Adani Power: Sell

Adani Power, set up just a few years ago, began with the right moves in the power generation business. It planned only coal-based projects (where operating risks are lower), invested in mines to fuel a portion of these projects, borrowed abroad to reduce cost of debt, and signed power purchase agreements (PPAs) to reduce cash-flow uncertainties. The company’s installed capacity as of September was 5,280 MW and is set to go up to 9,240 MW by next year — a blistering pace.

Yet, the stock has declined by 54 per cent since its initial public offering in October 2009 and 62 per cent below the price we recommended a ‘buy’ last year. The under-performance is largely due to a policy change in Indonesia, which has significantly increased the company’s cost of generation even while it is locked into tariffs which had no fuel-escalation component. As a result, Adani Power ended the past financial year with losses of Rs 287 crore. It is expected to bleed this fiscal as well. Rupee depreciation, low plant-load factors due to constrained transmission infrastructure and high debt levels also strained earnings. The company may require additional equity infusion to reduce its debt.

Given this backdrop, investors may be better off exiting the Adani Power stock. Even as revenues may rise rapidly for Adani Power, it may translate into strong earnings growth only after the regulatory issues of PPA revision are resolved and the rupee stabilises. At the current price of Rs 46.60, the stock is trading at two times its September-end book value, in line with other power utilities.

Fuel availability concerns

Adani Power had entered into 15-year fuel supply agreements with its parent company (Adani Enterprises) to supply coal to Mundra Phase 1, 2 and 3 at $ 36 per tonne. These projects have cumulative capacity of 2640 MW. However, the production ramp up from the Indonesia’s Bunyu Coal Mine was lower than expected and Adani Enterprises couldn’t supply the entitre coal requirement at the agreed price over the last few quarters. Hence, Adani Power had to rely on much more expensive spot coal market.

In 2011, the Indonesian Government made it mandatory to benchmark coal exports to market prices. This hurts Adani Enterprises’ plans to supply coal to Adani Power at $36 a tonne and may cause supply disruptions.

Imported coal is expected to account for 28 per cent of Adani Power’s total requirement, with domestic supplies making up for the rest. But only half of the expected domestic supply has been tied up. The fuel supply for Thiroda Phase-III (1,320 MW) and Kawai (1,320 MW) is yet to be tied up. These projects are expected to be commissioned by next year. Even for the coal linkages signed, Coal India may supply only 80 per cent of the contracted quantity, requiring Adani Power to make alternative arrangements..

Due to steep rupee depreciation and dependence on spot market, Adani Power’s fuel cost per unit rose from Re 1 during the financial year 2011 to Rs 2.60 for the half year ended September. In the near term, the fuel cost may stabilise at lower levels, as the Indonesian spot coal prices have moderated by 20 per cent in rupee terms. This is due to subdued offtake from the largest importer, China.

PPA overhang

Adani Power has entered into long-term PPAs for around 7,269 MW of projects and another medium-term agreement for 800 MW. The rest (around 1,171 MW) is to be sold in the short-term market. The average tariff from long-term PPAs is Rs 2.90 a unit, while the 800-MW PPA it signed with Maharashtra State Electricity Board was at Rs 4.10 a unit. Therefore, if one assumes that the merchant supply may be close to Rs 4.50 a unit, the company may get on an average Rs 3.20 tariff for unit sold.

Fuel cost has to come down significantly from the current Rs 2.60 a unit for the company to recover variable and fixed costs and make reasonable returns. This cost has declined recently. Yet some projects such as Mundra Phase-III and Thiroda Phase-I and -II will continue to lose money at tariffs of around Rs 2.35-2.64 a unit. There is no escalation of fuel and transportation costs in most of the PPAs. Only Kawai and Thiroda projects have partial pass-through of the fuel cost. The Central Electricity Regulatory Commission has admitted tariff revision petition of Adani Power, but the process may be long-drawn. Meanwhile, the company is litigating with Gujarat Urja Vikas Nigam Ltd on PPA revision in the Supreme Court. Any favourable judgement from Supreme Court or State electricity boards agreeing to revise PPAs will reverse the company’s fortunes.

High leverage

Adani Power had been implementing projects with a debt-equity ratio of close to 80:20 — higher than the normative 70:30 used by most Government power projects. On-time execution and strong cash flows might help projects with higher debt-equity ratio earn superior returns. But in the case of Adani Power, given the delays and lack of strong cash flows, leverage has turned out to be a drag. The company’s net debt-equity ratio as of September stands at 7.6. The interest cost has almost doubled during the first half of this fiscal and may continue to rise as the company capitalises new projects. While the company shifted from high-cost debt to low-cost external commercial borrowings, the rupee depreciation has neutralised the benefit. Around 72 per cent of the company’s total debt as of March was foreign-currency denominated, most of it unhedged. Adani Power plans to raise equity from its parent and refinance the completed projects to lower the interest burden.

A sharp gain by the rupee will reduce debt burden and fuel costs, but it appears unlikely in the near term.

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