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Rel. Energy: Sales enthuse, margins fuse!
Jul 19, 2006

Introduction to results
Reliance Energy has announced mixed results for the first quarter of FY07. The company has reported robust topline growth on the back of strong performances by both the electrical energy and EPC businesses. However, operating margins have come under pressure due to substantially higher other expenses. Higher cost of materials and sub-contracting in the EPC division has also dented the overall profitability during 1QFY07. However, higher other income and lower depreciation expenses have brought some respite to the bottomline.

Financial performance: A snapshot…
(Rs m) 1QFY06 1QFY07 Change
Sales 9,497 11,549 21.6%
Expenditure 7,882 10,214 29.6%
Operating profit (EBDITA) 1,615 1,334 -17.4%
Operating profit margin (%) 17.0% 11.6%  
Other income 1,348 1,711 27.0%
Interest 433 459 6.0%
Depreciation 817 619 -24.3%
Profit before tax 1,712 1,967 14.9%
Tax 146 201 38.1%
Profit after tax/(loss) 1,567 1,766 12.7%
Net profit margin (%) 16.5% 15.3%  
No. of shares 195.3 212.3  
Diluted earnings per share (Rs)*   31.6  
P/E ratio (x)*   13.6  
* On a trailing 12-month basis

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 Mumbai licensed region contributes to almost 85% of the company’s electricity sales. The company has an installed generation capacity of 941 MW, with 500 MW installations at Dahanu near Mumbai. The company also has a presence in the engineering, procurement and construction (EPC) business (21% of 1QFY07 revenues). During the period between FY01 and FY06, Reliance Energy has grown its revenues and net profits at compounded rates of 8% and 9% respectively.

What has driven performance in 1QFY07?
All charged up: The strong 22% YoY growth in Reliance Energy’s topline during the quarter has been a result of robust performance in both the business segments. While the electrical energy segment grew revenues at 18% YoY, the EPC business reported a 45% YoY growth. Performance of the electrical energy business was buoyed mainly by higher realisations, which seem to have grown by around 14% YoY. Volume sales for the segment increased by 3% YoY, from 2,161 m units (MUs) in 1QFY06 to 2,229 MUs in 1QFY07. Higher sales were propelled by both greater generation at Dahanu and power purchased from Tata Power. As a matter of fact, the Dahanu thermal plant operated at a PLF (plant load factor, or capacity utilisation) of 104.3% during the quarter, against 102.9% during 1QFY06. As for purchases from Tata Power, Reliance Energy bought 1,148 MUs during 1QFY07, against 1,067 MUs purchased in 1QFY06. Notably, Reliance Energy is one of the major customers of Tata Power, and buys almost 30% of the units that the latter sells to outside parties in Mumbai (including railways and BEST).

With a view of curbing its dependence on external sources (like Tata Power) and also to grow otherwise, Reliance Energy has out in an aggressive capital expenditure plan, towards setting up large generation capacities in the next 4-5 years. These include a 3,000 MW gas-based project in Uttar Pradesh (one phase of the larger project of 5,000 MW) and a 1,400 MW gas-based project in Maharashtra. 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 and Mumbai.

Segment-wise performance…
  1QFY06 1QFY07 Change
Electrical Energy
Revenue 7,909 9,340 18.1%
% share 82.5% 79.4%  
PBIT margin 9.9% 14.2%  
EPC and Contracts
Revenue 1,676 2,422 44.5%
% share 17.5% 20.6%  
PBIT margin 7.1% 6.2%  
Total*
Revenue 9,585 11,762 22.7%
PBIT margin 9.4% 12.6%  
* Excluding inter-segment adjustments

As for the other business segment of EPC, strong revenue growth in the same has been on the back of ongoing execution of the huge order backlog that the company has built up. At the end of 1QFY07, the segment’s backlog stood at around Rs 33 bn, to be executed within the next 18-24 months. Except for the last quarter (4QFY06), the performance of the EPC division has been strong over the past few quarters. The poor performance during 4QFY06, as indicated by the management, was due to delay in completion of some projects, which seem to have been taken care of during 1QFY07.

Electrical energy drives margins: Higher growth in realisations vis-à-vis cost of power purchased has benefited Reliance Energy in terms of improving the electrical business’ PBIT margins from 9.9% in 1QFY06 to 14.2% in 1QFY07. Cost of fuel has also witnessed a marginal decline. On the EPC front, higher cost of materials and sub-contracting has dented PBIT margins by 90 basis points, to 6.2% during 1QFY07. On an overall basis, significantly higher other costs (made up of general, distribution and administrative costs) have more than offset the decline in power purchase, fuel and staff costs, thus leading to a sharp decline in the company’s operating margins during 1QFY07.

All falls to the bottomline: The sharp contraction in operating margins during the quarter has flowed down to the bottomline, where growth has underperformed the topline growth by a large margin. Even lower depreciation expenses have failed to enhance the net profit growth during 1QFY07.

What to expect?
At the current price of Rs 430, the stock is trading at a price to earnings multiple of 10.2 times our estimated FY08 earnings, which we believe is attractive from a long term investment perspective. The results have been a mixed bag considering that while the strong growth in topline, especially the good performance of the electrical energy segment, has been a positive, the sharp contraction in margins raise doubts about the company’s cost control initiatives.

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