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BHEL: Future secured?

Apr 28, 2005

Performance summary
PSU engineering major, BHEL, has reported strong results for the quarter and fiscal ended March 2005. For FY05, while topline has grown YoY by 22%, the net profit growth has been much higher at 53%. The performance has been equally robust for the fourth quarter. Margins have improved by 210 and 170 basis points respectively for the quarter and fiscal.

Financial performance: A snapshot…
(Rs m) 4QFY04 4QFY05 Change FY04 FY05 Change
Sales 39,686 49,671 25.2% 87,715 106,861 21.8%
Expenditure 33,554 40,951 22.0% 76,961 91,990 19.5%
Operating profit (EBDITA) 6,132 8,720 42.2% 10,754 14,871 38.3%
Operating profit margin (%) 15.5% 17.6%   12.3% 13.9%  
Other income 1,910 1,628 -14.8% 4,246 4,347 2.4%
Interest 207 352 70.0% 574 777 35.4%
Depreciation 504 605 20.0% 1,980 2,174 9.8%
Profit before tax 7,331 9,391 28.1% 12,446 16,267 30.7%
Extraordinary income/(expense) (691) -   (2,298) (180)  
Tax 2,288 3,545 54.9% 3,566 6,049 69.6%
Profit after tax/(loss) 4,352 5,846 34.3% 6,582 10,038 52.5%
Net profit margin (%) 11.0% 11.8% 7.5% 9.4%
No. of shares 244.7 244.7   244.7 244.7  
Diluted earnings per share* (Rs) 71.1 95.5   26.9 41.0  
P/E ratio (x)         19.5  
(* 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 69% 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 FY05?
Power segment leads topline growth:  Growth in BHEL's FY05 topline has been a result of growth in both its segments of power (69% of revenues) and industry (31% of revenues). While the former grew YoY by 26%, the latter grew YoY by 15%. The strong growth in revenues in FY05 was coupled with a continued robust inflow of orders to BHEL's books. During the fiscal, the company recorded an order inflow of Rs 180 bn, a YoY growth of 9%. More importantly, a large part of the orders came in for EPC (engineering, procurement and construction) and turnkey contracts, which have a higher gestation period. At the end of the fiscal, BHEL's outstanding order books stood at Rs 320 bn, almost 3 times its FY05 revenues and a growth of 35% YoY.

Segment-wise performance…
  FY04 % of total FY05 % of total Change
Revenue 60,094 66.8% 75,828 68.9% 26.2%
PBIT 13,794 82.8% 16,653 79.6% 20.7%
PBIT margin 23.0%   22.0%    
Revenue 29,806 33.2% 34,231 31.1% 14.8%
PBIT 2,861 17.2% 4,277 20.4% 49.5%
PBIT margin 9.6%   12.5%    
Revenue 89,900   110,059   22.4%
PBIT 16,655   20,930   25.7%
PBIT margin 18.5%   19.0%    
* Excluding inter-segment adjustments

Now, if one were to look at the right hand chart below, the implications of having a strong order inflow are clearly seen. BHEL's FY05 sales are around 50% of its FY05 received orders. Engineering companies generally have an order conversion cycle of 18 months and this indicates that BHEL has already secured a strong revenue flow for at least the next two years.

In line with the country's plans of putting up around 32,000 MW of generation capacity during the 10th five year plan (2002-07), the company is gearing up to enhance its annual manufacturing capacity from the present 6,000 MW to 10,000 MW by FY07. This would involve an investment of around Rs 8-10 bn. BHEL's installed capacity has grown YoY by 5% to 74,780 MW, and it has maintained its share of 65% of the country's total installed capacity of 115,356 MW.

Industry segment leads margin expansion:  Despite a rise in raw material costs from 46% of sales in FY04 to 52% in this fiscal, the operating margins for FY05 have expanded by nearly 170 basis points. This has been made possible by a 300 basis points fall in staff costs as percentage of sales. Manpower rationalisation owing to the recent VRS has led to staff costs decline in the fiscal. Other expenses and excise costs have also declined during the year. Based on segments, the power business has seen its PBIT margins decline from 23% in FY04 to 22% in FY05, industry margins have improved by almost a 300 basis points to 12.5%.

Margin expansion aids bottomline growth:  The strong growth in 4QFY05 and FY05 net profits has been made possible essentially by the expansion in margins. The growth in the bottomline would have been higher but for a muted other income component and higher tax outgo during both the periods.

What to expect?
At the current price of Rs 800, the stock is trading at a price to earnings multiple of 19.5 times FY05 earnings and a price to sales of 1.8 times FY05 sales. 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 FY06 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.

Moreover, recently, NTPC had decided to do away with the preference that was given to PSUs under the purchase preference policy of Government, which lapsed on March 31, 2005. As per the policy, PSUs like BHEL were given a 10% price preference when bidding for contracts. Thus in competition to private players, PSUs were preferred if they fell in this 10% price band. One of the objectives of the policy was to provide support to ailing PSUs by enabling them to execute the contract even though their bids were not the lowest. The revocation is thus likely to affect companies like BHEL, which are large equipment suppliers to power plants of NTPC. Investors should keep this in mind.

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