New concerns on medium-term
execution as questions arise on
order book credibility
Action: Execution outlook worsens, while stock seems fairly valued
Recent news flow regarding several private sector power producers being
implicated in the ‘coalgate’ scandal, some of which are BHEL’s existing
customers, has negative implications for BHEL’s execution outlook. We
estimate that ~28% of BHEL’s existing order book is at risk now
(compared to ~19% earlier) and this drives our earnings cuts over the next
few years. Simultaneously, several other private power developers have
allegedly placed fake orders with power equipment companies in order to
boost their chances of securing coal mines in India. Such issues question
the credibility of the >115GW equipment orders placed in the system and
raise the possibility that post clean-up of some of these orders (through
cancellation/forfeiture), new order activity could revive sooner than earlier
expected, albeit likely to be in 2-3 years, in our view. In the medium term,
we believe the outlook remains highly uncertain as the clean-up of existing
orders will bring accompanying pain for the incumbents.
Catalysts: Orders, results and sector concerns
Execution and order inflow/cancellation clarity are key stock catalysts.
Valuation: Cut FY13F-14F earnings estimates 1-8% and TP to INR199
We continue to value BHEL based on a DCF methodology (Ke 13.5% and
terminal growth of 4%). Our TP of INR199/share factors in deteriorating
margins (down to 12-14% levels post FY14 and <8 and="and" fy17="fy17" p="p" post="post"><6gw coal-based="coal-based" given="given" inflow="inflow" medium="medium" order="order" over="over" p.a.="p.a." p="p" term.="term." the="the">potential upside from current levels, we maintain our NEUTRAL rating.
Medium-term concerns on order inflow
and execution to weigh on the stock
‘Coalgate’ raises risk of order cancelation
As per media articles (Cong minister, MP, kin in nationwide CBI coal raids, The
Hindustan Times, dated September 4, 2012), some of BHEL’s private sector customers
have been named by the Central Bureau of Investigation (CBI) in the alleged coal
allocation scam, widely referred to as ‘coalgate’. While the status of coal mines allotted
to them remains uncertain, we highlight potential risk to BHEL’s order book from projects
that were ordered on the back of these mine allocations.
As per our estimates, 28% of BHEL’s existing order backlog (as of June-12) is at risk of
cancellation/deferment due to either non-availability of coal linkage or cancellations of
existing coal mines/linkage due to the coal allocation scam. Of this, we have already
factored in potential risk of cancellation/deferment for ~19% of the June-12 order book.
Hence, the additional orders share at risk due to the coal allocation scam, as per our
estimates is ~9% of the existing order book.
Potential fake orders by several power developers could lead
to a mass clean-up in the next 2-3 years
As per another media article (Firms may have falsified equipment orders to get coal
blocks, Mint, September 7, 2012), several equipment orders placed in the past
(especially to Chinese firms) are potentially fake orders and were placed in order to
favourably boost their chances of securing coal mine allocation. The media article
suggests that some of these orders might be at risk of cancellation, as the promoters’
original intention was never to set up a power project but to secure coal mines.
As per our estimates, over 35% (i.e. ~41GW) of the total power equipment orders placed
for the 12th Five Year Plan period (i.e. ~116GW) have so far been placed to Chinese
companies. A potential risk of cancellation of these orders, in addition to risk from
cancellation/deferment of orders placed with BHEL as highlighted above, means that
there is a serious issue of credibility in the current system-wide order book with all power
equipment makers.
We believe the next 2-3 years could witness a significant clean-up of the system as
several orders could be restructured, cancelled or deferred. While one can argue that
advances would have been paid against potential fake orders too, we highlight that such
advances would have been negligible given the magnitude of gains that these coal
mines would have delivered to the promoters.
Extract from Article from Mint
Firms may have falsified equipment orders to get coal blocks, September 7, 2012
New Delhi: Several companies allotted captive coal blocks for their power projects
claimed to have placed orders for power generation equipment with Chinese
manufacturers to strengthen their candidature — only, these were not really orders.
An engineering, procurement and construction (EPC) contract works like this: the buyer
identifies a supplier and awards it the contract, but this doesn’t become an order till the
former pays an advance and sets a delivery date.
“There were many who claimed that they had placed EPC orders with Chinese
manufacturers such as Dongfang Electric Corp. and Harbin Power Equipment Co. Ltd to
improve their chances. But they never placed any firm orders. That’s a question that
needs to be asked,” said the chief executive officer of a private sector power firm who
spoke on condition of anonymity.
This seems common knowledge in the power business, although Mint couldn’t
immediately identify companies that claimed to have placed orders for power equipment
in a bid to strengthen their case. Mint also couldn’t immediately reach Dongfang Electric
and Harbin Power Equipment for comment.
Between June 2004 and 31 March 2011, the coal ministry allotted 195 coal blocks on a
nomination basis to various firms for captive use. Of these, 114 blocks were awarded to
companies developing power projects.
A Delhi-based power sector expert, who also didn’t want to be identified, confirmed the
modus operandi and said, “The suppliers don’t have a problem to issue such a letter.
The question is whether any money was paid. To be fair, it is extremely difficult to verify
such orders. Things such as equipment or land made a company go up the ladder (in the
coal block allotment process), although nobody knew the process of selection. One
made the case and then it was a lottery.”
A second power sector expert, who, too, spoke on condition of anonymity, confirmed that
this was common practice.
While power utilities placed orders for overseas equipment largely because of the
inability of local manufacturers to meet growing demand, India has already decided to
impose an import duty on power generation equipment in a move that will benefit
domestic firms.
Amol Kotwal, associate director (energy and power systems practice) for South Asia and
the Middle East at Frost and Sullivan, said, “A lot of companies who have got coal blocks
have benefited through this modus operandi. However, it is imperative that the
concerned authorities need to look at the actual progress on the project on ground and
take necessary actions if required.”
The Central Bureau of Investigation (CBI) has registered five cases over alleged
irregularities in allocation to and utilization of coal mines by private companies.
“The cases have been registered in connection with the allegations related to getting
coal blocks allocated on the basis of misrepresentations and false claims in the
applications, presentations and connivance/lack of due diligence on part of public
servants,” CBI said in a release.
Chinese imports are relatively cheaper because equipment makers from that country
benefit from low interest rates and an undervalued currency. Undervaluing the currency
makes exports cheaper and increases demand of products.
Post clean-up of the sector order backlog, order activity could
revive sooner than earlier anticipated, but incumbents will
likely bear the brunt in the interim
While the clean-up act will be painful for the incumbent power equipment makers,
domestic or foreign alike, we see a positive outcome post this clean-up act – in our view,
if a large chunk of the existing 115GW+ system wide order backlog of power equipment
is cleaned up, then new order activity could revive sooner than our earlier expectations
and vendors would get another opportunity to fill up their utilisation levels.
This, however, comes after the clean-up act ensues and in our view, could cause new
orders to come with significantly lower margins than current orders. Furthermore, the
clean-up act itself would lead to trouble for several equipment makers as it could affect
some of their projects where work has already started.
In any case, the positives are at least 2-3 years away, in our view and largely built into
our numbers.
Implementation of import duty, will only be a sentiment
positive, in our view
For several months now, there has been speculation regarding the implementation of an
import duty on imported power. Nevertheless, we believe that the proposed duty is still a
non-issue. Our contention rests on the following three key arguments:
• Chinese competition is already fading on the back of a depreciating Rupee; also, fewer
orders are anticipated from the private sector, while public-sector orders as well as
expected Ultra Mega Power Projects (UMPP) orders have a mandatory domestic
manufacturing clause.
• Surplus domestic manufacturing capacity is already a much bigger threat for BHEL
compared to Chinese competition, and even without Chinese imports, we believe BHEL
will face significant competition in winning new orders.
• As the following media article suggests, the proposed duty would be prospective in
nature and will not affect most of the already-placed orders scheduled to commission
over the 12th Five-Year Plan. The list of power plants with imported equipment is given
below.
Article from The Hindu Business Line
New Delhi, Sept. 10: Seven Ultra Mega Power Projects and 106 mega power projects
will not have to pay higher duty for importing equipment.
The Finance Ministry has notified a new duty structure that prescribes an effective duty
of over 22 per cent, including education cess. However, this new duty will not be
imposed on ultra mega power projects, mega power projects and expansion of existing
mega projects which had received certificate of approval from the Power Ministry till July
19, 2012, the date on which the Cabinet took the decision.
Power Secretary P. Umashankar told Business Line: “There is a list of projects given
mega status or provisionally declared as a mega project. These will not be affected. But
any other project beyond this list will have to pay duty as per Government notification.”
Exempted projects
The list of exempted projects includes 111 mega projects with permanent certificates and
two with provisional ones. The provisional approval holders have been given three
months to convert to permanent status, the official added. All these mega projects are
expected to take care of capacity addition requirements up to the end of 12th Plan.
Earlier, power equipment for projects with capacity over 1,000 MW were exempt from
basic Customs duty while those for projects with capacity of less than 1,000 MW
attracted basic Customs duty of five per cent. This was done at a time when there was
not enough capacity for ultra mega power projects (project with minimum capacity of
4,000 MW). Power producers such as NTPC and Tata Power say the imposition of the
Customs duty will increase the project cost.
Capacity additions
A senior NTPC official told Business Line, “The equipment that we will buy for our future
projects will be more expensive. There would be no change for the moment.’’
At the same time Tata Power said: “The easy import of equipment for power projects has
been a large contributor to the capacity addition in the 11th Plan, with almost 50 per cent
of additional coal-based capacities depending on imported equipment.
Added Customs duties will curb the import of superior technology products that are
already high priced, thus, hindering the advancement of the sector.”
Proposed means of improvement in coal supply could, in fact,
halt near-term order inflows
Complying with the directive from Prime Minister’s Office, Coal India (CIL) has initiated
the process of signing fuel supply agreements (FSAs) with power plants having longterm
power purchase agreements (PPAs) and expected to be commissioned by March
31, 2015. However, we note that the order could increase uncertainties on new order
inflows for BHEL. How will the scenario change?
• Earlier, power developers signed Letters of Assurance (LOAs) with CIL and hoped to
get at least some coal on a priority basis to start the power plant. However, based on
the new development, the projects will be evaluated to confirm whether the LOA will be
converted into FSA. We expect the Central Electricity Authority of India (CEA) to notify
the list of projects shortly. We note that there will be certain projects which will not
feature in this list. We expect these projects to face pressure from lenders on account
of increased fuel uncertainty and may be delayed/cancelled.
• Even though bulk of the XII Five-Year Plan orders are already finalised, projects not in
the notified list and yet to order equipment will have to wait for the results of the coal
block auctions for fuel security. Decision making for equipment orders, thus, could be
delayed further, in our view.
Changes in our estimates
We are cutting our earnings estimates by 1-8% over FY13-14F as we build in execution
concerns emerging from potential disruptions on the back of ‘coalgate’ as highlighted
above. Lower utilisation will have its impact on margins as well and coupled with margin
pressure from competition, our EPS estimates also move down.
Valuation methodology
We continue to value BHEL using a discounted cash flow (DCF) methodology, assuming
a cost of equity of 13.5% and a terminal growth rate of 4% (explicit forecast period until
FY20F). We believe that using 4% terminal growth is justified since rising competition
and demand saturation could put a check on high growth rates. Given ~0.5% potential
upside to our DCF-based TP of INR199, we maintain our NEUTRAL rating on the stock.
We estimate EBITDA margin compression from current levels of 21.3% in FY12 to
13.3% in FY17F. We also see further margin risk post FY17F (and estimate it to turn to
single digits) as orders received until FY13F will be completed by FY17F and lull in new
orders in the medium term will likely weigh on utilisation levels post FY17F.
Investment risks
Upside risks
• Commodity price decline can be a key upside risk as ~50% of the order book is on
fixed price contracts.
• Significant developments in new coal sourcing, whether domestically or through imports
could drive the new power capex, thus benefitting BHEL.
Downside risks
• Worsening of fuel availability for new and/or already ordered projects could lead to
delays in new and existing orders.
• Rising competition could drive pricing even lower than our current estimates, putting
pressure on margins.
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