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We maintain sell rating on Bharat Heavy Electricals (BHEL) with a 12-month target price of R183, which is based on a PE of 8.0x pegged of the average EPS over FY13e, 14e and 15e. The target P/E is set at a 40% discount to the historical average 13.4x given BHELs declining backlog, EPS CAGR of -7% over FY12-15e and RoEs falling from FY12 -28% to FY15e -15%. Investors tend to focus on PE while valuing industrial stocks. Our valuation methodology is similar to those used for peers like Crompton, L&T, Havells and Cummins.
Severe coal/gas shortages, high international coal prices, poor SEB financials and land acquisition/environmental delays have shrunk the opportunity pie for BHEL. Over the last 5-6 years, BHEL faced competition from Chinese suppliers. The problem has been compounded by the rise of domestic equipment suppliers like L&T-MHI, Toshiba-JSW, Bharat Forge-Alstom, BGR-Hitachi, Doosan, Thermax-Babcock Wilcox, Cethar Vessels and GB Engineering- Ansaldo.
Indian power BTG market is just like any other industry, where the incumbent making super normal profits attracts a host of new competitors leading to overcapacity. Once BHEL gets the last of reserved bulk orders in FY13e, every incremental order should be a hard-fought battle.
Power capacity build-out up and down cycles are long and deep. Investors enjoyed the benefits of the up-cycle from FY96 till FY11, and now one has to bear the brunt of the down-cycle which started one-and-a-half years back (backlog has declined 30%). We are nowhere close to the trough of this down-cycle. Issues which have created it are fuel shortages and poor SEB financials and they will not reverse soon. BHEL is a robust company and, if anything, the Chinese competition scare has only made it more capable. But the best of companies can do only so much in a down-cycle when there is overcapacity.
BHELs WC has historically been at precarious levels (receivables 7-9 months & inventories at 3-4.5 months). As long as the backlog grows, customer advances grow, and the illusion that everything is okay is maintained. But once the backlog starts declining, the illusion wears off. Net cash end Q2FY13 was R36.1 billion (R64.8 billion end FY12 and R94.5 billion FY11 end).
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