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Suzlon’s offer for REpower: Our view - Views on News from Equitymaster
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Suzlon’s offer for REpower: Our view
Feb 13, 2007

Indian wind energy equipment major, Suzlon Energy, has made a US$ 930 m (Euro 715 m) bid to acquire 70% stake in the German REpower Systems AG, one of the leading players in the wind turbine manufacturing industry. Importantly, Suzlon’s offer exceeds Areva’s (the largest shareholder in REpower) offer price by 20%. The offer is made through a special purpose vehicle, which is held 75% by Suzlon and 25% by Martifer (Portuguese company specialising in metallic construction), which currently holds 25.4% stake in REpower.

About Suzlon Energy
Suzlon Energy is Asia's leading manufacturer of wind turbine generators (WTGs) having around 58% share of India's domestic installations in 9mFY07. The company is also among the five largest manufacturers of WTGs globally in terms of annual installed capacity. It is the first Asian company to manufacture WTGs, which have MW and multi-MW capabilities. The products manufactured by Suzlon include rotor blades, control panels, nacelle cover and tubular towers. In 2005, the company acquired the Belgian Hansen Transmissions, which is one of the three major multi-MW gearbox suppliers in the world.

The company enjoys cost advantages over its global competitors by way of operating manufacturing capacities in India. Also, the company has a subsidiary for technology development in Germany and an R&D facility in the Netherlands for rotor blade molding and tooling. These factors combine to provide Suzlon some kind of competitive advantage in the technology intensive and competitive global wind power equipment market. Against the industry growth of 26% per annum during the period FY00 to FY06, Suzlon grew at a much faster rate of 64% per annum. At the end of 9mFY07, the company had an order backlog of over Rs 77 bn, inclusive of Rs 15 bn of domestic orders and Rs 62 bn of international orders.

About REpower AG
REpower Systems AG (REpower) is one of the leading turbine producers in the German wind energy sector with a market share in excess of 10%. REpower's technical strength also lies in offshore wind development sites, wherein its 5 MW product is currently one of the largest wind turbines in the world. In addition to its high technologically advanced wind turbines, it also offers comprehensive expertise in planning and constructing turnkey wind farms. In 2006, REpower advanced from fifth to third place in the ranking of the largest manufacturers of wind turbines in Germany. With a market share of 7.6% for the newly installed output of 2,233 MW in 2006 (1,808 MW in 2005), REpower established itself behind the competitors Enercon and Vestas and in front of other suppliers such as GE Energy, Siemens and Nordex.

Even in REpower’s foreign markets, where it makes 70% of its sales, the company has come closer to its target of becoming one of the largest manufacturers and being ranked among the top manufacturers in countries such as Great Britain, France, Portugal and Japan. The company earned revenues of US$ 386 m during the first nine-months of 2006 (January to September 2006), recording a growth of 52% YoY. The company operated at EBIDTA margins of 1.5% during this period and earned net profits of US$ 1.3 m. Its order backlog stood at 868 MW at the end of September 2006.

European wind power market
As per the annual statistics issued by the European Wind Energy Association (EWEA), the market for European wind power capacity broke new records in 2006. Around 7,600 MW of wind power capacity, worth some US$ 11.7 bn, was installed in the EU in 2006, a growth of 23% YoY.

The cumulative wind power capacity operating in the EU increased by 19% YoY and now exceeds 48,000 MW, or almost 3.3% of total EU electricity consumption. For the seventh consecutive year, wind power was second only to gas-fired capacity (approximately 8,500 MW in 2006) in terms of new electricity generating installations. EWEA further estimates that Europe accounted for approximately 50% of global wind power capacity installed during 2006.

What’s in the deal?
As for REpower, the company has faced supply constraints on the gearbox front. We believe this issue will be solved through Suzlon’s acquisition of the company. This is because Suzlon already owns Hansen Transmission, which is one of the world’s top three wind gearbox manufacturers. This acquisition (of Hansen by Suzlon) highlighted the strategic importance of the supply chain in the wind turbine industry. Considering, sourcing bottlenecks across a range of components, we continue to believe that Hansen gives Suzlon a strong competitive advantage vis-à-vis its peers, and this very advantage shall now flow in to REpower, once the acquisition is through. Excluding this benefit, REpower’s management expects the company to grow its revenues at a compounded annual growth of 36% during the period 2005 to 2008. This expected growth also does not factor in REpower’s recently concluded joint venture REpower North in China and the joint enterprise planned with the Essar Group in India.

REpower has a significant competitive advantage in its four offshore wind farms with 5 MW turbines. If demand for offshore wind farms increases, the company should be able to win a substantial market share. Such a rise in demand is indeed considered likely given the attractive fees for electric power in the UK and France and given the Infrastructure Acceleration Act in Germany. REpower does not manufacture any of the key components itself. And this is reflected in its higher cost base. With the combined benefits of the integrated manufacturing facilities of Suzlon, we expect the former’s profitability to improve from the current levels (1.5% EBIDTA margins in 9mFY07).

For Suzlon, REpower’s acquisition shall provide strategic advantages over the long term, especially in terms of access to the world's largest market in installed capacity, superior R&D technology, established infrastructure and customer base and access to technology for offshore development. Also, if Suzlon gets REpower, its share of the global wind power market will go up to a little over 14%, from the existing 11% level. The latter also fits well into Suzlon's ambitions of getting a foothold globally and gaining entry into the offshore market for wind turbines.

Comparative performance
(9mFY07) Suzlon REpower
Sales (US$ m) 1,147 386
EBIDTA margins 15.8% 1.5%
PAT (US$ m) 114 1
PAT margins 10.0% 0.3%
Employees (Nos.) 9,500 740
Revenue per employee (US$ m) 0.2 0.7
Return on equity 27.6% 0.7%
Debt to equity 1.00 0.02
Price to earnings 14.5 24.0
Price to sales 2.0 1.2
EV/EBIDTA 10.0 13.5
* Valuations are based on FY09E numbers (CY08E for REpower); Stock price for REpower is assumed as Euro 126 per share, i.e., the rate offered by Suzlon;
Source: Company reports, Equitymaster Research

Valuation analysis
As for valuations, Suzlon's offer of Euro 126 per share values REpower at Euro 1.02 bn (US$ 1.3 bn). This values the company at EV/EBITDA multiple of around 13.5 times CY08E and a price to earnings multiple of 24 times CY08E. This is taking into account REpower management’s estimates for operating margins of around 8% in CY08, from 4% estimated for CY06. Compared to this, at Rs 1,130, Suzlon trades at EV/EBITDA multiple of 10 times FY09E and a price to earnings multiple of 14.5 times FY09E.

Suzlon’s management has cited uncertainty of Areva hiking up its own offer of Euro 105 per share. We believe that the acquisition, if it goes through at the current offer price of Euro 126 per share, will not be really expensive considering the rationale behind the same, i.e., Suzlon getting access to the world's largest market in installed capacity, superior R&D technology, established infrastructure and customer base and access to technology for offshore development. However, integration will be a big challenge, as it has been with other acquisitions in the past. This shall also raise the risk profile of Suzlon, considering that its consolidated financials (inclusive of REpower) might be under strain due to the latter’s relatively lower profitability levels.

Another important thing to note is that, while Suzlon currently has a consolidated debt to equity ratio of almost 1x (debt of Rs 32 bn and equity of Rs 33 bn), the fact that this acquisition will be largely funded through debt (as Suzlon’s current cash balance stands at nearly US$ 180 m, against the funding requirement of US$ 930 m), it will raise the company’s leverage (debt to equity) further, to around 1.9 times. Additionally, there might be some equity dilution, which is another uncomfortable factor for existing shareholders. These factors shall raise the company’s overall risk profile.

Our revised estimates for Suzlon
Considering the 9mFY07 performance and the medium term challenges with respect to aggressive capex, we are downgrading our profitability estimates for Suzlon for FY07 to FY09, while largely maintaining our topline estimates. Against earlier estimates of 52% compounded annual growth in earnings during the period FY06 to FY09, our current estimates stand at 44% CAGR. On the topline front, against 54% CAGR estimated for the said period (FY06 to FY09), we have upgraded the same to 62% CAGR.

With strong demand for wind turbines expected from China, the US and India over the next few years, we are positive on Suzlon’s long-term growth prospects. Also, while profitability will be impacted in the medium term, owing to reasons like aggressive expansion of manufacturing capacities, we expect scale benefits from these to flow in over the long term.

We had recommended a ‘Buy’ on Suzlon in November 2006 at Rs 1,316 with a March 2009 target price of Rs 2,020. On the back of abovementioned arguments, while we maintain our positive stance on the stock, the target price shall stand revised downwards to Rs 1,710 from a March 2009 perspective.

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