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June 29, 2011

CESC
Integrated business at a discount
Company details Price target: Market cap: 52 week high/low: NSE volume: (No of shares) BSE code: NSE code: Sharekhan code: Free float: (No of shares) Shareholding pattern Rs413 Rs3,542 cr Rs433/257 1.2 lakh 500084 CESC CESC 6.6 cr

Buy; CMP: Rs282

Others 11% Institutions 17% Promoters 53%

Foreign 19%

Price chart

425 400 375 350 325 300 275 250 Mar-11 Jun-10 Sep-10 Dec-10 Jun-11

Key points Integrated business model with strong cash generation from distribution business: CESCs presence in both generation and distribution business is an advantage given the emergence of erratic purchase of power by the state electricity boards (SEBs) due to their deteriorating financial health. The power distribution business in Kolkata is growing at a healthy rate and generates substantial free cash to fund CESCs expansion plans. CESC is doubling its generation capacity by FY2015 through addition of 600MW in Chandrapur and 600MW in Haldia. Further, 1,920MW of capacities are at an early development stage. Moreover, led by the deteriorating financials of the SEBs, the potential privatisation of the distribution business could open up opportunity for CESC. Secured fuel supplies an added advantage: Besides coal linkage from Coal India, CESC has a secured supply of coal from two coal assets held by the promoters through ICML. Around 50% of the coal would be sourced from these mines and 30-40% of the requirement would come from the Coal India linkage; the balance 10% would be imported. CESC has a higher level of fuel security compared to most of its domestic peers which is a strong positive. Retail turns profitable at store level; current price ignores the turnaround possibility: The retail business of CESC is currently burning significant cash at the operation level; however, we believe it is close to the end of the tunnel. The silver lining is that there are initial indications of a recovery as the business reported profits at the store level in all four quarters of FY2011. Further, backed by the current strategy of the management, we believe it could break even at the corporate level in the next three years against the managements ambitious time line of five to six quarters. Moreover, the cash generation from the monetisation of its spare land through the development of a 400,000-squarefeet shopping mall in a prime area of Kolkata would partially negate the losses in the retail business. Significant discount to peers, Buy: CESC is one of the cheapest utility stocks available in the Indian market. It trades at a discount to its book value and at a 60-70% discount to the average multiple of the comparable companies. One of the key reasons for the discounted valuations is the concerns related to the losses in the retail business that depress the return ratios at the consolidated
Key financials (standalone) Net sales (Rs cr) EBITDA (Rs cr) Net profit (Rs cr) EPS (Rs) % Y-o-Y growth EBITDA margin (%) PER (x) P/BV (x) EV/EBITDA (x) Dividend yield (%) RoCE (%) RoE (%) FY2009 3031.3 610.7 409.7 32.6 15.3 20.1 8.6 0.7 7.7 1.4 5.6 8.7 FY2010 3292.8 749.7 433.3 34.5 5.8 22.8 8.2 0.7 7.0 1.4 6.1 8.6 FY2011 3937.0 994.9 486.9 38.8 12.4 25.3 7.3 0.6 4.9 1.4 7.5 9.1 FY2012E 4301.6 1102.1 542.9 43.2 11.5 25.6 6.5 0.6 4.4 1.4 7.9 9.5 FY2013E 4677.2 1167.5 590.3 47.0 8.7 25.0 6.0 0.6 4.0 1.8 8.0 9.6

Price performance (%) Absolute Relative to Sensex 1m 4.0 2.7 3m 6m 12m

-8.9 -23.3 -24.6 -6.6 -15.7 -28.6

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level. However, we believe that the improving financial health of the retail business and the growing scale of the power generation and distribution business would positively affect the return ratios in future. We value per share of CESC at Rs536 (Kolkata utility business at Rs472 + the upcoming power generation assets at Rs48 + the property at Rs17 share). Further, we deduct Rs123 per share for the retail business to account for the latters accumulated losses of Rs1,231 crore (over FY2008-11) and the estimated cumulative losses of around Rs316 crore to be incurred during FY2012-14 (before it turns profitable in FY2015) to arrive at a fair value of Rs413 for CESC. Hence, we recommend a Buy on CESC with a price target of Rs413. Investment arguments Integrated business model with regulated distribution business in a sweet spot CESCs regulated business of electricity distribution in Kolkata backed by a 1,200MW of power generation capacity is sustainable with a steady growth and healthy returns. It generates an assured return on equity (RoE) and the power demand is growing in the city with the changing lifestyle of consumers driving a steady growth. Moreover, we believe that compared to most of the power generators in India CESC is in an advantageous position currently since it owns a distribution business as well. The purchase of power by the SEBs has been erratic in recent times due to their deteriorating financial health and other factors.

Assured return and sustainable demand driven growth We believe electricity demand in West Bengal is growing at a decent pace (an average of 7-8%) and the trend is likely to remain firm in future. This is supported by our belief that in future the per capita consumption should only rise across India with the changing lifestyles (more usage of higher power consuming instruments). CESC has been meeting approximately 25% of West Bengals power requirement for a long time. Consequently, the power business of CESC has also charted a healthy growth and is likely to maintain the growth momentum in future. A decent increase in the consumer base and a steady growth in the per capita consumption in the state will support this growth. Hence, we believe the growth in the power generation and distribution businesses of CESC will sustain going ahead. We expect CESC to record a volume growth of 6% over the next five years and the management has guided to incremental capital expenditure (capex) of about Rs500 crore per year for the distribution network; out of this Rs150 crore would come from equity. Effectively, the incremental capex would bring earnings growth by generating additional regulated returns of 15% on the distribution assets. We are positive about the consistent cash generating ability of the companys regulated assets which would be largely funding its future growth plans.

Electricity trend in West Bengal and CESC Particulars WB power requirement (MU) % Y-o-Y growth Power sold by CESC in Kolkata (MU) % Y-o-Y growth No of consumers of CESC in Kolkata % Y-o-Y growth CESC-per consumer (units) % Y-o-Y growth Consistent cash generation Particulars Operating cash flow Capex Free cash flow Operating cash/sales (%) FY08 590.4 (627.8) (37.4) 21 FY09 358.0 (1345.4) (987.4) 12 FY10 591.8 (933.6) (341.8) 18 FY11 743.2 (277.4) 465.8 19 FY12E 800.4 (519.3) 281.1 19 FY13E 892.8 (500.0) 392.8 19 FY14E 963.5 (475.0) 488.5 19 FY04 22,125 6,080 1.9 3,120 FY05 22,755 2.8 6,437 5.9 2.0 3.6 3,188 2.2 FY06 22,571 -0.8 6,979 8.4 2.1 3.8 3,330 4.4 FY07 26,538 17.6 8,081 15.8 2.2 4.2 3,702 11.2 FY08 28,979 9.2 8,613 6.6 2.2 1.1 3,901 5.4 FY09 31,339 8.1 8,705 1.1 2.3 3.9 3,795 -2.7 FY10 33,750 7.7 8,991 3.3 2.4 3.9 3,771 -0.6 FY11 36,481 8.1 9,480 5.4 2.5 3.5 3,842 1.9 FY12E 39,217 7.5 9,959 5.1 2.5 3.0 3,919 2.0 FY13E 42,158 7.5 10,413 4.5 2.6 2.5 3,997 2.0 FY14E 45,320 7.5 10,886 4.6 2.7 2.5 4,077 2.0 (Rs cr) FY15E 1037.3 (500.0) 537.3 19

Source: Company and Sharekhan Research

Stock Idea

June 29, 2011

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stock idea

The regulated business gets an assured RoE of 14% after tax for the generation assets and a RoE of 15% after tax for the transmission and distribution (T&D) business. The power assets of CESC are regulated by the West Bengal Electricity Regulatory Commission (WBERC), which is expected to change its three-year tariffs to five-year tariffs in a few months. Integrated status puts it in better position vs most peers Currently in India, integrated power utilities (having generation and distribution businesses) are in a favourable position in the wake of the concerns over the deteriorating financial position of the SEBs. In recent times, several leading power generators have not sold higher power despite improved generation capacity, as several SEBs have backed out and opted for load sharing. This is in contrast to what we had seen in FY2009 and FY2010, which were periods influenced by elections. Moreover, their rising losses create fresh challenges for the SEBs; consequently, the SEBs are buying power as per their financial strength, which is deteriorating day by day. Having own distribution business, an advantage considering the deteriorating financial health of SEBs As per the latest report by Personal Finance Corporation, the losses of the SEBs were above Rs32,000 crore (after factoring in the subsidy) in FY2009; the same are expected to cross Rs40,000 crore in FY2010 and Rs68,000 crore in FY2011. The Finance Commission has estimated that the net annual losses of the state T&D utilities could be Rs100,000 crore by 2014-15 if the business-as-usual approach continues. We believe the T&D losses and heavy subsidy are the primary reasons for the SEBs poor fiscal health and it could take significant time to resolve this issue with reforms. Hence, in such a scenario, we like companies which are integrated in terms of having their own distribution business (or those that are less exposed to state-owned distribution companies) as these will have an advantage. Therefore, we believe the integrated status
Future projects Power plants Under implementation Chandrapur, Maharastra Haldia, West Bengal Under development Dhenkanal 1320 Coal 600 600 Coal Coal Capacity Fuel

of CESC will give it an edge in the coming days. The same is reflected in its healthy T&D losses data. CESC is having T&D losses of 13% against West Bengals 20% and Indias 20-25%. Moreover, CESC primarily distributes urban electricity to largely industries and households, where recoveries and realisations are fairly healthy compared to the agricultural sector. Doubling capacity of the cash machine We have mentioned earlier that the regulated utility business has been the cash-generating machine for the company, which currently has an aggressive growth plan for the business. CESC aims to add around 3,120MW of power generation capacity through four projects. However, as of now we have factored in only two projects (a total capacity of 1,200MW) located at Chandrapur and Haldia considering the development of the projects. After the completion of these two projects, the capacity will double by FY2015.
Power generation capacity (MW)
3000 2500 2000 1500 1000 500 0 FY08 FY09 FY10 FY11 FY12E FY13E FY14E FY15E 975 975 1225 1225 1225 1225 1825 2425

Source: Company and Sharekhan Research

We believe the Chandrapur project would get commissioned in FY2014 and the Haldia one in FY2015, and that these two projects would start generating cash soon after. The Haldia thermal power project would be set up under a subsidiary, Haldia Energy. The other

Fuel source Linkage Linkage

Offtake Mix (PPA & Merchant) Mix (PPA & Merchant)

Capex 280 330

Debt/equity 75 D : 25 E 75 D : 25 E

CoD FY14 FY15

Not yet

All major approvals have been received; however, coal linkage with Coal India awaited; environmental TOR received and EIA completed. 1. Joint allocation of coal block (110MT) obtained in Jharkhand for setting a 1,000MW plant. 2. Obtained a prospecting licence for the mine. 3. Land acquisition process has been initiated for the main power plant.
Source: Company and Sharekhan Research

Dumka, Jharkhand

600

Coal

Linkage

Stock Idea

June 29, 2011

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upcoming project at Chandrapur would be built under a company called Dhariwal Infra, a subsidiary of Haldia Energy. The above mentioned two projects would require a capex of Rs6,200 crore out of which Rs1,500 crore would be in the form of equity investment and the remaining as debt. As per the plan, these plants would sell some portion of power through the merchant route which could boost the returns. The Haldia power project would supply 75% of its output to CESCs Kolkata T&D business. Moreover, CESC is looking for opportunities to bid for new distribution areas. Given the deteriorating financial position of the SEBs despite their bail-out by the government a decade ago, the government would look to either raise the tariff for the subsidised consumers or privatise the distribution business in a massive way. In such a scenario, we see large opportunities opening up for companies like CESC. Cash generating assets to fund future growth plans We believe its cash generating assets would be crucial to fund the companys future growth plans. The current regulated business is primarily funding the equity for these new generation capacities and the losses of the retail business. The management believes that it needs to invest further to make the retail business profitable again. We understand that the existing regulated power business would be the primary source of funds for CESCs future growth plans in the power and retail businesses. In future, new capacities would also help generate healthy cash. Fuel security a strength, real estate adds value Though CESC is not having any captive coal mine or any direct control over any coal asset, it has investment in two of the coal assets held by the promoters through Integrated Coal Mining Ltd (ICML). Hence, CESC is in a relatively safer position as fuel availability is assured. Coal shortage is one of the most common challenges the Indian power generators are facing today and the shortage is likely to intensify in future.
Details of fuel supply/availability Existing power plants Captive source from group company The company sources 3MT (about 50-55% of its total requirement) from the Sarisatolli Coal Block, a captive block held by a promoter group company in which CESC holds a 26% stake. The Sarisatolli Coal Block has more than 60mn tonne of coal reserves and is located 230km from the plant. Coal linkage 40% of the total requirement is met from coal linkage with Eastern Coalfields, a subsidiary of Cola India. Open sources For blending purpose, 5-10% of the requirement is met through coal imported from Indonesia.

Upcoming power plants (Chandrapur + Haldia) Captive source from group company The company will import 1mn tonne of thermal coal per annum for three years and then 2mn tonne per annum for another 17 years. This would meet 4050% of the total requirement of its upcoming plants. Coal linkage Coal linkage with Coal India could be to the extent of 3040%. Open sources The balance would be sourced externally.

Supply of over 80% fuel assured, of which 50% from its invested company We understand that around 50% of its total coal requirement would be sourced from the mines where CESC has an indirect investment (this works out to be an assured supply of coal). Though this position is not comparable to 100% captive mine position, it gives a higher level of assurance of supply compared to most of the domestic peers. In India, most of the large power generators are dependent on coal linkage from Coal India or on a mix of imported coal and eauction coal. Hence, we read this as a positive for the company, especially when fuel insecurity is the most important concern plaguing the Indian power generators. Shopping mall under property subsidiary to generate high returns on investment CESC has ventured into the real estate business in a small way, primarily to capitalise on one of its idle lands in central Kolkata. It has a land piece of 3 acres in Park Circus, central Kolkata, where it plans to build a 400,000-square-feet retail shopping mall. Larsen and Toubro has been appointed as the turnkey contractor for the project and the mall is expected to start in October 2012. The project is expected to cost around Rs200 crore and the management expects revenue of around Rs50 crore from lease in FY2013. We believe this would be a high-margin and healthy cash generating asset, and would add value beautifully to the companys bottom line, though in a small way. Retail worries seem to be over, initial signs of improvement visible The retail segment of CESC is burning significant cash at the operation level currently which is an overhang on the stock price. In FY2010, the retail segment had incurred a loss to the tune of Rs278 crore against a Rs436-crore of profit generated by the power segment in the same period. However, there are initial indications of a recovery in H2FY2011 and the management expects the business to break even in the next five to six quarters.

Stock Idea

June 29, 2011

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stock idea

Our initial feel was that the company should get rid of this loss-making retail business as such a move could lead to a significant upward re-rating of the stock. However, from our interaction with the management we learnt that instead of selling the retail business, it intends to turn it around and initial signs of a recovery are already visible. Moreover, the management has highlighted its efforts and strategy to gradually reduce the retail business losses and steer it towards profits. Strategy to turn around retail The management has a three-pronged strategy for the retail business and is in the process of implementing the third phase of this strategy. The first phase, implemented during FY2008-09, was a phase of rapid growth to acquire a panIndia presence. The second phase, during FY2009-10, was a phase of consolidation and closure with the narrowing down of the focus on selective markets and the closure of the non-profitable outlets. The management claims that CESCs retail business will enter the third phase of the strategy from FY2012 when it will again expand selectively. In the third phase, the management also aims to recover the corporate level overheads (by spreading the overheads across a higher number of store level profit-making units) in the coming six quarters. The second phase had continued in FY2011 when the retail business saw consolidation with focus on reducing its losses. The primary steps taken during the second phase were the expansion of the reach of the affordable products and the rationalisation of outlets, man power and salaries. We believe this strategy has shown results as after incurring a loss at the store level during FY2010 the business turned profitable in FY2011 (refer chart below).
Store EBITDA turned positive
3 2 1

development and believe that in the third phasewith the focused expansion of the profitable storesthe overheads would be recovered fully and the retail business could break even at the corporate level. The management aims to achieve this in the next five to six quarters, that is mid FY2013. However, we are taking a conservative stand on this and feel the retail business would break even only in FY2015. We have learned that the managements expectations with regard to the retail business would be backed by the following targets set by the company. These targets would be the key monitorables for us. CESC aims to improve the store level EBITDA from Rs20 per square feet currently to Rs50 per square feet in the next 12-15 months. The same-store revenue growth should sustain at high teens. Aims for deeper geographic expansion with primary focus on eight to nine key markets. A change in the revenue mix, with a significant improvement in the share of the private labels. Retail could turn profitable by 10-12 quarters The losses from the retail business peaked in FY2009 and declined marginally in FY2010. However, from the beginning of FY2011 we have observed a silver lining in the form of profit at the store level. We believe, as per the abovediscussed strategy, the company could cut its retail losses in the next 10-12 quarters (we have conservatively assumed a period of three years will be required to wipe out the losses as against the managements expectation of five to six quarters). Nevertheless, the stock price has yet to absorb the likely turnaround in the foreseeable future. The retail business maintained this positive trend at the store level in all the four quarters of FY2011 and we sense the management is committed to sustaining this trend in the coming years.
Declining retail losses

(Rs cr)

0 H1FY10 -1 -2 -3 H2FY10 Q1FY11 Q2FY11 Q3FY11 H2FY11

50 0 -50 -100 -150 -200 -250 -300 -350 -400 -450 -500

FY08

FY09

FY10

FY11

FY12E

FY13E

FY14E

FY15E

Source: Company and Sharekhan Research

During FY2011 the store-level EBITDA turned positive vs negative EBITDA in FY2010. However, at the corporate level the overheads have yet to be recovered. We feel the store level profitability trend may not be temporary and may continue. Hence, we are cautiously positive on this

PBT

PAT

Source: Company and Sharekhan Research

Stock Idea

June 29, 2011

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stock idea

Against this backdrop, the stock provides a good investment opportunity as the current market price factors the possibility that the retail business may continue to make losses for a very long period. The retail business had been with the RPG group for a long time; however, the loss-making business was merged with CESC in 2007. We believe this affected the stock price adversely with the dwindling profitability of the consolidated entity. At the current price, the return on the stock has been mostly negative over the last five years and CESC has underperformed most of its peers. Hence, we opine that this concern is overdone especially when the management aims to turn around the retail business much earlier than expected. Financial analysis Revenue: sustainable nominal growth from tariff adjustment and incremental consumption During FY2011, the volume grew by 5% (due to the new 250MW unit) and tariff grew by 12% to boost the revenue by ~20%. We expect the stand-alone utility business to record a sales growth of about 8% over the next four to five years due to a combination of tariff growth and volume growth. We believe the consumer base will contribute around 2-3% of the growth, with the improving electricity intensity in Kolkata in future. This would lead to a 4-5% volume growth in the Kolkata region in the foreseeable future. Nevertheless, an average growth of 4-5 % in tariffs would also push the effective revenue growth to 8-9% for the next four to five years. Hence, we expect the standalone entity to record sales of Rs4,260 crore in FY2012 and cross Rs5,500 crore in FY2015.
Power utility (stand-alone) Particulars Installed capacity (MW) Additions (MW) Generation (MU) Units sold (MU) Selling unit growth (%) Consumers (crore) % Y-o-Y growth Power per consumer (units) % Y-o-Y growth Revenue (Rs cr) % Y-o-Y growth Tariff (Rs/unit) % Y-o-Y growth 3.48 7,901 8,705 0.2 1.1 3,795 -2.7 3,031 FY09 975 FY10 1225 250 7,836 8,991 3.3 0.2 3.9 3,771 -0.6 3,293 8.6 3.66 5.2

Stand-alone power growth: a mix of volume and tariff

22.0 Selling unit grow th (%) 19.0 16.0 13.0 10.0 7.0 4.0 1.0 FY10 FY11 FY12E FY13E FY14E FY15E Tariff grow th (%)

Source: Company and Sharekhan Research

Power segment (at consolidated level) to witness spurt in volume, with doubling of capacity by FY2015 Two generation units of 600MW each (at Chandrapur and Haldia) would be set up by CESC under its subsidiary, Haldia Energy. We expect the Chandrapur project to commence operation in FY2014 and the Haldia unit in FY2015. Consequently, we expect a spike in the generation volume in FY2014 and FY2015 from the current level. We estimate selling unit growth of 16% in FY2014 and that of 28% in FY2015. Moreover, the tariffs should continue to grow at least to adjust the inflationary pressure for the regulated part of the business. Nevertheless, we feel that the merchant power tariff should remain soft. Hence, we effectively expect the revenue to grow at 18% in FY2014 and at 28% in FY2015. Till then we could witness an annual revenue growth of about 9%. We expect the revenue to touch Rs4,300 crore in FY2012 and cross Rs7,000 crore in FY2015.

FY11 1225 0 8,757 9,480 5.4 0.2 3.9 3,842 1.9 3,937 19.6 4.15 13.4

FY12E 1225 0 8,916 9,959 5.1 0.3 3.5 3,919 2.0 4,302 9.3 4.32 4.0

FY13E 1225 0 9,089 10,413 4.5 0.3 3.0 3,997 2.0 4,677 8.7 4.49 4.0

FY14E 1225 0 9,122 10,886 4.6 0.3 2.5 4,077 2.0 5,110 9.3 4.69 4.5

FY15E 1225 0 9,214 11,382 4.5 0.3 2.5 4,159 2.0 5,583 9.3 4.91 4.5

Source: Company and Sharekhan Research

Stock Idea

June 29, 2011

sharekhan

stock idea

Power segment (consolidated) Particulars Installed capacity (MW) Additions (MW) Generation (MU) Units sold (MU) Selling unit growth (%) Revenue (Rs cr) % Y-o-Y growth Tariff % Y-o-Y growth Power segment driven by volume
35 30 25 20 15 10 5 0 FY09 FY10 FY11 FY12E FY13E FY14E FY15E Selling unit grow th (%) Tariff grow th (%)

FY08 975 7980 8613 2775 3.22 -

FY09 975 0 7901 8705 1.1 3031 9.2 3.48 8.1

FY10 1225 250 7836 8991 3.3 3293 8.6 3.66 5.2

FY11 1225 0 8757 9480 5.4 3937 19.6 4.15 13.4

FY12E 1225 0 8916 9959 5.1 4302 9.3 4.32 4.0

FY13E 1225 0 9089 10413 4.5 4677 8.7 4.49 4.0

FY14E 1825 600 10436 12095 16.2 5539 18.4 4.58 2.0

FY15E 2425 600 13682 15492 28.1 7075 27.7 4.57 -0.3

Source: Company and Sharekhan Research

over Rs700 crore by FY2015, reflecting a five-year compounded annual growth rate (CAGR) of 10%. The net profit of the consolidated entity should touch Rs900 crore in FY2015 compared to Rs330 crore in FY2011. This indicates a fiveyear CAGR of about 29%. Cash generating asset to fund growth and loss of retail, it will still be comfortable The stand-alone balance sheet of the company is healthy with a debt-equity (DE) ratio of 0.5x and CESC is unlikely to add any significant capex or debt on the stand-alone books. However, to feed its ambitious plan of doubling its power generation capacity the company will add debt of Rs4,650 crore over the next three years. Moreover, we believe the cash generated from the stand-alone utility business will continue to support the loss-making retail business for some time (till FY2014, as per our estimate). The company is generating cash from operations at both stand-alone and consolidated levels, and the trend is likely to continue in future. Hence, we believe CESC will remain in the comfort zone, as for a power generation utility a DE ratio lower than 1.5x is comfortable. Regulated RoE for utility but retail worries dampen consolidated RoE The regulated utility business is earning higher RoE of about 18% on the regulated equity, as it earns 3-4% of the RoE in the form of incentives. Currently, the regulated equity for the generation business (14% RoE by West Bengal SEB) is approximately Rs1,150 crore and a similar quantum is invested in the distribution business (which generates RoE of 15%). However, 11% of the total capital employed by the company is in the form of cash. Effectively, the standalone entity is generating RoE of about 9%. The RoE of the consolidated entity is severely hampered due to the significant loss from the retail business; the situation would improve only after the expected turnaround of the retail business.

Source: Company and Sharekhan Research

Stable margin from utility, but retail losses will continue to drag till business turns around Being in the regulated utility business, the stand-alone business should be able to pass on any cost pressure through tariff revision. Hence, the margin of the stand-alone business should broadly remain in a range despite some variations due to efficiency. However, the continued losses from the retail business would act as a drag on the consolidated margin of the company. In the last four years, the EBITDA margin of the consolidated business was in the range of 6-11% while the stand-alone entity managed to get an EBITDA margin of above 20% in the same period. We believe this will continue till the retail business becomes stable and breaks even. We expect that to happen by FY2015. Net profit could grow by 29% (five-year CAGR) if retail turns around Currently, half of the net profit generated by the utility business is eaten by the retail business. This would continue till the retail business turns around in FY2015. Nevertheless, the property segment would contribute about 3% of the profit after tax (PAT) from FY2014 onwards. We expect the PAT of the stand-alone entity to grow from Rs487 crore in FY2011 to

Stock Idea

June 29, 2011

sharekhan

stock idea

Valuation and view CESC is one of the cheapest utility stocks available in the Indian market. It trades at a discount to its book value and at a 60-70% discount to the average multiple of the comparable companies. One of the key reasons for the discounted valuations is the concerns related to the losses in the retail business that depress the return ratios at the consolidated level. However, we believe that the improving financial health of the retail business and the growing scale of the power generation and distribution business would positively affect the return ratios in future.
Power generation peer group valuation Company NTPC Tata Power Neyvelli Lignite Reliance Power Torrent Power KSK JSW Energy Adani Power CESC P/BV (x) FY11 2.2 2.3 1.5 1.8 2.3 1.4 1.9 3.7 0.6 FY12E 2.0 2.0 1.4 1.6 1.9 1.2 1.6 2.7 0.6 RoE (%) FY11 13.3 14.6 11.8 4.5 21.0 11.2 18.7 9.9 9.1 FY12E 13.7 15.9 11.8 4.5 21.0 15.2 20.3 9.9 9.5

of the power units in the developing stage should get some premium over the amount invested by the developer for the efforts to develop the project with critical clearances, coal linkages and other necessary ingredients. Some of the deals in the recent past suggest about 50% premium over the actual investment made by a power plant developer. However, we believe a valuation with a 20-25% premium over the amount invested till date in a power generation project with all clearances and linkages is fair and justified. Hence, we value the upcoming projects of CESC under its subsidiary, Haldia Energy, at a 20% premium over the invested capital. So, we arrive at a value of Rs600 crore, implying a value of Rs48 per share. Property subsidiary implies a valuation of Rs17 per share The company is developing a shopping mall of 0.4mn square feet on its 3-acre land located at Park Circus, central Kolkata. The construction work is in progress and the work is allotted to engineering, production and construction (EPC) contractor, Larsen and Toubro (L&T). It is estimated to invest Rs200 crore till FY2011 end (it has already invested about Rs100 crore and the balance will be invested in FY2012) to develop the mall. In addition, the 3-acre land, easily valued at Rs150-200 crore, implies a value of Rs15 per share. However, we are not factoring the land value and are considering only the investment of Rs200 crore that will go into this development. This would translate into a value of Rs17 per share for the property subsidiary. Discounting over retail concern overdone, we initiate Buy with price target of Rs413 We value per share of CESC at Rs536 (Kolkata utility business at Rs472 + the upcoming power generation assets at Rs48 + the property at Rs17 share). Further, we deduct Rs123 for the retail business to account for the latters accumulated losses of Rs1,231 crore (over FY2008-11) and the estimated cumulative losses of around Rs316 crore to be incurred during FY2012-14 (before it turns profitable in FY2015) to arrive at a fair value of Rs413 for CESC. Hence, we recommend a Buy on CESC with a price target of Rs413.
SOTP valuation Business/Segments Existing power generation and distribution business Upcoming power capacities CESC Property Retail Total Valuation method Valuer per share (Rs) 472

Source: Bloomberg, Sharekhan Research

Arriving at value through SOTP method Stand-alone business can fetch a value of Rs472 per share Our study suggests that the stand-alone business (the Kolkata utility) is doing well as a utility business, driven by a decent growth in the volumes and tariffs. It is operating in a deficit environment and the demand is running ahead of the supply. Hence, the visibility of the growth opportunity is quite strong. The company is exhibiting efficiency with a remarkably good plant load factor (PLF) on the generation side and the low aggregate, technical and commercial (AT&C) losses of the distribution business. Moreover, it is generating healthy cash flow and regulated RoE. However, given the lower RoE of the stand-alone company (about 9% compared to 11-15% of most of the peers), we value its stand-alone business at 1x its FY2012 book value. That hints at a discount of 40-50% to the average price/book value multiple of its peers. This translates into a fair price of Rs472 per share. Investment in upcoming capacities to be valued at Rs48 per share CESC is adding 1,200MW of generation capacity (2x600MV) and the same is in the construction stage and would effectively double its generation capacity. Till now the company has invested Rs500 crore in these two projects that works out to be about Rs40 per share. The valuation

1x BV (FY2012), 45% discount to peer average (industry average 1.85x) 1.2x on amount invested till now 1x investment

48 17

1x losses made till date and (123) the likely losses till it breaks even 413

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sharekhan

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Investment concerns Failure to reduce loss and turn around retail business in future The loss incurred from the retail business is definitely the biggest concern of the stock currently. However, as we have discussed earlier in the report, we have seen some signs of revival in this business and found the management to be quite confident about bringing the retail business into black from red. However, in case the efforts put in by the management fail and the retail segment fails to turn around in the expected time line, the financial health of the company will deteriorate and this would adversely affect the stock price. Hence, the retail business will be the key monitorable and if there are any signs that the revival is temporary, it would substantially affect our valuation and affect our price target adversely. Music World, part of the retail segment, would remain a drag We didnt like the scaleability and viability of one of its retail businesses, Music World. We believe digitisation of music has hurt the scaleability of the music business. Hence, the capital of Rs90 crore deployed in this business would remain a drag. Delay or any hindrance in new projects could affect future earnings If the new capacities that are in the construction phase get delayed for a considerable time it could affect our estimated future earnings for CESC. Also, the new projects are dependent on the coal supply from an Australian coal mining company, Resource Generation (RG), in which ICML (CESC has a 26% stake in ICML) has acquired a 10% stake. We build our estimate on the assumption that RG would supply the targeted quantity of coal in the stipulated time. Hence, any mismatch in the quantity supplied or any delay in the supply would affect the generation volume and the cost of generation from the upcoming projects. Company background Established in 1897, CESC, a power utility company, is engaged in generation, transmission and distribution of power. The company has four thermal power plants with 1,225MW of generation capacity and a transmission and distribution system that includes 474 kilometer circuit of transmission lines. It serves approximately 2.6 million domestic, industrial and commercial customers in the area of 567 square kilometer in Kolkata and Howrah. The company is also involved in organised retail business and real estate development, including a warehouse in Howrah. It has also economic interest (through associate company, ICML) in coalmines in India and abroad.

Brief segmental description Power Currently the company has 1,225MW of operational power capacity. In order to expand its capacity the company has planned to set up a 600MW power plant at Chandrapur, Maharashtra and another 600MW power plant at Haldia, West Bengal. With this the total enhanced capacity of the company will stand at 2,425MW. Both the plants will have partial coal linkages from Coal India and some portion will be fed by the coal imported from RG, an Australian coal mining company. The Chandrapur plant involving a total capex of Rs280 crore is expected to commence operations by mid 2013 and the Haldia plant with a capex of Rs330 crore will start by mid 2014. The company also has around 4,000MW of capacity under planning stages coming up at different locations.
Operational plants Power plants Budge Budge, WB Southern, WB Titagarh, WB New Cossipore, WB Capacity 750 135 240 100 Fuel Coal Coal Coal Coal Fuel source Link/Captive Link/Captive Link/Captive Link/Captive Offtake PPA PPA PPA PPA

Retail The company has presence in the retail segment through Spencerss Retail Ltd (SRL), a wholly owned subsidiary of CESC. SRL operates 210 stores in India including 21 hypermarkets. Under SRL, it has Music World and Books & Beyond that sell various genres of musical albums, movies and books. Recently the company has set up several outlets of Bevery Hills Polo Club (BHPC), under which it will retail BHPCs entire range of apparels, accessories and watches in the country. It also plans to follow the franchisee model for the BHPC business. CESC has also ventured into the bakery caf chain business under the name Au Bon Pain (ABP). Currently, it operates nine retail cafes in Bangalore and is looking forward to expand aggressively to the other cities. Real estate The company has ventured into the real estate business in a small way, primarily to capitalise on one of its idle lands in central Kolkata. It has a land piece of 3 acres in Park Circus, central Kolkata, where it plans to build a 400,000 square-feet retail shopping mall. We believe that L&T has been appointed the turnkey contractor for the project and the mall is expected to start during October 2012. The project is expected to cost around Rs200 crore and the management expects revenue of Rs50 crore from leasing out outlets in the mall. We believe this would be a high-margin and healthy cash generating asset and would add value to the companys bottom line, though in a small way.

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Financials
Profit & Loss statement Particulars Net sales % growth (net sales) Cost of fuel Cost of electricity purchased Employee cost Other exp Total expenditure EBITDA % growth EBITDA margin (%) Other income Interest Depreciation Profit before tax PBT after except. Tax Net profit % growth EPS (Rs) % growth DPS (Rs) Payout (%) FY09 9.2 412.5 370.2 693.2 610.7 9.6 20.1 170.0 141.0 174.9 464.9 464.9 55.2 409.7 15.3 32.6 15.3 4.0 12.2 FY10 8.6 637.0 426.0 403.1 749.7 18.5 22.8 156.2 178.2 205.6 522.1 522.1 88.8 17.0 433.3 433.3 5.8 34.5 5.8 4.0 11.5 FY11 3937 19.6 1426.0 665.0 433.0 418.1 2942.1 994.9 24.6 25.3 152.0 271.0 267.0 608.9 608.9 122.0 20.0 486.9 486.9 12.4 38.8 12.4 4.0 10.3 FY12E 4301.6 9.3 1524.7 777.9 451.7 445.2 3199.5 1102.1 9.7 25.6 167.8 295.2 278.6 696.0 696.0 153.1 22.0 542.9 542.9 11.5 43.2 11.5 4.0 9.2 Rs (cr) FY13E 4677.2 8.7 1646.9 894.5 481.8 486.4 3509.6 1167.5 5.6 25.0 182.4 309.3 283.8 756.9 756.9 166.5 22.0 590.3 590.3 8.7 47.0 8.7 5.0 10.6 Balance sheet Particulars Equity Reserves Net worth Secured loans Unsecured loans Total loans Adv against depr Gross block Depreciation Net block Add: CWIP Investments Inventories Debtors Cash Deffered payments Less: Current liabilities Creditors Provisions Misc exp Capital deployed Cash flow Particulars PAT Depreciation Cash profit Changes in WC Capex Free cash flow Dividend Equity issued Debt raised Investments Misc expenses Others Net cash flow Opening cash Closing cash FY09 409.7 174.9 584.6 -226.6 -1345.4 -987.4 -58.5 0.0 793.0 259.3 0.7 281.1 288.3 FY10 433.3 205.6 638.9 -47.1 591.8 -933.6 -341.8 -58.3 0.0 389.9 -368.2 0.7 222.7 -154.9 FY11 486.9 267.0 753.9 -10.7 743.2 -277.4 465.8 -58.5 0.0 0.0 -445.0 0.7 374.6 337.7 1119.8 1457.5 FY12E 542.9 278.6 821.5 -21.0 800.4 -519.3 281.1 -58.5 0.0 0.0 -387.5 0.7 253.1 89.0 1457.5 1546.4 Rs (cr) FY13E 590.3 283.8 874.2 18.7 892.8 -500.0 392.8 -73.1 0.0 0.0 -428.8 0.7 218.3 110.0 1546.4 1656.5 Key ratios Particulars PER (x) P/BV (x) EV/EBITDA (x) RoCE (%) RoE (%) Debt/Equity (x) Interest cover (x) Fuel/Sales (%) Elec pur/sales (%) Staff/Sales (%) Others/Sales (%) Net debt /share CF (from opt)/share Debtors days Creditors days Inventory days FY09 8.7 0.7 7.7 6.1 8.6 0.5 3.1 28.7 13.6 12.9 12.2 91.3 28.5 43 199 29 FY10 8.2 0.7 7.0 7.5 9.1 0.5 2.7 27.4 19.3 11.0 10.6 134.7 47.1 49 225 32 FY11 7.3 0.6 4.9 7.9 9.5 0.5 2.8 33.2 16.9 10.5 10.4 107.8 59.2 50 225 32 FY12E 6.5 0.6 4.4 8.0 9.6 0.4 2.9 32.6 18.1 10.3 10.4 100.7 63.7 50 225 32 FY13E 6.0 0.6 4.0 7.9 9.9 0.4 3.1 32.2 19.1 10.2 10.0 92.0 71.1 50 225 32 FY09 125.6 FY10 125.6 FY11 125.6 5411.1 5536.7 2749.9 61.9 2811.7 1082.7 633.6 FY12E 125.6 5801.2 5926.8 2749.9 61.9 2811.7 1182.9 800.8 Rs (cr) FY13E 125.6 6221.6 6347.2 2749.9 61.9 2811.7 1286.2 942.7

3031.3 3292.8 944.7 1077.1

4757.3 5071.2 4882.9 5196.8 2236.1 2749.0 185.7 62.7 896.5 446.7 2421.8 2811.7 337.6

Cons security deposit 821.2 Capital employed 8463.5

2420.6 2543.1

9351.7 10064.7 10722.2 11387.8 4488.1 7375.7 55.7 1123.6 3466.6 261.5 546.8 1457.5 1181.1 19.7 1963.2 1838.8 124.4 1503.4 6.4 4846.7 7517.1 75.0 1511.1 3740.3 284.4 597.4 1546.4 1290.5 21.5 2126.9 1999.7 127.2 1613.4 5.7 5200.6 7663.3 75.0 1939.8 4044.6 312.0 649.6 1656.5 1403.2 23.4 2339.9 2193.5 146.3 1704.7 5.0

9428.9 11363.8 11863.8 12363.8 12863.8 3826.1 4131.1 5602.8 7232.7 1279.6 310.4 212.0 402.7 278.3 678.6 238.3 499.9

Total current assets 2964.3 2883.9

Effective tax rate (%) 11.9 Reported net profit 409.7

1274.7 1119.8 42.2 15.5

Loans and advances 1032.7 1010.5 1701.5 1728.9 1578.4 1606.3 123.1 7.9 8463.5 122.7 7.1

Net current assets 1262.8 1155.0

9351.7 10064.7 10722.2 11387.8

Operating cash flow 358.0

986.4 1274.7 1274.7 1119.8

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June 29, 2011