Despite a SELL, Stock is unmoved

Most of the times, it is hard to find stocks with most of the analysts at sell and still the stock being nearly 50%-80% higher than the analysts price. When something of that shows up, it is really interesting to know what is supporting the price. In this case,the company in point being BHEL. As per my understanding BHEL is undergoing a "DHOOM" problem

 

1. Debtors Collection

2. High Operational Leverage

2. Order Cancellation possibility on slow moving orders

3. Order Inflows

4. Market sluggisheness

 

This in my opinion should have ideally lead to at-least a EV/EBITDA multiple compression and hence lower market prices. That however, does not appear to be the case.  So is there something that has been missed.

 

Though I don't disagree with BHEL contention that it is not something they are facing at an individual level, it is an economy wide phenomenon. The government has started initiating steps, but the real effect of these steps coming to action is some time away. 

 

I believe, the past order book levels are difficult to reach as during FY10-12 the order inflows comprised of huge private sector orders. Such interest has wanned considerably given the issues of fuel, land, clearances and distribution companies health being faced by such developers. I believe INR300bn-INR350bn would be a decent run rate to assume for order inflows. Moreover, even if the central government were to be strong, I still don’t see order inflows increasing to FY10-12 levels simply because the current PLF of power plants is low at 65%. So if the coal were to be actually available, it would first be used up to increase PLFs of existing plants. So, the real incentive for setting up new power plants has come down. 

 

In addition, the recent CERC guidelines for 2014-19 leave a meager 10-11% IRR over the life of the project for the thermal developer due to which NTPC may decide to go slow on projects. However, being a government enterprise they might not be able to do so. But if the project were to take longer than accepted, the IRR may drop to 9% at which point NTPC would be better putting its money in a FD without setting up any power project. Most of the SERCs follow CERC guidelines, hence even if the activity from the state generating utilities were to slow down, my expectation of INR300-350bn order inflow could be under threat. 

 

I believe at the order inflow run-rate expected the revenues would be closer to 300-350bn for the company. Given high operating leverage for BHEL, which is acting negatively on a muted revenue base, the margins may not increase more than 10-11%. The margins earlier when revenues were INR300-350bn were in the range of 18-20%,m so cant they get back to those margins again.

 

I don’t think that is possible over the medium term. BHEL completed a capacity expansion to 20GW from 15GW earlier, hired new people and has high fixed overheads. So, BHEL was ideally not prepared for a downturn but an upturn which has not happened and is not expected in the medium term. 

 

On Revenues of INR350bn, EBITDA would be 35bn, 10bn as annual capex. Assuming a 5% growth rate in sales and cash conversion cycle of 200 days. WACC of 11% for the company, the value should be nearly 300bn. 

 

However, if BHEL were to make margins of 13% in the long range and an overall cash conversion cycle of 200 days with rest all assumptions remaining constant. The value would be closer to INR500bn, the current valuation.  

 

 

Can BHEL really make 13% EBITDA margins over the long term. In my opinion after 4-5 years may be if they cut the over-head slack and employee slack. But not with INR350bn as revenue run-rate. So even if BHEL were to rationalise say employee costs over the next 3-4 years, the EBITDA could be more closer to 11-12% at which i believe the valuation would be INR355-420bn. 

 

So it all depends on the margin profile the management is able to show. 

 

In addition to my fixed cost theory of why margins cannot increase, there are other evidences which point to non-increase of margins. 

 

1. The order book is comprised of orders booked during FY11-13 which were taken at extremely competitive prices as competition was fierce. This could lower gross margins, though management says they have been able to de-package and indigenise components, To what level is it sustainable is questionable. But i still believe there is some merit because the current order book comprises of large 660-800MW orders. In such sets the surface area increases by square while volume by cube hence the raw material required for larger sets automatically decreases. Thus BHEL gross margins could still be protected but to what extent is the question. 

 

2. Management has been looking at areas other than Power like Railways, Solar PV for propelling growth indicating the growth is most likely to be slow in the power segment. The transformers space is a low margin segment and has large competition. So BHEL cannot compensate the lost margins from shift to this segment. Secondly against supply of BTG to generators, transformers are supplied to state discoms which are worse off financially. Hence the overall returns on the business might not be great. 

 

3. Also Railways is not such a good at payments, at-least this is what my experience with talking to some of the smaller players who supply to Railways suggest. But can BHEL alter that, may be. But I am not aware about the margins from such segment. Most likely they cannot be as lucrative as those in BTG space earlier as this space also has decent competition. 

 

I believe the analytical community is correct in its appraisal of BHEL. The valuations cannot be justified fundamentally until BHEL is able to rationalize costs. Should i short the stock. Possibly yes, but will I short it? No. Why? Because like BHEL I don't want to be leveraged. Though in my case it would be financially and not operationally.