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BHEL: Power(ful) display!

Feb 1, 2005

Performance summary
PSU engineering major, BHEL, has reported strong results for the quarter and nine-month period ending December 2004. For 3QFY05, while the topline has grown YoY by 28%, the net profit growth has been much higher at 79%. This is mainly owing to the write-off of deferred revenue expenditure in the third quarter of FY04. Excluding this effect, the net profit growth in 3QFY05 has been a more sober 12% YoY. Margins have improved marginally for both 3QFY05 and 9mFY05.

Financial performance: A snapshot…
(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Sales 19,728 25,297 28.2% 48,029 57,190 19.1%
Expenditure 17,068 21,767 27.5% 43,408 51,038 17.6%
Operating profit (EBDITA) 2,660 3,530 32.7% 4,621 6,152 33.1%
Operating profit margin (%) 13.5% 14.0% 9.6% 10.8%
Other income 896 998 11.4% 2,337 2,720 16.4%
Interest 136 129 -5.1% 367 426 16.1%
Depreciation 512 544 6.3% 1,476 1,570 6.4%
Profit before tax 2,908 3,855 32.6% 5,115 6,876 34.4%
Extraordinary income/(expense) (794) - (1,607) (180)
Tax 784 1,481 88.9% 1,278 2,505 96.0%
Profit after tax/(loss) 1,330 2,374 78.5% 2,230 4,191 87.9%
Net profit margin (%) 6.7% 9.4% 4.6% 7.3%
No. of shares 244.7 244.7 244.7 244.7
Diluted earnings per share* (Rs) 21.7 38.8 12.1 22.8
P/E ratio (x) 33.2
(* annualised)

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 68% of the company's total revenues, with the remaining being contributed by the industrial segment (32% of revenues). 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 3QFY05?
All-round growth aids topline: Growth in BHEL’s 3QFY05 topline has been a result of growth in both its segments of power (68% of revenues) and industry (32% of revenues). While the former grew YoY by 33%, the latter grew YoY by 19%. By the end of 3QFY05, BHEL’s outstanding order book position stood at Rs 317 bn, up 35% YoY over the order book of Rs 235 bn by the end of 3QFY04. The current order book is nearly 4 times the company’s FY04 revenues. The company secured, among others, two major contracts during the quarter. First was worth Rs 8.3 bn from MPSEB to set up one unit of 210 MW capacity plant. The second was valued at Rs 17.7 bn, secured from Jindal Power, for the 4x250 MW plant in Chhattisgarh. Considering that the current order book is likely to be converted in next 18 months and that the Indian power sector is seeing increased investments into new capacities, we expect the coming 5-6 quarters to be strong for the company. More importantly, fourth quarter typically contributes significantly to the full year performance of any engineering major (in line with the completion of the orders) and therefore, we expect significant growth in 4QFY05.

Segment-wise performance…
3QFY04 % of total 3QFY05 % of total Change
Power
Revenue 13,394 65.7% 17,752 68.2% 32.5%
PBIT 2,172 69.4% 3,974 83.3%
PBIT margin 16.2% 22.4%
Industry
Revenue 6,986 34.3% 8,283 31.8% 18.6%
PBIT 959 30.6% 798 16.7% -16.8%
PBIT margin 13.7% 9.6%
Total*
Revenue 20,380 26,035 27.7%
PBIT 3,131 4,772 52.4%
PBIT margin 15.4% 18.3%
* Excluding inter-segment adjustments

Power business leads margin expansion: Stability on the raw material consumption front and lower staff costs (as % of revenues) has led to the 50 basis points improvement in BHEL’s margin for 3QFY05. Manpower rationalisation owing to the recent VRS has led to staff costs decline from 19% of sales in 3QFY04 to 16% in this quarter. Based on segments, the power business has seen its PBIT margins improve strongly by over 600 basis points to 22.4%. This seems a result of the fact that as projects in the power segment reach completion, a large part of revenue flow straight to the profits. PBIT margins for the industry segment have contracted by 410 basis points to 9.6%.

Higher tax outgo pares net profit growth: While the net profit growth in 3QFY05 look solid at one glance, if one were to remove the effect of the write-off of deferred revenue expenditure in 3QFY04, the YoY net profit growth declines to nearly 12%. A substantial 89% YoY growth in tax outgo has led to the net profits growing slower than the growth in revenues.

What to expect?
At the current price of Rs 757, the stock is trading at a price to earnings multiple of 33.2 times annualised 9mFY05 earnings. During 3QFY05, the management had declared and paid an interim dividend of Rs 3.5 per share (dividend yield of 0.5%).

In August 2004, we had recommended a ‘Hold’ on BHEL at a price of Rs 529, with a target price of Rs 700 in the medium term. The stock has crossed our target. We will be revisiting our earnings estimate for FY05 and beyond. As a market leader in the power business and being a government company, we expect significant growth in the company’s power division in the next five years. Perhaps, this is one of the key reasons for high valuations, even when compared to global majors like ABB.

Having said that, our interaction with engineering majors like ABB suggest that order book position cannot rise at a much faster rate than what is executable and therefore, investors have to be realistic with respect to the order book growth. Unlike the past, most of the global engineering majors (upon reading their annual reports) are looking at India and China for growth opportunities, and competition, in this sense, is only going to increase. On the balance, BHEL will be our preferred engineering sector player on the power side with a three to five year perspective.

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