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Reliance Energy: EPC show, again! - Views on News from Equitymaster

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Reliance Energy: EPC show, again!
Jan 18, 2007

Introduction to results
Reliance Energy has announced mixed results for the third quarter and nine-months ended December 2006. While topline growth has been strong for both the periods, the company has faced tremendous pressure on its profitability. Operating margins have contracted to 5.4% in 3QFY07, from 17.7% in 3QFY06. The pressure has been inflicted on account of substantially higher expenses on the EPC front, which has otherwise been the main revenue driver for the company during both the periods under consideration. Strong showing of the EPC business should be seen in light of delayed execution of past orders.

Financial performance: A snapshot…
(Rs m) 3QFY06 3QFY07 Change 9mFY06 9mFY07 Change
Sales 9,830 15,337 56.0% 29,715 40,962 37.8%
Expenditure 8,090 14,510 79.4% 24,379 36,580 50.1%
Operating profit (EBDITA) 1,739 827 -52.5% 5,336 4,382 -17.9%
Operating profit margin (%) 17.7% 5.4%   18.0% 10.7%  
Other income 1,547 2,867 85.4% 4,120 5,894 43.1%
Interest 467 551 17.8% 1,442 1,680 16.6%
Depreciation 907 612 -32.6% 2,595 1,866 -28.1%
Profit before tax 1,912 2,532 32.5% 5,419 6,729 24.2%
Tax 265 522 96.7% 611 1,089 78.4%
Profit after tax/(loss) 1,646 2,010 22.1% 4,809 5,640 17.3%
Net profit margin (%) 16.7% 13.1%   16.2% 13.8%  
No. of shares       201.9 213.1  
Diluted earnings per share (Rs)*         34.4  
P/E ratio (x)*         15.3  
* On a trailing 12-month 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 Mumbai licensed region contributes to almost over 80% of the company’s electricity sales. The company has an installed generation capacity of 941 MW, with 500 MW installations at Dahanu near Mumbai. The company also has a presence in the engineering, procurement and construction (EPC) business (32% of 9mFY07 revenues). During the period between FY01 and FY06, Reliance Energy grew its revenues and net profits at compounded rates of 8% and 9% respectively.

What has driven performance in 3QFY07?
EPC leads the way, yet again: Carrying on from the stellar performance in the previous quarter, Reliance Energy’s engineering, procurement and construction (EPC) business once again led the overall topline growth. During 3QFY07, the business reported sales growth of 251% YoY, and in consequence more than doubling its share in the company’s total revenues to 38% (17% in 3QFY06). As we had indicated in the previous quarter’s analysis as well, it is the lumpiness (completion of contracts ahead/behind the schedule creates quarterly fluctuations) in this business that has created waves in the past few quarters. The strong growth reported by the EPC business in the past two quarters is due to delayed completion of some large contracts, which were earlier scheduled to get over by 4QFY06. The execution of these very contracts has led to the company taking in lesser contracts in the first three quarters of the fiscal. This is seen from the reduction in order backlog from Rs 33.0 bn at the end of 1QFY07 to Rs 23.7 bn in 2QFY07 and Rs 17.1 bn at the end of 3QFY07.

Segment-wise performance…
  3QFY06 3QFY07 Change 9mFY06 9mFY07 Change
Electrical Energy
Revenue 8,374 9,881 18.0% 24,486 28,382 15.9%
% share 82.7% 61.7%   80.8% 67.6%  
PBIT margin 11.2% 8.0%   10.7% 11.1%  
EPC and Contracts
Revenue 1,751 6,139 250.5% 5,835 13,591 132.9%
% share 17.3% 38.3%   19.2% 32.4%  
PBIT margin 29.3% 2.9%   18.8% 4.2%  
Total*      
Revenue 10,125 16,021 58.2% 30,321 41,973 38.4%
PBIT margin 14.3% 6.1%   12.3% 8.9%  
* Excluding inter-segment adjustments

The company’s electrical energy business reported sales growth of 18% YoY during 3QFY07. This growth was largely due to the strong performance on the volumes front (units sold). These grew by 16% YoY during 3QFY07. However, the company sold these units at 2% lower tariffs as compared to 3QFY06.

Higher sales of electricity were propelled by both higher generation at Dahanu (DTPS) and greater amount of power purchases (largely from Tata Power). While DTPS operated at a plant load factor (capacity utilisation) of 100.6% (97% in the corresponding period of previous year), Reliance Energy’s bought units from Tata Power increased by 22% YoY. It its important to note that Reliance Energy is one of the major customers of Tata Power, and buys almost 30% of the units that the latter sells to outside parties in Mumbai (including Railways and BEST). And due to the relatively higher cost of generation at Tata Power’s Trombay plant, which largely uses the expensive liquid fuel (LSHS), the purchase cost for Reliance Energy has been on a rise over the past few quarters. As a matter of fact, the company purchased power at 42% YoY higher rates from Tata Power during 3QFY07.

As far as tariff in Mumbai is concerned, considering the acute shortage of power owing to strong growth in demand and inadequate increase in supply, the Maharashtra Electricity Regulatory Commission (MERC) had recently passed an order allowing utilities in the region, like Reliance Energy and Tata Power to raise their tariffs across consumer categories. As for Reliance Energy, while the Commission raised the effective tariff (charged to all consumers, except those consuming less than 30 units per month) by around 30% for the period October 2006 to March 2007, the company has opted for a 10% hike but for an extended period of 18 months, i.e., October 2006 to March 2008.

EPC dent to profitability: Despite the fillip that the EPC business provided to Reliance Energy’s topline during 3QFY07, it was the costs from this very segment that severely impacted the company’s overall profitability. As a percentage of EPC sales, the segment’s direct operating costs jumped from 54% in 3QFY06 to 92% in 3QFY07! As for electricity related costs, except the rise in cost of power purchased (as indicated above), all other major heads like cost of fuel and staff costs reduced on a YoY basis.

Higher other income, lower depreciation saves the day: Despite the pressure on operating profitability, Reliance Energy was able to post decent growth in bottomline during 3QFY07. This was mainly due to strong growth in other income (due to higher interest income) and lower depreciation costs. But for the rise in effective tax rate, from 13.9% in 3QFY06 to 20.6% in 3QFY07, the bottomline growth would have been higher during the said period.

What to expect?
At the current price of Rs 526, the stock is trading at a price to earnings multiple of 15.3 times its trailing 12-month earnings. We shall have to marginally upgrade our FY07 EPC revenue estimates for the company, considering the performance during the first nine-months of the fiscal. However, we shall maintain our margin outlook for the consolidated entity, given that the fourth quarter is a tad more profitable for EPC businesses. As for the electricity business, there still needs to be more clarity regarding the targeted capacity expansion. Of course, there are challenges with respect to fuel availability and pricing, especially when a large part of the company’s expansion is planned to be gas-based. We shall soon update our research report on the company.

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