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Just an eclipse ... brighter days ahead
Expect gradual recovery from 2012; prefer CPSUs
The euphoria in the Indian power sector (2007-09) has now led to selfcorrection
(2010-11). Investment plans are facing multiple execution
challenges, affecting project economics and cash flows.
We believe the next five years, beginning 2012, will be a redefining period
for the sector. Over time, we believe the sector will regain its lost reputation
of steady long-term growth with reasonable returns.
CPSUs are our preferred sectoral theme, given acceleration in their earnings
growth and valuations at historic lows. We are Neutral on private IPPs.
Lanco Infratech, CESC and PTC India are our top mid-cap picks.
Euphoria (2007-09): Fresh wave of private investments
The Electricity Act 2003 brought revolutionary changes to the power sector, including
de-licensing of generation, opening of short-term power markets, enabling open access
and power procurement through competitive bidding. During 2007 and 2008, base
deficits were at historic highs of 12% due to strong demand growth coupled with
delays in capacity additions. Then, in 2009, the General Elections led to further buoyancy
in demand for power. As a result, short-term prices hit new highs, and merchant power
projects were expected to generate super-normal returns. Thus, 2007-09 was a period
of euphoria; perceived robust business dynamics and supportive equity markets
combined to fuel a fresh wave of private investment in the sector:
(1) Jindal Power commissioned a 1GW plant, the first merchant IPP project;
(2) Reliance Power floated an initial public offer, the first large IPO from a private IPP;
(3) Coal mines were allocated to private IPPs (peak production capacity of 350mt).
Self-correction (2010-11): Project economics hit; survival of the fittest
Euphoric investment plans are now facing ground realities. Several challenges have
significantly affected project economics: (i) deterioration in SEB finances have lowered
power demand, (ii) low demand coupled with accelerated capacity addition has hit
merchant profitability, (iii) physical constraints are slowing project execution (land
acquisition, regulatory clearances, fuel availability, etc) and (iv) raising funds has become
critical due to tight bank finance and lack of investor appetite. Such factors have
pushed the sector to "self correction". Capacity addition plans have slowed and the
focus is on execution. We believe only the fittest will survive, and there will be several
M&A opportunities.
Redefining period (2012 onwards): Gradual but fundamental changes
will lead recovery
We believe the next five years beginning 2012 will be a redefining period for the sector.
Although constraints and challenges exist, many have been magnified; and gradual
but fundamental changes are being ignored:
1. Capacity addition pace is accelerating: We expect capacity addition of over
100GW over FY12-16, an annual run rate of ~25GW, a meaningful acceleration
2. Fuel scarcity impacts project economics, but generation growth to accelerate:
Given 100GW capacity addition, by FY15-16, we see a 60% increase in power generation
despite fuel availability constraints. This is possible as coast-based projects, run on
imported and captive coal, contribute 41% to incremental generation. Our estimates
factor in blending at just 12% in FY15.
3. SEB losses - alarming, but worst seems to be over: A key concern is the financial
health of SEBs. However, almost all the cash losses of Rs206b incurred in FY09 were
driven by a ~Rs198b YoY increase in the short-term market size. This sudden spurt
came as a shock, and the system would take time to transition to the new reality.
Between then and FY11, the market size stagnated despite a 60% volume increase.
We believe the worst is over in FY11, and going forward, SEB finances will gradually
improve due to (1) increased power availability from long-term contracts, (2) tariff hikes
and (3) lower T&D losses.
4. Short-term power prices to correct, but still remain viable: We expect a ~3x
increase in short-term power volumes by FY13. We further believe merchant power
may not remain a viable option for base load demand, given transmission constraints.
Thus, we expect merchant prices to correct to Rs3.5/unit in FY13 (v/s Rs4.1/unit in
FY11). Still, they will continue to be at levels that allow break-even for projects even in
the highest cost quartile (i.e. imported coal based, ~500km from the coast).
A V-shaped recovery looks unlikely, but over time, we believe the sector will regain its lost
reputation of steady long-term growth with reasonable returns.
Investment strategy: Prefer CPSUs; neutral on private IPPs; Lanco, CESC,
PTC India top mid-cap picks
The BSE Power Sector Index corrected 18% over the past 18 months (relative
underperformance of 26%) given headwinds impacting project economics. The current phase
of self-correction is marked by significant challenges of execution; which we believe will
lead to M&As, especially of new IPPs.
Given this backdrop, we recommend an investment strategy which focuses on the
"essentials", namely, (1) upfront capacity addition, (2) relatively secure fuel supply,
(3) dynamic PPA structure (with cost escalation) and low dependence on the merchant
market, and (4) strong balance sheet/cash flow and earnings visibility.
CPSUs are our preferred sectoral theme, given acceleration in their earnings growth
and valuations at historic lows. NTPC, Powergrid and Coal India are our top picks.
We are Neutral on private IPPs. After their recent underperformance, further meaningful
downsides may well be limited. However, re-rating is contingent on improvement in
operational and financial parameters.
Among mid-caps, we prefer Lanco Infratech, CESC and PTC India given improvement
in their business fundamentals and valuation comfort.
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