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BHEL: ‘Ultra-mega’ hopes!

Oct 30, 2006

Performance Summary
Public sector power generation equipment major, BHEL, announced strong results for the second quarter and first half ended September 2006 late last week. For 2QFY07, while topline has grown by 32% YoY, backed by higher other income and stable interest and depreciation cost, bottomline growth has been higher at 38% YoY. Stock related adjustments have, however, impacted operating margins, which have contracted by 80 basis points (0.8%) for the quarter.

Financial performance: A snapshot
(Rs m) 2QFY06 2QFY07 Change 1HFY06 1HFY07 Change
Sales 27,878 36,654 31.5% 49,021 65,527 33.7%
Expenditure 24,188 32,091 32.7% 43,616 57,782 32.5%
Operating profit (EBDITA) 3,690 4,563 23.7% 5,405 7,745 43.3%
Operating profit margin (%) 13.2% 12.4%   11.0% 11.8%  
Other income 1,057 1,699 60.7% 1,987 2,900 45.9%
Interest 133 135 1.5% 256 267 4.3%
Depreciation 624 667 6.9% 1,200 1,305 8.7%
Profit before tax 3,990 5,460 36.8% 5,936 9,073 52.8%
Tax 1,388 1,860 34.0% 2,056 3,106 51.1%
Profit after tax/(loss) 2,602 3,600 38.4% 3,880 5,967 53.8%
Net profit margin (%) 9.3% 9.8%   7.9% 9.1%  
No. of shares       244.7 244.7  
Diluted earnings per share (Rs)*         77.1  
P/E ratio (x)*         31.7  
* On a trailing 12-month basis

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 73% of the company's total revenues, with the remaining being contributed by the industrial segment. The company has strong ties with the power generation major, NTPC, and historically, has bagged over 70% of the contracts floated by the former. During the period between FY01 and FY06, BHEL’s sales and net profits have grown at compounded rates of 19% and 40% respectively.

What has driven performance in 2QFY07?
Orders come pouring in: Strong accretion to the order book combined with execution to the already bulging backlog, has helped BHEL’s power division rake in a superior performance during 2QFY07. Sales for the segment have grown by 29% YoY, and the contribution to total sales now stands at 73%. Major project wins in the Power segment during 2QFY07 include:
  • Two thermal power projects in Rajasthan, valued at Rs 8.4 bn, for setting up a 250 MW unit at Suratgarh and a 195 MW unit at Kota. The gestation period of the contracts is 24 months.

  • Contract for setting up a 500 MW thermal power plant in Uttar Pradesh, valued at Rs 12.2 bn. The contract will be executed over a period of around 36 months.

  • Another contract for setting up a 500 MW thermal power plant in Uttar Pradesh, valued at Rs 12.2 bn. This contract will also be executed over a period of around 36 months.

Segment-wise performance…
(Rs m) 2QFY06 2QFY07 Change 1HFY06 1HFY07 Change
Revenue 21,080 27,141 28.8% 37,167 48,968 31.8%
% share 73.2% 72.3%   73.4% 73.0%  
PBIT margin 20.0% 21.3%   17.2% 20.2%  
Revenue 7,713 10,399 34.8% 13,487 18,106 34.2%
% share 26.8% 27.7%   26.6% 27.0%  
PBIT margin 14.9% 12.2%   11.8% 9.0%  
Revenue 28,793 37,540 30.4% 50,654 67,074 32.4%
PBIT margin 18.6% 18.8%   15.7% 17.2%  
* Excluding inter-segment adjustments

Apart from the abovementioned contracts in the Power segment, the company has also bagged Rs 9.5 bn order from Bharat Oman refinery Limited, for setting up a 99 MW captive power plant in Madhya Pradesh (this order forms part of the Industry segment of BHEL). Importantly, this is the highest-value single order for a captive plant for BHEL and indicates the growing clout of the company amidst increasing competition in the Industry segment from other domestic and MNC generation equipment makers.

At the end of September 2006, the company’s order backlog stood at Rs 457 bn, which is over three times the company total sales in FY06, and 16% higher than the backlog at the end of 1QFY07. In line with the huge anticipated demand for setting up generation capacities in the tenth (2002-07) and eleventh (2007-12) five-year plans, BHEL is in the process of expanding its annual capacity from 7,700 MW currently to 10,000 MW. However, it is important to note that this is largely a two shift capacity while the company has also included a third shift for certain critical tools, in order to meet its contractual obligations.

BHEL has already taken necessary steps to cater to the likely demand for the next higher rating 800 MW thermal sets (through a technology transfer agreement with the French power equipment major, Alstom) and is actively looking at opportunities in ultra mega projects with various project developers. As a matter of fact, the government has identified eight ultra mega power projects, which are to be executed within the next five to seven years. Each of these projects would have five units of 800 mw each (total of 4,000 MW per project). Consequently, there could be demand of almost 40 such units (of 800 MW) using super critical technology over the next few years. BHEL’s proactiveness in its agreement with Alstom will, thus, go a long-way in helping the company place itself on a stronger ground in bidding for these ultra mega projects.

In addition, the company is also gearing up for 700 MW and higher rating nuclear sets, besides shoring up its capability for higher rating hydro sets and advanced class gas turbines to cater to upcoming market requirements. All these factors are likely to be key growth drivers for the company going forward.

Stock adjustments dent margins: Despite lower staff and raw material costs, BHEL’s operating margins took an 80 basis points (0.8%) hit during 2QFY07, largely due to stock related adjustments. The company, however, continues to benefit from reducing staff costs (as % of sales) on the back of its voluntary retirement scheme for excess employees. Based on segments, while PBIT margins for the Power division expanded from 20% in 2QFY06 to over 21% in 2QFY07, those for the industry segment contracted by 270 basis points (2.7%) to 12.2%. We estimate the company to earn operating margins of 17.8% in FY07 (17.6% in FY06) and the performance for the first half indicates that the company is moving in that very direction.

Higher other income aids bottomline: Despite the contraction in operating margins, BHEL’s net margins expanded by 50 basis points to 9.8% during 2QFY07. This was made possible by higher other income and stable interest and depreciation costs. The profitability performance for the first half has been even better, aided also by higher operating margins.

What to expect?
At Rs 2,447, the stock is trading at a price to earnings multiple of 31.7 times its trailing 12-months earnings. However, while the valuations stand at 20.2 times our estimated FY08 earnings, we shall have to revise upwards our growth numbers for BHEL, while keeping the profitability margin estimates intact. The stock has outperformed our estimates in the past, mainly due to our conservatism on the growth front. However, with more clarity on the company’s growth prospects and some real action actually being witnessed on ground in the power sector, of which BHEL will be a direct beneficiary, we shall have to revise upwards our growth targets for the company.

However, we continue to stand by our valuation argument that investors need to consider the execution risks involved with engineering stocks as contracts period are of very long duration and any adverse change in the economic or political environment can led to pressure on performance deliveries. Assigning higher P/E valuations to engineering companies (by using the PEG ratio) just because they have strong order backlog and thus robust earning prospects shall be a no-no!

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