BHEL- Upgrade to ADD on recent sharp underperformance: Kotak Sec

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Bharat Heavy Electricals (BHEL)
Industrials
Upgrade to ADD on recent sharp underperformance; business call unchanged.
Upgrade our rating on BHEL to ADD based on recent underperformance providing 14%
upside to target price, (2) relatively cheap valuations - trading at a steep discount to
historical levels and peers, (3) likely strong near-term operating performance and
earnings. We maintain our business call: inflow traction may be difficult to sustain with
rising competition affecting earnings growth potential in the medium term.

Sharp underperformance offers opportunity; trading at sharp discount to peers and historical levels
BHEL has recorded a sharp underperformance over the past one-month and three-month periods,
correcting by 13% on an absolute basis and about 10% on a relative basis in the past month. The
current market price provides about 14% upside to our target price. The company is also trading
at steep discount (~ 27%) to its historical levels as well as at a sharp discount to other industrial
peers. We believe the current levels already price in the negatives related to increasing competition
impacting market share and margins, order inflows likely to lag revenue growth and likely higher
working capital requirements, leaving little scope for further underperformance.

Operating performance remains strong minimizing near-term earnings risk
BHEL reported strong 2Q and 1HFY11 results with (1) recording a 21% yoy growth in revenues
and about 216 bps yoy margin expansion, (2) strong 1HFY11-end order backlog of Rs1,540 bn
and inflows of Rs280 bn till October 2010, and (3) capex of Rs5.3 bn so far - on-track for full-year
capex of about Rs15-16 bn. There is limited risk to near-term estimates as revenue is secured by
the large backlog. FY2012E being the last year of XIth plan may further support earnings.
Increasing commodity prices may put pressure on margins (1) operating leverage due to higher
volumes and (2) lower employee costs as a percentage of sales would help sustain margin levels.

Upgrade to ADD on sharp underperformance; retain estimates, target price & business call
We retain our estimates of Rs115.5 and Rs138.6 for FY2011E and FY2012E and our TP of Rs2,500
(18X FY2012E earnings). We upgrade our rating on the stock to ADD (from REDUCE) based on
recent underperformance, relatively cheap valuations and strong near-term earnings potential.

We retain our business call that BHEL may face headwinds in order inflow traction as (1) domestic
competition scales up even as Chinese stay strong contenders, (2) XIIth plan ordering and private
sector utility gold rush abates and (3) other segments potentially unable to scale up. Lower inflows
traction may reduce visibility and revenue growth post FY2013E despite stronger execution.
Aggressive competition in boiler bulk tenders and dependence on relatively smaller utilities for
orders may be negative catalysts. Reverse DCF of target price suggests reasonable +ve assumptions
- increase in execution to 20 GW by FY2021E and sustained long-term EBIT margin of 14%.