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Rel. Energy: EPC drives top, dents bottom - Views on News from Equitymaster
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Rel. Energy: EPC drives top, dents bottom
Oct 20, 2006

Performance summary
Reliance Energy announced mixed results for the second quarter and half year ended September 2006. While the company has managed to rake in a strong growth in topline for both the periods, mainly helped by a good showing of the EPC business, net profit performance has failed to enthuse. On the back of sharp reduction in operating margins for both 2QFY07 and 1HFY07, the bottomline growth trails topline growth by a substantial margin. The doubling of EPC costs, as percentage of revenues, has impacted the margins during the quarter. Strong showing of the EPC business should be seen in light of its poor performance in 4QFY06, when some of the contracts were delayed in terms of their completion schedule.

Financial performance: A snapshot…
(Rs m) 2QFY06 2QFY07 Change 1HFY06 1HFY07 Change
Sales 10,394 14,076 35.4% 19,885 25,625 28.9%
Expenditure 8,406 12,301 46.3% 16,288 22,417 37.6%
Operating profit (EBDITA) 1,988 1,775 -10.7% 3,597 3,208 -10.8%
Operating profit margin (%) 19.1% 12.6%   18.1% 12.5%  
Other income 1,219 1,761 44.4% 2,573 3,374 31.1%
Interest 541 671 24.0% 974 1,130 16.0%
Depreciation 871 635 -27.0% 1,688 1,254 -25.7%
Profit before tax 1,796 2,230 24.2% 3,508 4,197 19.7%
Tax 200 366 83.1% 346 567 64.1%
Profit after tax/(loss) 1,596 1,864 16.8% 3,162 3,630 14.8%
Net profit margin (%) 15.4% 13.2%   15.9% 14.2%  
No. of shares       201.9 213.1  
Diluted earnings per share (Rs)*         32.7  
P/E ratio (x)*         14.0  
* 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 over 80% 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 (29% of 2QFY07 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 2QFY07?
EPC show the way: It was the engineering, procurement and construction (EPC) business of Reliance Energy that led the overall growth in topline during 2QFY07. The segment more then doubled its sales and, as result, increased its share in total revenues to 35.4% in 2QFY07 (22.7% in 2QFY06). It is important to note that EPC business is lumpy in nature and completion of contracts ahead/behind the schedule creates quarterly fluctuations. The similar thing happened with this segment in 4QFY06, when owning to delay in execution of some contracts, sales of the segment declined by 65% YoY. And seemingly, the execution of these very contracts has led to the company taking in lesser contracts in the first and second quarter of the fiscal. This is seen from the reduction in order backlog from Rs 33.0 bn at the end of 1QFY07 to Rs 23.7 bn at the end of 2QFY07. It is because of this fact that despite the strong performance from the division in 1HFY07 (sales up 83% YoY), we shall maintain our full year growth for the business at near 50% YoY.

Segment-wise performance…
  2QFY06 2QFY07 Change 1HFY06 1HFY07 Change
Electrical Energy
Revenue 8,203 9,160 11.7% 16,112 18,500 14.8%
% share 77.3% 64.6%   79.8% 71.3%  
PBIT margin 11.0% 11.4%   10.5% 12.8%  
EPC and Contracts
Revenue 2,408 5,030 108.9% 4,084 7,452 82.5%
% share 22.7% 35.4%   20.2% 28.7%  
PBIT margin 19.3% 4.6%   14.3% 5.2%  
Revenue 10,611 14,190 33.7% 20,196 25,952 28.5%
PBIT margin 12.9% 9.0%   11.3% 10.6%  
* Excluding inter-segment adjustments

As far as the electrical energy business is concerned, the growth, at 12% YoY, is lower than what was achieved in 1QFY07 (18% YoY). Growth in sales of this division during 2QFY07 has been made up of 9.2% YoY growth in volume sales (2,187 MUs) and 2.8% YoY improvement in tariff. Higher sales of electricity were propelled by both higher generation at Dahanu and greater amount of power purchases (largely from Tata Power). As far as tariff in Mumbai is concerned, considering the acute shortage of power owing to strong growth in demand and inadequate increase in supply, the Maharashtra Electricity Regulatory Commission (MERC) had recently passed an order allowing utilities in the region, like Reliance Energy and Tata Power to raise their tariffs across consumer categories. As for Reliance Energy, while the Commission raised the effective tariff (charged to all consumers, except those consuming less than 30 units per month) by around 30% for the period October 2006 to March 2007, the company has opted for a 10% hike but for an extended period of 18 months, i.e., October 2006 to March 2008.

Coming back to the 2QFY07 performance, the Dahanu thermal plant (500 MW, or 53% of the company’s total generation capacity) operated at a PLF (plant load factor, or capacity utilisation) of 99.2% during the first half of this fiscal, against 94% during 1HFY06. As for purchases from Tata Power, Reliance Energy bought 1,170 MUs during 2QFY07, higher by 5.4% over its 2QFY06 purchases. In its important to note that 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). And due to the relatively higher cost of generation at Tata Power’s Trombay plant, which largely uses the expensive liquid fuel (LSHS), the purchase cost for Reliance Energy has been on a rise over the past few quarters.

As a result of this rising cost of external purchases, and also to curb its dependence on an outside party, Reliance Energy has chalked out an aggressive capital expenditure plan, towards setting up large generation capacities in the next 4-5 years. These include a 4,000 MW gas-based project in Uttar Pradesh (one phase of the larger project of 8,000 MW) and a 4,000 MW gas-based project in Maharashtra. The managemnet has indicated that if gas for the Maharashtra project is not available within a specified price range of US$ 3.5 to US$ 4 per MMBTU, the company will work towards an alternate coal based plant of 1,200 MW to 1,400 MW at the same location. 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. While the company has adequate financial muscle to take forward a large of this planned expansion, fuel related issues (especially gas availability and pricing) is what we are cautious about.

EPC dents margins: While strong growth in EPC sales has driven Reliance Energy’s overall topline growth, its is the pressure on EPC margins that has impacted the overall margins during the second quarter. On the back of substantial rise in EPC costs, from 16% of sales in 2QFY06 to 32% in 2QFY07, the segment’s PBIT margins have contracted to 4.6% during the quarter (19.3% in 2QFY06). On the electricity front, growth in realisations and strong volume growth has benefited the segment, where PBIT margins have expanded, though marginally. While cost of electricity purchased has increased on a per unit basis, it has declined as percentage of sales due to relatively higher growth in realisations.

Lower margins, higher taxes hit bottomline: Despite the strong growth in topline, lower operating margins and rise in effective tax rate has led to the bottomline growth underperforming the growth in topline during both the periods. Even lower depreciation expenses have failed to enhance the net profit growth.

What to expect?
At the current price of Rs 457, the stock is trading at a price to earnings multiple of 10.8 times our estimated FY08 earnings. The results are almost in line with our FY07 estimates but for the EPC margin performance, which we may have to revise downwards. On an overall basis, while we expect capacity expansion to drive growth for the company’s electricity business going forward, there are challenges with respect to fuel availability and pricing, especially when a large part of the expansion is planned to be gas-based. On the EPC front, we expect this business to be a growth drivers for the company considering the large capex plans of several Indian industrial houses and the government’s infrastructure initiatives.

We shall soon update our research report on the company.

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