Small is beautiful. That certainly seems to be what investors think when they stack up Bharat Heavy Electricals (Bhel), India’s largest power equipment maker, and global heavyweights such as General Electric (GE), Siemens and ABB REG next to each other. Consider this: last year, Bhel registered revenues of $5.5 billion (Rs 26,234 crore). Global engineering giant GE clocked 30 times Bhel’s revenues; Siemens raked in 21 times as much, while ABB REG raked in 6 times the Indian company’s revenues. In terms of profits, GE’s were 21 times Bhel’s; Siemen’s was twice as much, while ABB earned four times as much.

Naturally, you would assume that their market capitalisation would be similarly larger than Bhel’s. You’d be wrong. GE is valued seven times over Bhel, while Siemens and ABB are quoted at just 3 and 2 times respectively over Bhel’s market cap. Sure, these companies do not have strictly comparable businesses but the difference in valuations is stark. So what makes Bhel so valuable? And can this premium really last?

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	Sales' ($ mn)	No. of times Bhel’s sales	Net profit’	No. of times Bhel’s profit	Market cap	No. of times Bhel’s m-cap
BHEL	5,549	1	652	1	24,007	1
Shanghai Electric	7,412	1.34	302	0.46	13,950	0.58
L&T	8,417	1.52	794	1.22	20,357	0.85
ABB REG*	33,055	5.96	2,467	3.78	45,026	1.88
Mitsubishi Electric	40,716	7.34	135	0.21	15,660	0.65
Toshiba	73,926	3.32	-3,814	-	20,336	0.85
Hitachi	111,095	20.02	-8,747	-	10,088	0.42
Siemens AG-REG**	114,556	20.64	1,399	2.14	79,628	3.32
General Electric*	169,945	30.63	13,516	20.72	168,223	7.01

Source: Bloomberg;
'Trailing 12 month ending June 2009 quarter; * year ended December; ** Year ended September

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For sure, there are a couple of things going for Bhel. A major differentiating factor for the PSU and its global rivals is former’s superior profitability and strong balance sheet. The Indian company’s balance sheet has a near-zero debt level, cash worth $2 billion in its coffers and stunning return ratios with return on capital employed (ROCE) at 30 per cent. Combine that with the fact that the global giants operate in mainly developed markets that are not experiencing the turbo-charged growth seen in India and it becomes easy to see why Bhel is placed in a different league as far as market caps are concerned.

Bhel’s balance sheet has a near-zero debt level, cash worth $2 billion in its coffers and stunning return ratios with ROCE at 30 per cent

But then, isn’t it possible that those international giants could step into India and wipe that smile off the faces of Bhel’s investors? After all, they, admittedly have the superior technology. So far, that’s been easier said than done. A key reason is that power capacity expansion had been terribly sluggish until recently and not worth the time or resources of foreign companies. Also, the expansion was mainly undertaken by NTPC and other government-owned enterprises thus favouring Bhel.

Now that growth in the sector has picked up by several notches and also has been opened up to the private players, they can no longer afford to say ‘not interested’.

Today, every company, big and small, wants to grab a slice of the action in the power sector as the country plans to crank up power capacity on an ambitious scale. India faces a power deficit of around 10 per cent and a peak power deficit of over 12 per cent and the inadequate power supply, it is believed, will soon create hurdles in sustaining the country’s growth beyond the 8-9 per cent mark. The Integrated Energy Policy recommends that India’s power generation capacity be raised six-fold, to 9,60,000 megawatts (MW) by 2030 from 1,50,000 MW currently to sustain 9 per cent growth in gross domestic product. No wonder then, there is a frenzied rush to improve power generation capacity.

The aim is grandiose. The government is targeting adding more than 78,750 MW in the 11th Plan (2007-12) and 82,000 MW in the 12th Plan. It’s highly ambitious given that the country managed to add only about 19,000 MW and 21,000 MW in the earlier two five-year Plans respectively. “Now we need to add 20,000-25,000 MW every year under the 11th and 12th plan,” points out an official from one of the country’s largest private-sector power producers.

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Narrowing gap

Between 2000 and 2009, Bhel’s market capitalisation has grown 42 times compared with Siemens’ 1.1 times

	Market capitalisation ($ mn)						Debt-equity ration (x)
	Oct 2000	Over BHEL (x)	Oct 2006	Over BHEL (x)	Oct 2009	Over BHEL (x)	OFY09/CY08
BHEL	567	1	12,332	1	24,007	1	0.01
L&T	922	1.6	7,555	0.6	20,357	0.9	0.79
General Electric*	5,84,028	1,029.3	372,673	30.2	1,68223	7	2.90
Shanghai Electric	-	-	4,105	0.3	13,950	0.6	0.09
Siemens AG-REG	72,469	127.7	76,554	6.2	79,628	3.3	0.52
ABB REG	30,083	53.0	28,833	2.3	45,026	1.9	0.17
Hitachi	38,639	68.1	19,628	1.6	10,088	0.4	0.59
Toshiba	26,688	47.0	20,834	1.7	20,336	0.9	1.02
Mitsubishi Electric	17,959	31.6	18,068	1.5	15,660	0.7	0.41

BHEL will continue to trade at a premium to its global peers. However, this gap is expected to shrink in the long term

	Price	Currency	P/E (x)		P/BV		EV/Ebitda
			FY10E	FY11E	FY10E	FY11E	FY10E	FY11E
BHEL (March ended)	2,342	Rs	26.1	21.2	7.1	5.7	17.0	13.4
L&T	1,655	Rs	28.6	23.4	6.0	4.8	20.9	17.0
General Electric*	15	$	15.8	17.3	1.5	1.4	20.3	18.4
Shanghai Electric	4	HKD	Loss	18.9	1.9	1.8	19.3	17.5
Siemens AG-REG**	60	Euro	12.5	13.1	1.9	1.7	7.2	7.6
ABB REG	20	CHF	17.8	19.3	3.7	3.4	8.8	9.4
Hitachi	269	Yen	Loss	26.4	1.0	1.0	5.5	4.5
Toshiba	431	Yen	Loss	20.1	2.4	2.2	7.3	5.5
Mitsubishi Electric	655	Yen	Loss	23.2	1.6	1.5	7.5	5.8

Source: Bloomberg;
Price as on October 5; *Year ended December; ** Year ended September

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According to estimates by Emkay Research analyst Ajit Motwani, private utilities or independent power producers (IPPs) such as Tata Power and Reliance Power are likely to add about 23 per cent of the planned capacity under the 11th Plan. This is likely to go up to 40 per cent under the 12th Plan. That throws up a sizeable opportunity of 37,000 MW, worth Rs 73,600 crore, for the private sector.

To meet this huge demand for power generation capacity, India will have to simultaneously and substantially augment the capacity of critical power equipment – boiler, turbine and generator (BTG). BTG are the critical pieces of equipment used to generate power, particularly from coal. When coal is pulverised (crushed to power or pounded) and then burned in a furnace with a boiler, the furnace heat converts boiler water to steam, which is then used to spin turbines (a sort of fan) which in turn, generates electricity.

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Good going

Analysts expect robust topline growth and stable margins despite competitive pressures

in Rs cr	FY09	FY10E	FY11E
Revenues	26,234	30,509	38,136
Change (%)	35.9	16.3	25.0
Operating Profit	3,801	4,996	6,910
Change (%)	5.4	31.4	38.3
OPM (%)	14.5	16.4	18.1
Net profit	3,138	4,275	5,237
Change (%)	9.7	36.2	22.5
NPM (%)	12.0	14.0	13.7
EPS (Rs)	64.1	87.4	107.0
P/E at Rs 2,342	36.5	26.8	21.9

Source: Analysts Reports

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For the past four decades, Bhel has dominated the equipment market and even now, it boasts a market share of 60-65 per cent. Its current installed capacity of 10,000 MW puts it in an enviable position because the business potential is far greater than what it can service so getting orders is not an issue for the company. Currently, the company is sitting pretty on an order book of four times revenues which explains the premium valuation its shares enjoy. The key will be how it manages to execute those orders.

Bhel stock has gained about 70 per cent in the past one year

Also, it’s not just the current order book position but whether the company manages to bag more orders as it goes along and more importantly maintain its profitability as competition intensifies from various fronts – Local rivals such as Larsen & Toubro tying up with foreign players with a technology edge and the Chinese’s low-cost advantage. India will need all the power equipment suppliers it can get to meet the targeted power generation. Thus, this rush of competition will throw up winners and losers. “Over the next 3-4 years, India will have 4-5 main power equipment players with a capacity of over 25,000 MW,” says R V Shahi, ex-chairman and managing director of BSES (now Reliance Infrastructure) and a former power secretary. That’s why there are growing doubts about the sustainability of Bhel’s premium market valuations.

Competition calling

Bhel may have had the field mostly to itself so far. At the moment foreign companies have an almost negligible presence in India, a legacy of the small power capacity additions that happened in earlier years. That will change quickly. “Now more power projects are coming in larger capacity 800 MW,” says Hitesh Kuvelkar, associate director of research at First Global. “In the above-500 MW category, Bhel has competition. The company currently dominates the sub-500 MW market, which is comparable to Maruti’s leadership in small cars.” The ascent of competition is already visible. Convinced by the huge opportunities embedded in power, engineering giant Larsen and Toubro has spoken of focusing on this sector. In pursuit of this goal, it’s sewn up a joint venture with Japan’s Mitsubishi Heavy Industries (MHI) for manufacturing boilers and turbines. Similarly, there have been three other JVs: Alstom and Bharat Forge, JSW and Toshiba and Ansaldo Caldie and GB Engineering. Consequently, roughly 23,000-25,000 MW of power equipment capacity is expected to come up over the next 4-5 years, even as Bhel (which also has a JV with NTPC) itself ups capacity, says a Citigroup Global Markets report released in August.

According to market experts, L&T’s JV with MHI will make it the biggest rival to Bhel. The L&T JV has already raced past Bhel in bagging super-critical orders. Out of the four projects recently awarded by MAHGENCO, JP group, APGENCO and NTPC, the first two (3,300 MW) were bagged by L&T while the rest (2,920 MW) were won by Bhel. The L&T-MHI combine will set up 4,000-6,000 MW capacity in India, which is expected to become operational by 2015.

Even in the bulk tender order of 7,260MW worth Rs 21,000 crore for 11 units to be handed out by NTPC (for 9 units) and Damodar Valley Corporation (2 units) under the 12th Plan, some analysts believe Bhel will face a tough fight from Larsen for emerging as L1, the lowest-cost bidder, although B P Rao, the new chairman and managing director of Bhel is confident that the company will be able to counter it. The tender bids will be invited soon and the winner will be announced in March 2010.

Again, industry and market experts do not see an immediate threat. “Except for L&T, the other joint ventures are at a land acquisition stage or at the memorandum of understanding stage and thus will take time,” says Bhel, ex-chairman, Ravi Kumar. A point noted by analysts as well. “You need at least five players for there to be real competition,” says First Global’s Kuvelkar. In addition, Bharat Forge has no experience in power sector, while JSW lacks experience in the power equipment space, he adds. That’s why experts like Shahi believe that “Bhel will have its plate full in terms of orders.”

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Heating up

New capacities are coming up in India, giving competition to Bhel

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The Chinese threat

Until now, Chinese competition hasn’t been much of a threat to Bhel as majority of the power capacity additions in the past have been driven by the government sector. According to research by Crisil and Asian Markets Securities, out of the total 73,462 MW BTG orders placed for the 11th Plan, 58 per cent has gone to Bhel while an equal share of 21 per cent each has gone to Chinese and other international players.

Of the 48 super-critical equipment orders placed so far, 28 have gone to China while only nine have gone to India

However, going ahead and in the 12th Plan, private players bring in a bulk of capacity additions. And they seem to prefer Chinese equipment as these boast of large capacities, which ensures timely delivery (in about 30 months). More importantly, Chinese equipment is typically 15-20 per cent cheaper than Bhel’s. Large private power producers such as Reliance Power, Adani Power, JSW Energy, Sterlite Energy and Lanco are sourcing power equipment from Chinese companies like Shanghai Electric, SCMEC (Sichuan Machinery and Equipment Corporation) and SEPCO-III (Shandong Electric Power Construction Corporation). While Sterlite is sourcing equipment for 2,400 MW, Adani Power is sourcing for 7,920 MW. It’s a similar story for Reliance Power (1,200 MW), Lanco (1,800 MW) and JSW Energy (1,200 MW). “More than half the orders for the 12th Plan have already been placed and most of these have gone to Chinese players,” says an analyst who did not wish to be named. That should be worrying for Bhel though the company is working on this front. For example, it secured more than 80 per cent of orders in the first half of this fiscal from the private sector.

In the meantime, Chinese equipment’s success rate has not been very satisfactory. “Chinese equipment doesn’t work efficiently on Indian coal and soil conditions,” points out Rao. One example of that is the collapse of the turbine blade at the Sagardighi thermal power project in West Bengal. Thus, experts are still divided on how big a threat the Chinese could be in the coming years.

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Going green

Super-critical technology, which emits less carbon, will see its share increasing in future power generation

Plan	Sub-critical	% share	Super-critical	% share	Total
10th	9,620	100	0	0	9,620
11th	45,470	89.3	5,420	10.7	50,890
12th	18,270	29.9	42,900	70.1	61,170
13th	4,000	7.1	52,560	92.9	56,560
14th		0	71,300	100	71,300

Source: CEA and Citi Investment Research

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On one hand, factors such as a domestic capacity build-up, a thrust on super-critical equipment ( as against China’s strength in sub-critical technology), unresolved quality issues over Chinese equipment and the clause on domestic manufacturing for bagging bulk orders from NTPC-DVC suggest Chinese can only go so far. On the flip side, Chinese companies have already helped to expand power capacity massively in their own country and are fast running out of growth options. “China has built up more than 6,00,000 MW of power capacity over the past many years,” says BSES, ex-chairman, Shahi. “So it’s unlikely the country will go in for any more rapid expansion like witnessed in the past.” The huge Indian market next door should be a natural port of call. “Overall, competition will increase and Chinese competition, which right now is subdued, will come back,” agrees Bhel’s Rao. As for all those vocal criticisms about sub-par Chinese quality, well, the power producers in China don’t seem to be making a fuss yet.

Super-critical, really

The pace at which Bhel adopts the new technology will also play a large part in how its future will shape up. Super-critical and ultra-super-critical technology is the most advanced thermal power technology used in the world today. With either technology, a power-generating unit operates under a mix of temperatures and pressures above the critical point at which the boundary of water’s liquid state and the vapour state disappears. By eliminating the process under which water transforms into steam, power units can markedly increase fuel efficiency. According to the London-based World Coal Institute, power plants that use super-critical generating units can improve energy efficiency by up to 46 per cent.

For ultra-super-critical plants, the improvement can be as high as 50 per cent. In an attempt to play its part in reducing greenhouse gases and mitigate the impact of climate change, the Indian government is encouraging the use of super-critical technologies in all new projects. The share of super-critical technology-based power projects is, therefore, expected to steadily rise from 10.7 per cent in the 11th Plan to 70 per cent in the 12th Plan to nearly 100 per cent in the 14th Plan.

Currently, super-critical technology projects make up about 20 per cent of Bhel’s order book. “For super-critical projects, Bhel has relatively less of an advantage over other players.” wrote CLSA, analyst, Rajesh Panjwani in a report in April. “This is likely to have a substantial impact on the company’s Ebitda margins in the medium to long term.” While competition from the ever-present Chinese companies is far lesser in the super-critical category, it would be a mistake to underestimate them, say experts. A Kotak Institutional Equities report on Bhel last month highlights the fact that out of the 48 super-critical equipment orders placed so far, 28 have gone to China while only nine have gone to India.

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Keeping the pace

Analysts believe maintaining robust order inflows will be a challenge for Bhel

in Rs cr	Sep-08	Dec-08	Mar-09	Jun-09
Order book	104,000	113,500	117,000	124,000
Y-o-Y growth (%)	45,43.3	45.5	39.6	30.5
Order inflows	14,800	16,000	12,900	12,600
Y-o-Y growth (%)	1.4	46.8	-5.8	-20.8

Source: Company, Analysts Reports

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However, the company is working towards the same. It is forging strategic alliances by way of JVs to leverage equipment sales in the super-critical technology domain, JVs for technology sourcing and sourcing critical inputs and equipments.

Derisking business

It’s not as though Bhel is not upping it ante. It’s working at expanding its array of offerings by developing higher-range equipment (over 500 MW) in the sub-critical and super-critical segments. It has already signed technology transfer agreements with Siemens (for turbines) and Alstom (for boilers). However, to take some of the risk out of its main operations, Bhel aims to build up its other businesses. “We will maintain a 70:30 share between the power and other business,” says Rao. In the transmission business, in which the PSU is a market leader for equipment up to 400 KV is searching for partners in the 765 KV and above category. It also supplies equipment and locomotives to the Indian Railways, and this business seems set to continue on its growth path. Bhel sees money-making potential in nuclear power, defense and renewable energy businesses and Rao says the margins in these are not that different from those seen in power. The company, is thus, planning to spend about Rs 2,400 crore in FY10 for its various businesses.

Experts believe the average 18 per cent that Bhel enjoyed in the past six years may be as good as it gets on the margins front

Challenges ahead

Until recently, up to 80 per cent of Bhel’s order book came from government orders. But private sector will ramp up faster going ahead. Bhel has won large orders worth Rs 18,280 crore for a total of 8,090 MW from big private-sector companies such as Hindalco, Jindal, Monnet Power and Avantha Group. “We expect the share of private players to be 40-50 per cent in the total order book in FY10,” says Bhel’s Rao. He expects the share of private players to keep on increasing. This will be a bit of a challenge because the company will have to match the lower prices quoted by rivals while maintaining the quality of its products. That’s why despite the private-sector wins in this fiscal, analysts want to wait a while to see what the eventual impact of going after private-sector clients will be for Bhel, especially on prices and margins. “The key challenges for Bhel will be the ability to expand much more at the right time, maintaining quality, upgrading technology, meeting delivery schedules, and creating the right construction and commissioning teams with skilled manpower,” says Shahi, who now runs an independent power consulting business.

Orderly growth

As it stands, Bhel’s order book is robust – Rs 1,24,000 crore at the end of the June quarter, four times FY10 estimated sales revenues. Going forward, the pressure to innovate, expand capacity, maintain market share and most importantly protect profitability will be quite high for the company. Analysts believe that it is inevitable that Bhel will end up losing market share although on an absolute basis, it might still witness growth as the overall market for power generation will expand.

Undeniably, in the next three to four years, the strong order book will keep revenues rolling in. So topline growth will not be an issue for the company. However, the chances of a moderate decline in profitability in the medium term seem more likely as Bhel adopts aggressive bidding tactics and price cuts forced by its competitors. Lower raw material costs are forecast to give some relief. The one possible area of a spike is employee costs -- the company is negotiating with the labour union over the implementation of the Sixth Pay Commission and could push up salary cost 15-20 per cent higher.

In the longer term, revenues will hinge on the pace of orders and the degree of pricing pressure, which Rao acknowledges will continue. “Over the next 2-3 years, we can expect heavy growth but after that the pace will slow down,” says First Global’s Kuvelkar. “Bhel is not going to have a four-years order book forever.”

Margins wise, two things don’t look good. First, Bhel will have to increase outsourcing and importing a larger proportion of most of its inputs to meet its order deadlines and ensure it supplies only top-notch super-critical based equipments to clients.

Second, increasing competition over time will make it that much harder to protect margins. That’s why many experts believe that the average 18 per cent Bhel enjoyed in the past six financial years may be as good as it gets on the margins front. And those good days may soon be over. That will, in turn, affect the high return ratios.

Market experts unanimously rate Bhel’s stock as fairly valued at 21 times FY11 estimated earnings, which is higher than its average historical one-year forward price-to-earnings multiple of 18-20 times. Bhel has already started trading at a discount to L&T’s 23 times FY11 estimated earnings; the reverse has been true in the past. A further de-rating of the stock cannot be ruled out.