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BHEL: Electrifying the future! - Views on News from Equitymaster
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BHEL: Electrifying the future!
Aug 1, 2005

Performance Summary
Public sector engineering major, BHEL (Research: BHEL), had recently announced its results for the first quarter of FY06. The company has reported strong growth in both topline and bottomline. Strong order backlog of the past and a robust order receipt of Rs 7.5 bn during the quarter helped the company rake in this superior performance. The operating margins have witnessed a strong 5% expansion.

Financial performance: A snapshot
Rs m) 1QFY05 1QFY06 Change
Sales 12,755 21,143 65.8%
Expenditure 12,358 19,428 57.2%
Operating profit (EBDITA) 397 1,715 332.0%
Operating profit margin (%) 3.1% 8.1%  
Other income 786 931 18.4%
Interest 125 123 -1.6%
Depreciation 509 576 13.2%
Profit before tax 549 1,947 254.6%
Extraordinary income/(expense) (179) -  
Tax 135 668 394.8%
Profit after tax/(loss) 235 1,279 444.3%
Net profit margin (%) 1.8% 6.0%  
No. of shares 244.7 244.7  
Diluted earnings per share* (Rs) 3.8 20.9  
P/E ratio (x)   47.5  
(* annualised)      

What is the company’s business?
Bharat Heavy Electricals Limited (BHEL) is India's largest public sector 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 1QFY06?
Power play:  The power business continues to lead topline growth from BHEL as it has witnessed a revenue growth of 77% YoY. Also, the segment has seen its revenue contribution increase from 68% in 1QFY05 to 74% in 1QFY06. The strong growth in revenues in this quarter was coupled with a continued robust inflow of orders to BHEL’s books. During the quarter, the company recorded an order inflow of Rs 7.5 bn, which took its order backlog to Rs 306 bn, almost three times its revenues of FY05. This order backlog also represents a growth of 9% over the backlog at the end of 1QFY05.

Segment-wise performance…
  1QFY05 % of total 1QFY06 % of total Change
Power
Revenue 9,114 68.1% 16,087 73.6% 76.5%
PBIT 1,167 97.1% 2,163 83.1%  
PBIT margin 12.8%   13.4%    
Industry
Revenue 4,268 31.9% 5,774 26.4% 35.3%
PBIT 35 2.9% 440 16.9%  
PBIT margin 0.8%   7.6%    
Total
Revenue 13,382 100.0% 21,861 100.0% 63.4%
PBIT 1,202 100.0% 2,603 100.0%  
PBIT margin 9.0%   11.9%    
* Excluding inter-segment adjustments

BHEL’s industry business, where the company is involved in setting up captive power units, has also witnessed a strong revenue growth of 35% YoY in 1QFY06.

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 in the Indian power sector is around 74,780 MW, and it has maintained its share of 65% of the country’s total installed capacity of 115,356 MW. Going forward, considering the huge investments lined up for the development of India's power industry, the order inflow is likely to grow and, to that extent, we are positive on the company.

Lower staff costs aid margin expansion:  BHEL’s staff costs declined from 30% of revenues in 1QFY05 to 20% of revenues in 1QFY06 and this has led the expansion in the company’s operating margins. Manpower rationalisation owing to the recent VRS has seemingly led to the decline in staff costs during the quarter. However, due to the rise in raw material costs (as % of sales) from 47% in 1QFY05 to 54% in the latest quarter, the improvement in margins has been pared to that extent. Based on segments, while the power business has seen its PBIT margins improve by 60 basis points, industry margins have expanded strongly by almost 7% (see table above).

Margin expansion aids bottomline growth:  The effect of a strong expansion in operating margins has flowed to the bottomline, which has grown strongly by 444% YoY during 1QFY06. The growth in the bottomline would have been higher but for a strong rise in tax outgo during the quarter.

What to expect?
At the current price of Rs 993, the stock is trading at a price to earnings multiple of 17.8 times our estimated FY06 earnings. Investors should note that business for engineering companies generally picks up momentum during the second half of the year and, as such, valuations based on first and second quarter earnings tend to be skewed, as can bee seen in the first table above.

BHEL continues with its growth march, benefiting from the high level of investments taking place in the Indian power sector. The company has also garnered a good reputation in the global markets considering its recent large wins in Indonesia (US$ 100 m order) and Oman (US$ 200 m order). As a market leader in the power business, we expect significant growth in the company’s power division in the next five years.

However, while the reforms that have been announced by the government for the improvement of the power sector indicate huge growth potential for engineering companies like BHEL, one needs to understand that the past track record of the government in executing the reforms process on the ground has not been too encouraging. The company's growth prospects, to that extent, depend on the pace of power sector reforms.

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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