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Reliance Energy: Margin impetus!

Jan 18, 2006

Performance summary
Reliance Energy (Research), has announced strong results for the third quarter and nine-month period ended December 2005. Robust growth in revenues for the company EPC division and a dramatic improvement in its profitability, has aided the overall performance of the company during the nine-month period. Power revenues have also shown strong growth coupled with improvement in margins for both the periods. The company has also reported a strong expansion in operating margins during the quarter and the nine-month period.

Financial performance: A snapshot…
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Sales 9,291 9,884 6.4% 26,636 29,809 11.9%
Expenditure 8,695 8,090 -7.0% 22,637 24,379 7.7%
Operating profit (EBDITA) 596 1,793 200.7% 3,999 5,430 35.8%
Operating profit margin (%) 6.4% 18.1%   15.0% 18.2%  
Other income 2,056 1,493 -27.4% 3,390 4,025 18.8%
Interest 356 467 31.4% 909 1,442 58.6%
Depreciation 841 907 7.9% 2,489 2,595 4.3%
Profit before tax 1,456 1,912 31.3% 3,992 5,419 35.8%
Tax 111 265 138.9% 335 611 82.2%
Profit after tax/(loss) 1,345 1,646 22.4% 3,656 4,809 31.5%
Net profit margin (%) 14.5% 16.7%   13.7% 16.1%  
No. of shares 185.6 201.9   185.6 201.9  
Diluted earnings per share* (Rs)         31.1  
P/E ratio* (x)         19.6  
* On a trailing 12-months basis            

What is the company’s business?
Reliance Energy is a leading private sector power company in the country and has presence in generation, transmission and distribution in Mumbai, Delhi, Orissa and Goa. The company has an installed generation capacity of 941 MW. The company has envisioned increasing its generation capacity to 9,000 MW by 2012, and, towards that, has unfurled its plan of setting up a 7,480 MW gas based power plant in phases, in Uttar Pradesh. This shall involve a capital expenditure of around Rs 220 bn. The company also has a presence in the engineering, procurement and construction (EPC) business (19% of 9mFY06 sales), which has been a strong revenue and margin driver in the past few quarters.

What has driven performance in 3QFY06?
EPC business scores: For a change over the past few quarters’ performance, Reliance Energy’s power and not the EPC business has led the company’s topline growth during 3QFY06. While revenues from the power division grew by over 12% YoY during 3QFY06, those from the EPC division declined by around 9% YoY. In the power business, the company has chiefly benefited from improved realisations, as volumes sales have actually declined. As a matter of fact, while realisation per unit sold had improved by 13% YoY during 3QFY06, Reliance Energy’s sales of electricity has declined by 13% YoY to 1.9 bn units during the period. As seen from the adjoining graph, electricity sales of the company are following a seasonal pattern with volumes being the highest during the first quarter (April-June being the hottest months) and gradually declining as the year progresses. Realisations (revenue per unit) have, however, shown an uptrend, mainly due to rise in fuel costs (that are a pass-through to the consumers).

Of the total power supplied by Reliance Energy during the nine-month period, almost 51% (52% in 1HFY06) was purchased from external sources (including Tata Power). The company paid Rs 2.7 per unit purchased during the first half, representing a decline of over 9.6% YoY (Rs 3.0 per unit in 9mFY05). Investors should note that Reliance Energy buys a large part of its requirement from its peer, Tata Power, and, as per the MERC order, the rate at which the latter supplies to the former has been reduced from Rs 3.1 per unit to Rs 2.7 per unit. This is reflected in the lower per unit purchase cost during 9mFY06.

Segment-wise performance…
  3QFY05 3QFY06 Change 9mFY05 9mFY06
Electrical Energy
Revenue 7,450 8,374 12.4% 22,634 24,486
% share 79.5% 82.7%   84.2% 80.8%
PBIT margin 6.7% 11.2%   10.4% 10.7%
EPC and Contracts
Revenue 1,918 1,751 -8.7% 4,260 5,835
% share 20.5% 17.3%   15.8% 19.2%
PBIT margin 1.0% 29.3%   3.4% 18.8%
Revenue 9,368 10,125 8.1% 26,894 30,321
PBIT margin 5.6% 14.3%   9.3% 12.3%
* Excluding inter-segment adjustments

As far as the EPC business is concerned, revenues from the same declined by 9% YoY during the quarter. These, however, witnessed a strong 37% YoY growth during the nine-month period, thus increasing their contribution to total revenues (to 19% in 9mFY06 from less than 16% in 9mFY05). The EPC business has benefited on account of the surge in domestic capital investments. At the end of December 2005, the EPC segment had an order backlog of Rs 35 bn, almost 3 times the segment’s FY05 revenues.

Lower power purchase and EPC costs aid margins: Decline in the cost of power purchased from Rs 3.0 per unit to Rs 2.7 per unit helped Reliance Energy post a strong 450 basis points PBIT margin expansion in the electricity business during 3QFY06. Fuel costs for electricity generated in-house, however, increased from 23% of electricity sales to 25% level during the quarter. Strong expansion in EPC margins was on the back of almost halving of cost of EPC materials and sub-contracting charges during 3QFY06.

It boils down to the bottomline: Bottomline witnessed robust growth during both the periods under consideration, mainly on the back of strong expansion in operating margins. But for decline in other income and a higher tax liability, the net profit growth would have been higher for the company during the quarter.

What to expect?
At the current price of Rs 600, the stock is trading at a price to earnings multiple of 18.8 times our estimated FY08 earnings, which would have to be revised upwards considering the stronger than expected growth in the company’s business segments and improvement in margins.

However, considering the mega expansion plans that the company has lined up for the future, and which would entail equity contribution of 30% (as per the 70:30 debt to equity funding requirement), a large equity dilution is imminent in the future. Investors should also note that large-scale projects like these will take several years for completion and, to that extent, there is uncertainty with regards to the return on funds employed.

As part of the demerger plan of Reliance Industries, the board of Reliance Energy has announced a swap ratio of 7.5:100 i.e., for every 100 shares held in Reliance Industries, investors will get 7.5 shares of Reliance Energy (through the demerged arm called Reliance Energy Ventures Ltd.). This share exchange ratio is based on the number of shares of Reliance Energy held by Reliance Energy Ventures Ltd (REVL). Post the swap process, the shares of Reliance Energy held by REVL will be cancelled and the fully diluted equity capital of the former will remain as at the current levels (though excluding the impact on conversion of FCCBs issued earlier by Reliance Energy). As per our calculations, the proposed amalgamation of REVL into Reliance Energy will add Rs 145 to the latter’s book value.

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