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BHEL: Fully charged

Jan 31, 2006

Performance Summary
It has been a dream run for the PSU engineering major, BHEL. The benefits of significant investments in the power sector have been clearly reflected in the topline growth of the company (revenues have increased by 43% YoY and 49% YoY in 3QFY06 and 9mFY06 respectively). Combined with the robust topline growth, margins in both its key divisions have also expanded, resulting in operating profit growing by 71% YoY in 3QFY06.

Financial performance: A snapshot…
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Revenues 25,297 36,146 42.9% 57,190 85,167 48.9%
Expenditure 21,767 30,117 38.4% 51,218 73,733 44.0%
Operating profit (EBDITA) 3,530 6,029 70.8% 5,971 11,434 91.5%
Operating profit margin (%) 14.0% 16.7%   10.4% 13.4%  
Other income 999 1,187 18.9% 2,720 3,174 16.7%
Interest 129 136 5.6% 426 392 -7.8%
Depreciation 544 620 13.9% 1,570 1,820 15.9%
Profit before tax 3,855 6,460 67.6% 6,695 12,396 85.1%
Tax 1,481 2,229 50.4% 2,504 4,285 71.1%
Profit after tax/(loss) 2,374 4,232 78.3% 4,191 8,112 93.5%
Net profit margin (%) 9.4% 11.7%   7.3% 9.5%  
No. of shares 244.7 244.7   244.7 244.7  
Diluted earnings per share (Rs)*         57.0  
P/E ratio (x)         31.6  
(* trailing 12-month basis)            

What is the company’s business?
Bharat Heavy Electricals Limited (BHEL) is India's largest engineering company with market leadership in supply of equipments to the energy-related/infrastructure sectors. The company has installed equipments for over 90,000 MW of power generation in the country, which includes capacities set up by utilities, captive and industrial users. Revenues from the power sector form around 74% of the company's total revenues, with the remaining being contributed by the industrial segment. The company has strong ties with NTPC, and historically, has bagged around 85% of the contracts floated by the former.

What has driven performance in 3QFY06?
Power division shows the way: As is evident from the table below, the power division witnessed a 55% YoY growth in revenues in 3QFY06 and in the process, outpaced the industrial division. The growth in the power division could be attributed to significant investments made by NTPC, by far the biggest investor in the sector on the generation front for now. While the industrial segment grew at a relatively slower rate of 16% YoY in 3QFY06, it is nevertheless a commendable performance. During the third quarter, the company recorded a net order inflow of Rs 16 bn, thus taking its order backlog to Rs 338 bn, more than 3 times FY05 revenues.

Segment-wise performance…
Division 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Revenue 17,752 27,518 55.0% 39,815 64,685 62.5%
% share 68.2% 74.2%   67.4% 73.7%  
PBIT margin 22.4% 23.0%   19.5% 19.6%  
Revenue 8,283 9,568 15.5% 19,300 23,055 19.5%
% share 31.8% 25.8%   32.6% 26.3%  
PBIT margin 11.6% 14.2%   9.8% 12.8%  
Total revenue 26,035 37,087 42.4% 59,115 87,741 48.4%
PBIT margin 18.9% 20.7%   16.4% 17.8%  
* Excluding inter-segment adjustments

Lower staff costs aid margins: Despite a rise in raw material costs from 50.3% of sales in 3QFY05 to 53.5% of sales in 3QFY06, BHEL has managed to expand its operating margins by 270 basis points during the quarter. This has been mainly due to a decline in staff costs, from 16.3% of sales in 3QFY05 to 12.5% of 3QFY06 sales. Manpower rationalisation owing to the VRS has seemingly led to staff costs continuing their decline in this quarter as well. Based on segments, while the power PBIT margins have expanded by 60 basis points to 23% in 3QFY06, those for the industry division have improved by 260 basis points to 14.2%.

We expect employee rationalisation and efficient cash conversion to help the company shore up its profitability going forward. However, considering the buoyant nine-month performance, we also need to revise upwards our earlier estimates on margins.

It all flows to the bottomline: Apart from the robust performance on the topline and operating margins front, higher other income and a lower effective tax rate have also aided BHEL’s bottomline during the period under consideration. The company is all set to outperform our bottomline target for FY06, thus, requiring us to revise our numbers upwards.

What to expect?
At the current price of Rs 1,800, the stock is trading at a price to earnings multiple of 23.3 times our estimated FY08 earnings. As we have mentioned earlier, we would have to upgrade our topline and bottomline estimates for FY06 onwards.

While we are positive about the continuation of the reforms process in the Indian power industry, it is the pace at which the sector is growing that concerns us. In a recent meeting with NTPC’s management, we get the indication that the government will miss its generation capacity plans by around 25% to 30% during the tenth and eleventh five-year plans. As far as BHEL is concerned, while we do not doubt the strong growth that is coming in for the company, what we are worried of is the stretched valuations that the stock trades at currently.

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