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Reliance Energy: EPC dent and drive! - Views on News from Equitymaster
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Reliance Energy: EPC dent and drive!
Apr 19, 2006

Performance Summary
Reliance Energy (Research) , has announced mixed results for the fourth quarter and year ended March 2006. While the topline has declined for both the periods, net profits have grown on the back of strong improvement in operating margins. Expansion in margins has been brought about by reduction in cost of material and sub-contracting costs in the EPC division. The board has recommended a dividend of Rs 5 per share (Rs 1.2 per share of quarterly dividend and Rs 3.8 per share of final dividend), implying a dividend yield of 0.8%.

Financial performance: A snapshot…
(Rs m) 4QFY05 4QFY06 Change FY05 FY06 Change
Sales 14,670 10,382 -29.2% 41,307 40,191 -2.7%
Expenditure 12,784 8,480 -33.7% 35,420 32,859 -7.2%
Operating profit (EBDITA) 1,886 1,901 0.8% 5,887 7,332 24.5%
Operating profit margin (%) 12.9% 18.3%   14.3% 18.2%  
Other income 1,229 1,863 51.5% 4,619 5,888 27.5%
Interest 439 477 8.7% 1,348 1,919 42.3%
Depreciation 976 891 -8.7% 3,464 3,486 0.6%
Profit before tax 1,700 2,396 40.9% 5,693 7,815 37.3%
Extraordinary income/(expense)   -     -  
Tax 221 701 217.4% 490 1,311 167.5%
Profit after tax/(loss) 1,479 1,695 14.6% 5,203 6,503 25.0%
Net profit margin (%) 10.1% 16.3%   12.6% 16.2%  
No. of shares 185.6 212.3   185.6 212.3  
Diluted earnings per share (Rs)         30.6  
P/E ratio (x)         20.8  

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 also has a presence in the engineering, procurement and construction (EPC) business (21% of FY06 revenues), which has been a strong margin driver in the past few quarters.

What has driven performance in FY06?
Topline – The EPC dent: Despite an 11% YoY growth in revenues from the electrical energy segment, Reliance Energy’s topline witnessed a 3% YoY decline in FY06. This was perpetuated by a big 30% YoY decline in revenues from the EPC business (21% of FY06 revenues compared to nearly 30% in FY05). Incidentally, the EPC division had been leading the company’s growth in the past few quarters, while the electrical energy business was growing steadily. Since the management has not indicated the reason for this sharp decline in EPC revenues, we shall avoid our view for now. Actual revenues from this division are almost half of what we had estimated in our research earlier. This makes the company underperform our total FY06 revenue estimates by around 15%.

Segment-wise performance…
  4QFY05 4QFY06 Change FY05 FY06 Change
Electrical Energy
Revenue 6,639 8,013 20.7% 29,274 32,500 11.0%
% share 44.9% 74.0%   70.2% 79.0%  
PBIT margin 6.7% 11.6%   9.5% 11.2%  
EPC and Contracts
Revenue 8,150 2,818 -65.4% 12,410 8,653 -30.3%
% share 55.1% 26.0%   29.8% 21.0%  
PBIT margin 7.5% 10.5%   6.1% 14.0%  
Total*
Revenue 14,789 10,831 -26.8% 41,683 41,153 -1.3%
PBIT margin 7.2% 11.6%   8.5% 11.9%  
* Excluding inter-segment adjustments

As far as the electrical energy business is concerned, the same contributed to around 79% of Reliance Energy’s total revenues in FY06 (70% in FY05). Both volume growth and realisation improvement contributed to growth in revenues for this business. While the company sold an aggregate of 8,064 m units in FY06 (1.3% YoY growth), average realisations improved by 8.4% YoY to Rs 3.9 per unit. We had estimated FY06 volume sales to be 8,288 m units at an average rate of Rs 3.7 per unit.

Despite lower plant load factor (PLF, or capacity utilisation) for all the stations, the growth in volumes has been mainly brought about by higher levels of external purchases. Reliance Energy bought 3,921 m units of electricity during FY06 (from Tata Power), which formed around 49% of its volume sales. This indicates the company’s high dependence on external sources. The cost of these purchases stood at Rs 2.8 per unit (Rs 3 per unit in FY05), almost 70% higher than the cost incurred in generating power in-house.

In order to curb its dependence on external sources and also to grow otherwise, the company has planned investments in the power generation segment. These include a 3,000 MW gas-based project in Uttar Pradesh (one phase of the larger project of 5,000 MW), 1,400 MW gas-based project in Maharashtra and 12,000 MW coal-based project in Orissa. Total investments towards this expansion are estimated to be around Rs 660 bn, to be spent over the next few years. In our interaction earlier this year, the management had clearly indicated that these additions to the power generation capacity would not be of merchant nature (involving power to be sold to external distribution companies). Rather, these ventures will be towards meeting the company’s own distribution requirements in Delhi, Mumbai and Orissa.

Margins – The EPC drive: While poor performance of the EPC division has impacted the topline performance of Reliance Energy during 4QFY06 and FY06, the same business has been the margin driver during these periods. This is because while the major cost heads – cost of electricity purchased and fuel costs – have witnessed rise in FY06 (as % of sales), the cost of material and sub-contracting relating to the EPC business have declined substantially from 26% of total sales in FY05 to 15% levels in FY06. Even when calculated on the base of EPC revenues alone, these costs have declined from 88% in FY05 to just above 70% in FY06.

Other income aid bottomline: Apart from the expansion in operating margins, strong growth in the other income component combined with lower depreciation costs aided Reliance Energy’s bottomline growth during both 4QFY06 and FY06. Growth in net profits is despite the strong rise in the effective tax rate (16.8% in FY06 against 8.6% in FY05). This rise in tax liability was due to Rs 805 m of outgo as tax adjustment for earlier years. Led by these factors, the company has outperformed our FY06 net profit estimates by 15%.

What to expect?
At the current price of Rs 636, the stock is trading at a price to earnings multiple of 20.8 times its FY06 earnings. The results have been a mixed bag considering that while the strong margin expansion was a positive surprise, the decline in EPC revenues was unexpected, considering the kind of projects that the company has won in recent times.

On the power business, considering the mega expansion plans of the company, 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. Cash flows are also likely to be severely impacted during the expansion phase. To that extent, investors need to practice caution. Keeping in mind the growth prospects and current valuations in balance, we have a negative view on the stock.

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