiate with a Buy rating.
Risk factors include upward revision in prices of coal sourced from ADE and COAL.
JSW
JSW’s RoE is likely to change significantly with a change in merchant tariffs. While the company’s sales
mix is likely to change in favor of its PPAs with JSWI and DISCOMs, 46% of the installed capacity, as of
FY14, is likely to be sold at merchant tariffs. The proportion of fuel requirement exposed to variations
is likely to reduce from 83% in FY12 to 39% in FY14f. A large proportion of installed capacity under
merchant and spot purchases for most of its fuel requirement leads to lower earnings visibility. This
may cap the upside to valuations. We have used the DCF method that pegs the Mar13 TP for JSW at
INR46. We initiate coverage with a Hold rating.
Risk factors
Upside risks
Significant increase in domestic coal production: We expect domestic coal production to increase at
a CAGR of 5% over FY12f–FY14f. A higher‐than‐expected increase in coal production is likely to
reduce costs for power producers and lead to better RoEs.
Notable rise in tariff by DISCOMs: The approval of tariff hikes by most DISCOMs is likely to improve
their ability to buy high‐cost power. This may raise merchant tariffs, leading to better realizations by
power producers.
Downside risks
Delay in project execution: A delay in project execution is likely to impact the consolidated RoEs,
leading to a dent in valuations.
Significant increase in global coal price: A notable rise in global coal prices may increase royalty
expenses and taxes. This may impact the operating profits of ADANI and JSW.
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