J.P. Morgan - Bharat Heavy Electricals (BHEL)

Bharat Heavy Electricals (BHEL) (BHEL IN) Audited Mar-q results better than provisional, working capital fairly stable		Underweight Price: Rs243.30 29 May 2014 Price Target: Rs151.00 PT End Date: 31 Mar 2015

BHEL reported Mar-q net sales of Rs148bn (-22% YoY), EBITDA margin of 18.2% (-604bps YoY) and PAT of Rs18.45bn, down 43% YoY. Although audited sales was in-line with provisional FY14 numbers reported in April, audited Mar-q PAT of Rs18.45bn was 14% higher; reported FY14 EPS was Rs14.2 vs. Rs13.2 implied by flash results. Audited Mar-q PBT of Rs27bn was 26% higher than the flash number; the extent of deviation is significantly higher than past levels. It is notable that other income in FY14 of Rs16.2bn was up 44% YoY and included Rs6.42bn FX gain (vs. Rs1.4bn FX gain in FY13. Past disclosure on FY14 order inflows of Rs280bn (-11.2% YoY) and order backlog of Rs1015bn (-11.8% YoY) remain unchanged.

· Mar-q EBITDA margin down 604bps YoY. Reported EBITDA margin of 18.2% was significantly better than 14.6% that we back calculated from provisional numbers. Staff cost in Mar-q was down 8.2% YoY, for the year staff cost was up 3% YoY. Overall BHEL’s net employee count of 47525 as of Mar-14 is down by 874 over Mar-13. In 4Q gross margins reduced from 44.7% to 42.3% and for the year from 43.5 to 42.4%. In FY14 other expenses of Rs61.4bn included Rs22.6bn of contractual provisions, up 44% YoY. Overall during the year EBITDA margin declined from 19.4% in FY13 to 11.6%. Our FY15E imply 7% sales decline (vs. 20% decline in FY14) and EBITDA margin of 11.9% (+30bps YoY).
· Working capital fairly stable, after three years of steep deterioration. Working capital (calculated as current trade receivables + inventories + other current assets – trade payables – other current liabilities) in FY14 was Rs180bn vs. Rs177bn in FY13 (171 days in FY14 vs. 168days in FY13). Inventory and receivables were down YoY in absolute terms though payables/advances position was tighter owing to higher support to contractors/decline in order inflows. ST and LT debt put together was higher by Rs14bn. However stable working capital translated into operating cash flow generation of ~Rs27.5bn (similar to FY13), even though EBITDA fell 52% in the year. BHEL ended FY14 with an all-time high cash level of Rs118.7bn (vs. Rs77.3bn as of FY13). BHEL’s FY14 dividend of Rs2.83/share implies 20% payout ratio (same as FY13) and a dividend yield of 1.2%.

· Summarized conference call takeaways. BHEL is confident that 16GW pipeline of state and central government projects are likely to get awarded in FY15 (vs. 6.2GW in FY14). The company wants to pursue EPC turnkey orders in a bid to grow order inflow volume. In our assessment civil construction component of such orders would have significantly lower gross margins then on products, however incremental revenue may help absorb staff/other SG&A costs better, especially when BHEL’s 20GW capacity is not fully utilized. Management is hopeful that opportunities in solar PV and uptick in railway modernization shall help BHEL shore up industry segment orders in the medium term. However they expect coal to remain the mainstay (~60%) of power capacity addition over next 2 decades. As per management, the provisioning for wage revision under 7^th pay commission shall begin on 1^st Jan 2017- higher salary costs can erode long term profitability of BHEL unless order inflow growth trajectory surprises positively.

Table 1: BHEL: P&L summary

Rs. in bn, year-end March

	4QFY13	3QFY14	4QFY14	4QFY14E	FY14	FY14E	FY15E	FY16E	FY17E
Order inflows (Rs bn)	208	72	163	163	280	280	351	404	475
Order backlog (Rs bn)	1,152	1,006	1,015	1,015	1,015	1,015	1,003	1,025	1,100
Quarterly revenue (Rs bn)	189	84	147	147	383	383	356	362	380
Revenue of 4-trailing quarters (Rs bn)	476	424	383	531	383	383	356	362	380
Book/Bill (x)	2.42	2.37	2.65	1.91	2.65	2.65	2.81	2.83	2.89
Revenue growth (% YoY)	(2.1)	(16.1)	(21.9)	(21.9)	(19.6)	(19.6)	(7.0)	1.7	4.9
Order book growth (% YoY)	(14.9)	(11.5)	(11.8)	(11.8)	(11.8)	(11.8)	(1.2)	2.2	7.3
Book/Bill growth/ (decline) (% YoY)	(15.6)	(5.9)	11.9	(19.2)	9.6	9.6	6.2	0.5	2.3
Net sales	188,502	84,238	147,549	147,286	383,888	383,073	356,342	362,346	380,041
Other operating income	3,542	1,725	2,766	3,475	7,200	7,908	8,304	8,719	9,155
Total Net income	192,044	85,963	150,315	150,761	391,088	390,982	364,646	371,065	389,196
(Decrease)/Increase in Stocks	9,666	(595)	11,922	1,348	10,574	0	0	0	0
Raw Materials	96,624	49,396	74,806	86,179	214,614	225,987	213,318	217,073	227,680
Staff costs	14,391	15,256	13,204	15,617	59,338	60,300	61,506	62,630	70,488
Other Expenses	24,850	11,883	23,049	25,644	61,364	62,779	46,602	48,757	51,189
Total expenditure	145,532	75,940	122,981	128,788	345,890	349,067	321,426	328,460	349,356
EBITDA	46,512	10,024	27,334	21,973	45,198	41,915	43,220	42,604	39,840
As % of total net income
(Decrease)/Increase in Stocks	5.0	(0.7)	7.9	0.9	2.7	0.0	0.0	0.0	0.0
Raw Materials	50.3	57.5	49.8	57.2	54.9	57.8	58.5	58.5	58.5
Staff costs	7.5	17.7	8.8	10.4	15.2	15.4	16.9	16.9	18.1
Other Expenses	12.9	13.8	15.3	17.0	15.7	16.1	12.8	13.1	13.2
Total expenditure	75.8	88.3	81.8	85.4	88.4	89.3	88.1	88.5	89.8
EBITDA margin (%)	24.2	11.7	18.2	14.6	11.6	10.7	11.9	11.5	10.2
bps change		(432.9)	(603.5)	(964.5)
	44.7

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Investment Thesis

BHEL is a power plant equipment manufacturer with a capacity by end of FY13 to supply 20GW per annum. It caters to an over-served domestic market facing severe price competition. Amid declining demand supply deficit for electricity, fuel constraints, weak SEB health and high IPP leverage levels, developer appetite for Greenfield projects is unlikely to improve in near term. Order backlog is down 38% from peak levels. Earnings decline shall persist in FY15.

Valuation

Our Mar-15 PT of Rs151 is based on DCF (using a WACC of 13.2%, terminal growth rate of 3%, and terminal year of FY24) vs. Rs130. Our PT implies ~12x FY15E/16E earnings.

Risks to Rating and Price Target

Upside risks include higher-than-expected order inflows due to accelerated award of fresh coal blocks to the private sector, award of new UMPP equipment to BHEL, ability to cushion margin fall by reigning in employee costs, and larger-than-expected order inflow surprise from nuclear/defense/railways.