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Suzlonís purchase of REpower: Our view - Views on News from Equitymaster

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Suzlonís purchase of REpower: Our view

May 25, 2007

Indian wind energy equipment major, Suzlon Energy, has won the bid to acquire the German REpower Systems AG, one of the leading players in the wind turbine manufacturing industry. Importantly, Suzlonís offer exceeds Arevaís (currently the largest shareholder in REpower, and which opted out of the race yesterday) offer price by 7% (Suzlonís final bid was at Euro 150 per share against Arevaís Euro 140 per share). 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. Suzlon is now reported to hold 60% stake in REpower through its direct and indirect (Areva) holdings. It further expects around 15% stake to come into its fold over the next few days through the offer that it has made to other shareholders in REpower. The management has indicated of a Euro 250 m initial outflow for this acquisition, out of which it has already invested Euro 150 m for a stake of around 7%. At Euro 150 per share, Suzlonís bid for REpower has been valued at Euro 1.2 bn (US$ 1.6 bn).

The deal is structured like this Ė

  • Suzlon currently holds around 30% stake in REpower through its holding in the special purpose vehicle (SPV) with Martifer as also the 7% stake that it had recently bought;

  • Areva has agreed for a ĎPutí option, whereby it can sell its current stake of 30% in REpower to Suzlon anytime after 1 year, at a fair value that will be determined by independent agencies later. As a matter of fact, whenever Areva decides to sell this stake after 1 year, it can only do so to Suzlon;

  • Suzlon has the option to buy out Martiferís 25% stake in REpower anytime after a period of 2 years;

About Suzlon Energy
Suzlon Energy is Asia's leading manufacturer of wind turbine generators (WTGs) having over 50% share of India's domestic installations in FY07. 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.

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 REpowerís 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.

Whatís in the deal?
As for REpower, the company has faced supply constraints on the gearbox front. We believe this issue will be solved through Suzlonís acquisition of the company. This is because Suzlon already owns Hansen Transmission, which is one of the worldís 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-ŗ-vis its peers, and this very advantage shall now flow in to REpower.

Suzlonís management has broadly classified a few of its priorities post this acquisition of REpower:

  • Increase the volume growth for REpower by providing adequate support with respect to component supply Ė As a matter of fact, REpowerís low margins (2.6% EBIDTA margins in 2006) are largely a result of high cost of inputs, which form around 84% of the companyís total sales);

  • Accelerate growth in the offshore market, where REpower is already an established player;

  • Integrate product portfolio as also the R&D technologies Ė Suzlon has competencies in component technology while REpower specialises in turbine technology;

  • Strive for improvement in REpowerís margins and bring them to double digit levels over a period of 3 to 4 years

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 formerís profitability to improve from the current levels (2.6% EBIDTA margins in 2006).

REpower: Financial performance snapshot
(Rs m) CY05 CY06 Change 1QCY06 1QCY07 Change
Sales 335 462 37.7% 89 125 41.2%
Operating profit margin (%) -3.4% 2.6% 2.2% 0.7%
Net income (7) 7 -204.5% 1 0 -97.1%
Net profit margin (%) -2.0% 1.5% 0.9% 0.0%
Source: REpower

For Suzlon, REpowerís 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, post this acquisition of REpower, Suzlonís 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.

What to expect?
Suzlonís stock has recorded strong gains in todayís trade, and currently trades at a multiple of 18.3 times our estimated FY09 earnings. Considering the FY07 performance and the medium term challenges with respect to aggressive capex, we have already downgraded our profitability estimates for the company for FY08 and FY09, while largely maintaining our topline estimates. As for valuations for the REpower deal, Suzlon's offer of Euro 140 per share values the former at Euro 1.2 bn (US$ 1.6 bn). This values the company at a multiple of 28.6 times REpower managementís estimated CY08 earnings, which we believe is fair considering the strong growth opportunities for Suzlon that REpower shall bring.

With strong demand for wind turbines expected from China, the US and India over the next few years, we are positive on Suzlonís long-term growth prospects. We maintain our positive recommendation on the stock from a 2-3 years perspective. However, investors need to be wary of challenges that the company might face in terms of integrating REpower with itself as also maintaining profitability over the next 2-3 years.

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