Chances of marginal re-rating

Management suggestions of declining competitive intensity a surprise: BHEL (Bharat Heavy Electricals Ltd) Q2 results looked like a repeat of the past five quarters with the company missing numbers, the stock falling 7% and management holding its customary earnings call in which it mentioned a slowdown in domestic and international markets and the demand revival efforts of various government bodies. So what now? With a dividend yield at 2.8% and FCF (free cash flow) yield of 13.5%, valuations do not seem expensive.

Further, management's closing remarks of a 10-15 GW (giga watt) order pipeline and indications of a possible decline in competitive intensity suggest a turnaround could be in the offing. We maintain that it is difficult to time the bottom, and at current valuations we reiterate Buy.

Industry performance slides, power resilient: Industry sector sales contracted sharply by 31% year-on-year and margins fell 572bps on account of (i) an absence of short-cycle orders (we forecast 13% growth); (ii) lower dispatches to customers who were delaying payment; and (iii) instability in the Middle East affecting revenue recognition. The power sector continues to show resilience, with 15% sales and 34% Ebit (earnings before interest and taxes) growth. Despite the slowdown, NWC (net working capital) /sales did not deteriorate much.

New PSU projects of 9,100MW in tender pipeline: Order inflows for Q2, at R32 billion, suggest that full-year expectations can be met. Management detailed c9.1GW of fresh tenders, primarily from the PSU firms. The management plans to diversify into railway and mono-metro-rail and be competitive in the power space.

Twelve-month target of R300 per share based on DCF–this implies 12x FY13e PE (price-to-earnings ratio)—We use a combination of target FCF yield of 10% and DCF (discounted cash flow) as the basis of our 12-month target price, which implies a marginal re-rating of the company to 12x (times) FY13 PE. We believe the de-rating in the stock, from 28x one-year-forward earnings in FY11 to 10x one-year-forward earnings for FY12, largely factors in the decline in the company's earnings in the current demand scenario. A big re-rating in the stock would happen only if the demand environment becomes more benign, likely in FY15e.

... contd.

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