Switch from BGR Energy to BHEL

Delay in commissioning of power projects, difficulty in getting customers to pay dues on time and unrelenting competition from foreign players have made the going tough for power boiler, turbine and generator (BTG) makers in the country.

The impact of the harsh environment is visible in the performance of mid-sized players such as BGR Energy Systems. With the company facing slowing order flows, high debt and a decline in sales and profits for three quarters now, investors can pare exposure to the stock.

The stock will be worth revisiting on an improvement in the power development scenario.

Overcrowding

BGR Energy made a well-timed move into the power equipment space but soon witnessed competition from local players, which entered into ventures with foreign companies. Then there were the Chinese and Koreans who were already giving market leader BHEL a run for its money. The overcrowding now has led to aggressive pricing by new players such as BGR Energy, even as the market leader BHEL has simply decided to forsake a bit of its market share.

For instance, as the lowest turbine bidder in NTPC's bulk tender, BGR quoted an aggressive price of Rs 0.9 crore per MW, reportedly at least 20 per cent lower than the next bid. Such aggressive bidding may have negative margin implications, if it becomes the norm.

BGR's operating profit margins actually expanded over 2 percentage points to 13.7 per cent in the September quarter, over a year ago, aided by strong growth in the capital goods (BTG) space.

However, high margins may not be sustainable for two reasons: One, the present order book is tilted 85 per cent in favour of the less lucrative engineering, procurement and construction (EPC) contracts. Two, aggressive pricing of equipment orders may mean lower profit margins on such projects.

Order slump

BGR Energy's order book as of September 2011, at Rs 7280 crore, covered sales of FY-11 by just 1.5 times. This is well below 6.2 times two years ago and 2.6 times a year ago, suggesting reduced revenue visibility.

This problem is compounded by significant delays in the awarding of prime orders such as the Rs 6500-crore EPC order by Rajasthan SEB. Resurgence of order flows in the power equipment space will be key to providing the critical mass needed to improve BGR's revenue prospects.

On the funding side too, BGR Energy has been troubled by delayed payments by a few State Electricity Boards. The average time taken to realise cash from sales — also called debtor days — was 330 days as of September 2011, up from 240 days in the last fiscal.

This stretched working capital is cause for worry as it may not only force the company to borrow more but also limit its order intake. The company's debt to equity ratio at 2.1 times, although not alarming, provides limited room for stretching itself for capital investments planned.

Given the above concerns and the current order tilt in favour of the lower margin EPC segment, BGR Energy's price earnings multiple of 8.3 times its expected FY-13 earnings (current price of Rs 274) is not at a sufficient discount to market leader BHEL's estimated valuation of nine times (at Rs 276).

BHEL offers value

Given the current choppy market conditions, this isn't an ideal time for an investor to bail out of any stock. Therefore, investors with a two-three year perspective can consider switching their money from BGR to BHEL, a larger stock in the power equipment space. Investors with a two-year perspective can also invest in this large-cap stock on declines linked to broad markets. The stock is currently close to its yearly low price-earnings multiple. Even after factoring in the concerns in the industry, the valuation appears attractive for the following reasons:

BHEL has continued to keep up the momentum in its revenue growth, essentially suggesting smooth execution. Sales and profits for the latest quarter were both 24 per cent higher than a year ago. The company wisely focussed on the more lucrative industrial segment, which accounted for a third of sales as of September. We expect this segment to temper any slowdown arising from power equipment space.

BHEL's order inflows over the same period were up 6 per cent — certainly not high but still better than the decline in order intake witnessed by most capital goods companies. Order book at Rs 1.6 lakh crore covers FY-11 sales four times over, providing revenue visibility.

Given its scale of operations and the already absorbed technology costs in areas others than the supercritical space, BHEL will continue to enjoy higher operating margins than peers. While margins have slipped from the 20-per cent-plus levels, 17-19 per cent operating margins appears feasible over the next couple of years, given that BHEL has not so far bid aggressively. With an over 50 per cent market share, the company is yet to feel the need to cut back on profitability, to stay at the top. Any introduction of duty on imported power equipment may provide some respite for local players, on the pricing front.

Concerns

In the medium term, capacity constraints and resulting execution delays may stretch working capital days. Additional capacities expected to go on stream next year may alleviate this problem. While current orders are expected to keep the company busy for a couple of years, the real test will be when players such like L&T also rise to imposing levels. A relook may be called for then.

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