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BHEL: Visit note
Sep 30, 2005

We had recently met up with the management of BHEL, India’s largest public sector engineering company, to gain a first hand understanding of the company’s long-term growth strategy and outlook for the Indian power equipment sector. Here are the extracts of the meeting.

Key extracts
On bridging technology gaps: In order to counter the competitive pressures applied by large domestic and MNC engineering players, BHEL is on a rapid expansion drive that is also being accompanied by absorption of cutting edge technologies through global tie-ups and internal R&D. The company plans to raise its manufacturing capacity from 6,000 MW to 10,000 MW by FY07 and is presently pursuing R&D in emerging technologies like fuel cells.

On competition: The management has indicated that while the company is competing with the American and European players on price, it counters competition from Chinese manufacturers on quality terms. However, there is a fear that China might pose competition on quality as well in the future and this has led the company to increasingly scout for latest technologies. BHEL is restricted to enter some of the markets in the Euro zone. On enquiring, the management indicated that this was on the basis of the fact that the company was not allowed to source clients in regions from where it imported technologies.

On efficiency gains: The management indicated that while economies of scale have helped the company reduce its overhead costs in the past, employee rationalisation and cash conversion factors have helped it shore up its profitability in recent times. And this is expected in the future as well. The company has been consistently shedding its employee base, from 54,000 employees in FY00 to 44,000 in FY05, and this has seen its employee productivity grow at a CAGR of 16% during the said period. It must also be noted that the APDRP scheme is likely to help companies like BHEL clean up and strengthen their balance sheets. A case in point is the reduction in debtor days of the company, which declined from 245 in FY00 to 200 in FY05. When enquired of the still high levels of receivable days, the management indicated that the company has to book revenues on equipment sales as soon as these leave the factory premises and are delivered at the buyer’s site. And since it takes a long time in this delivery process, debtor days are elongated.

On international foray: The management indicated its plans of aggressively targeting global markets for growth. BHEL is specifically eyeing the West Asian and African markets. The company had recently reported winning two large orders in the international markets. The first was a US$ 100 m contract for setting up a 120 MW co-generation plant in Indonesia and the second was a US$ 207 m contract to build two power projects in Oman. Export revenues formed around 23% of BHEL’s total revenues in FY05, and we expect them to reach 25% of sales by FY08. BHEL’s exports are estimated to grow at a CAGR of nearly 19% during the period FY05 and FY08.

On relationship with NTPC: Around 40% (or around Rs 130 bn) of BHEL’s existing order backlog is from the PSU power sector major, NTPC. Considering NTPC’s large expansion plans, BHEL‘s relationship with the company will be promising in the long run. As a matter of fact, from the current levels of 23,749 MW, NTPC is planning to raise its generation capacity to 30,000 MW by the end of FY07 and to 46,000 MW by the end of FY12. However, investors should note that contracts from NTPC are garnered only after an intensive international competitive bidding. So, considering the alterations made to the purchase preference policy arrangement, BHEL will have to further improve its competitiveness to maintain the flow of orders from the power major.

On rate of attrition: Attrition rate in BHEL has been indicated to be ‘surprisingly low’ by the management. This is a positive considering the mass scale exodus of key people from other engineering companies towards MNC players. We believe that people, especially from the design department, are core to the engineering business as it involves key technological skill-sets. In our interaction with some engineering companies, the managements have indicated their fears about losing key personnel to competition. Unlike the past, most of the global engineering majors are looking at India and China for growth opportunities, and competition for talent, in this sense, is only going to increase for BHEL. Whether BHEL has the wherewithal to sustain low attrition levels remains to be seen.

On vision for the future: The management visualizes BHEL to be a key global engineering player in the future and is planning technology tie-ups and acquisitions to bring this vision to fruition. It has, however, not specified whether the acquisition will be of an Indian company or a foreign one. The company has embarked on an aggressive capacity expansion drive and is likely to spend Rs 10 bn in the next few years towards the same.

What to expect?
We had earlier recommended a ‘Sell’ on BHEL in August 2005 at Rs 1,086. While the stock has gained almost 12% since then, we continue to believe that all the positives with respect to the company’s growth have been factored into the stock price. At the current price of Rs 1,215, the stock is trading at valuations of 17.8 times our estimated FY08 earnings and 2.0 times our estimated FY08 sales, which are at the higher end of the spectrum.

While we are positive about the continuation of reforms process in the Indian power industry, it is the pace at which the sector is growing that concerns us. In a recent meeting with NTPC’s management, we have been indicated that the government will miss its generation capacity plans by around 25% to 30% during the tenth and eleventh five-year plans. This is huge, considering the already existent electricity demand-supply mismatch in the country.

Background
Bharat Heavy Electricals Limited (BHEL) is India’s largest PSU engineering company catering to the power and infrastructure sectors. The company has a 25-year history of consistent profitability and manufactures over 180 products for industries like power generation and distribution, transportation, telecommunications and renewable energy. The company’s operations are organised around two major business segments – power (69% of FY05 revenues) and industry (31%). The company has around 44,000 employees and 14 manufacturing units. BHEL built sets account for around 74,500 MW, or 65% of India’s power generation capacity of 115,000 MW. During the period FY00 and FY05, BHEL’s net sales and profits have grown at compounded rate of 11% each.

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