Aug 4, 2011

BHARAT HEAVY ELECTRICALS LTD. (BHEL)

Initiating Coverage - ACCUMULATE

Analyst Rajiv Bharati

rajiv.bharati@destimoney.com

BHEL ACCUMULATE with a target upside of 10%

ACCUMULATE
TARGET : `1,964 CMP : `1,785

Key Data Ticker (Bloomberg) NSE Code BSE Code Sector Industry Face Value (`) Book Value per share (`) Dividend Yield (%) 52 Week Range (`) Market Cap. (` mn.) BHEL BHEL 500103 Capital Goods Electrical Equipments 10 412 1.7% 1780-2695 873,818

(In ` m n) - S ta nda lo ne Net Sales EBITDA EBITDA Margin EPS (`) EV/Sales EV/EBITDA P/E(x) Price Performance Absolute Relative

FY10 333,549 59,200 17.7% 88.1 2.3 12.7 20.3 CY08 -47% 5%

FY11 415,788 80,460 19.4% 122.8 1.8 9.4 14.5 CY09 78% 2%

FY12E 491,117 94,482 19.2% 144.2 1.5 8.0 12.4 CY10 -2% -20%

FY13E 550,210 104,200 18.9% 159.0 1.4 7.2 11.2 CY11 -23% -10%

Shareholding Pattern as on 30 Jun 2011

MF/UTI/FIs/ Insurance Co. 12.7%

Relative Stock Performance (Aug'10=100)

120 110 100

FIIs 13.1% Government 67.7%

Individuals 1.9% Bodies Corporate 4.2% Others 0.4%

90 80 70 Aug-10 Oct-10 Dec-10 Jan-11 BHEL Apr-11 NIFTY May-11 Jul-11

Source: Company, Bloomberg, Destimoney Research

Powering three out of every four Indian homes

BHEL is the largest engineering and manufacturing enterprise in India in the energy-related / infrastructure sector. It has the best revenue visibility, 3.7xFY11 revenues, among its peers in current challenging environment marred by high interest rate, rising commodity prices, unavailability of coal and capex deferment by companies. High R&D expenses (2.3% of revenue) ensures sustainable margin (on account of tax rebate) and technological superiority. After resolution of wage cost related concerns till FY17, the management is channelizing its energy to grapple with other business challenges. Industrial players migrating to higher megawatt power plants recently bodes well for BHELs industrial segment growth. Considering the concerns on poor visibility of order inflows due to languishing financials of SEBs, competition from Chinese players and poor availability of coal, we expect the company to grow comfortably at 13.2% CAGR in FY11-FY16. We expect that a slew of orders from the strategic tie-ups in near term will set the tone for 12th Plan. Preferential treatment in NTPC bulk orders and potential order from NPCIL for 6 additional 700 MW boilers will help BHEL to streamline supercritical technology. In light of the recent correction in the stock, we initiate coverage on BHEL with a ACCUMULATE rating and a target price of `1,964 per share.

Catering to the core sectors of Indian Economy

BHEL

Power
The company supplies power plant equipments and executes power projects

Industry
Undertakes captive power projects and transmission projects, manufacturing power transformers, switchgears, locomotives etc.

International
Includes both power and Industry business overseas

Revenue Mix
100% 75% 50% 25% 0% FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E

Power Segment Source: Company

Industry Segment

Performance edge over competitors resulting in confidence reposed among customers

Performance of 475-525 MW Set

87.4% 92.3% 91.0% 62.2%

Performance of 190-220 MW Set

88.5% 92.7% 92.0% 56.7%

7.8% 6.3% Operating Availability PLF Planned Maintenance BHEL

6.0% 2.5% Forced Outage due to Equip Operating Availability PLF

6.1% 5.5% Planned Maintenance BHEL

5.6% 2.1% Forced Outage due to Equip

NERC Members

NERC Members

Order Received in FY10 (16,489 MW)

State 4% IPP 91%

Order Received in FY11 (15,071 MW)

State 40%

IPP 51% Central 5% Central 9%

NERC member countries (North America, Canada, Europe part) Source: Company, North America Electric Reliability Council

While maintaining its leadership in the ongoing 12th plan allocation

11th Plan (~74,264 MW)

NonChinese Companies 16,201 22% BHEL 36,496 49% NonChinese Companies 25,857 27%

12th Plan (>100,000 MW)

Chinese Companies 21,567 29%

Chinese Companies 22,230 23%

Bhel 49,009 50%

Source: Company

BHEL remains the best play in the capital goods space in the present challenging business environment
Stagnating order inflow
2400 1800 1200 600 0 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E FY14E FY15E 4.8 3.6 2.4 1.2 0.0

Total Order Book (Rs. bn) - LHS Revenue (Rs. bn) - LHS Source: Company, Destimoney Research

Total Order Inflow (Rs. bn) - LHS Order Book to Sales Ratio - RHS

The order inflow has stagnated for the last 3 years and we expect the trend to continue in the coming 3-4 years as well. Revenue growth will be driven by present strong order book 3.7xFY11 revenues. Headwinds in the power sector are taking a toll on one and all, Rising interest rate and poor coal availability domestically Rising international coal prices, tax on coal exports by Indonesia Deteriorating gas production by Reliance Industries BHEL is expected to weather these better on the back of sheer size and steady non-core income (interest income on advances -13% on order confirmation). 7

In light of the 100 GW power capacity commissioning target for 12th five year Plan

Installed Capacity in India (GW)

143 148 159 174 54% 31

Significant improvement in completion percentage

79% 47% 40 16 19 51% 41 21 62 55

100

118 124 105 108 113 102

132

8th Plan 2001 2003 2005 2007 2009 2011

9th Plan

10th Plan Achieved (GW)

11th Plan

12th Plan

Planned (GW)

% completion

Source: Planning Commission

Ministry of Power has revised 11th Plans target of 78.7 GW to 62 GW. It is expected that India will achieve 55 GW during 11th Plan recording 79% completion. We are estimating 80 GW installation in 12th Plan i.e. 80% completion on the back of increased participation of overseas players in JV with local counterparts.

BHEL is in the process of augmenting its installed capacity and workforce

24 18 12 6 0 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12E Capacity Augumentation (GW) - LHS Source: Company, Destimoney Research

54,000 50,000 46,000 42,000 38,000

72 54 36 18 0 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E Wage Cost (Rs. bn)

24% 18% 12% 6% 0%

Employee Strength - RHS

Wage cost as % of Net Revenue

Management has guided to add ~3,000 personnel in FY12 in order to run the new 5 GW capacity addition in progress. With management striking a wage-settlement agreement with employees until FY17, employee cost as percent of sales is expected to decline thereby boosting the margins.

and is investing heavily in R&D to gear up for the next big leap

12000 9000 6000 3000 0 FY07 FY08 FY09 FY10 FY11 R&D Spend (Rs. Mn) R&D % TO

3% 2% 1% 1% 0%

At 2.3% of turnover spent in R&D, BHEL is recognized as one of the most innovative companies in the capital goods domain. Commercialization of products and systems developed by in-house R&D contributed around 18% to the companys turnover in FY11. BHEL is the leader in India in absorbing the Supercritical technology from its partners Alstom (Boiler), Siemens (TG) and MHI (Pumps). The company in total has 14 TG and 14 SG orders. With new coal linkage formula giving more weight to supercritical technology, BHEL stands to have an early movers advantage.

Supercritical Order Basket for BHEL 2X660 MW Barh (SG & TG) 3X660 MW Bara (SG & TG) 2X800 MW Krishnapatnam (SG) 2X800 MW Yermarus (SG & TG) 1X800 MW Edlapur (SG & TG) 1X700 MW Bellary #3 KPCL (EPC) 2x660 MW NTPC Bulk Tender (TG) 3x660 MW Bajaj Hindustan (SG & TG)
Source: Company

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While competition is eyeing opportunities in supercritical coal-fired technology

Due to inadequate experience in dealing in supercritical technology, Indian players have joined hands with foreign counterparts to bid for some of the high profile projects in 12th Plan
JV Partner Capacity 5000 MW to be expanded to 6000 MW by 2012 Location - Hazzira 5000 MW to be commissioned by 2013 Location - Mundra Rs. 1 bn to be invested 3000 MW to be commissioned in 2011 Location Chennai 3000 MW by Q4FY12 Location - Kesurdi, off Pune-Bangalore highway Rs. 8 bn to be invested Status

L&T - Mitsubishi

Current Order Book = Rs. 320 bn

Bharat Forge Alstom GB Power - Ansaldo JSW Toshiba

Thermax Babcock & Wilcox BGR Hitachi

Rs. 7.24 bn to be invested Rs. 44 bn to be invested

Source: Media Reports

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BHEL has been proactively forging JVs with various entities to garner business in the years to come

JV Partner Raichur Power Corporation Ltd.-Karnataka Dada Duniwale Khandwa Project-MPPGCL Udangudi Power Corporation Ltd-TN Jhangir-Champa from Dainik BhaskarChattisgarh Mahagenco (Latur) NPCIL-Alstom-BHEL JV NTPC for Power Projects

Rating 2x800 MW 2x800 MW 2x800 MW 2x600 MW 2x660 MW 8x700 MW

Status Sets are ordered Land acquisition in progress Waiting for Coal linkage and environmental clearance Civil work in progress Land acquisition in progress 2 turbine orders for 700 MW already bagged. Hopes to get others soon. Rs. 1150 mn order already booked in year 1 Plans to increase the capacity in Jhansi to 100 engines per year from current 50. IR has slowed down in ordering, fresh mandate sought. Setting up capacity Market opportunity = Rs. 180 bn

GE for IR locomotives Engines GEIIPL JV for manufacturing water treatment plant

Source: Company

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...coupled with promising government plans

Under the purview of Indo-US civil nuclear agreement GoI wants to set up 36 nuclear plants of 1000 MW spread across 6 states. NPCIL-BHEL JV is envisaging participating in the same. Additionally, GoI has a vision to have a 63 GW nuclear power generation capacity by 2032. GoIs mandate to establish 20 GW of solar power generation capacity by 2022 will act as a shot in the arm for BHELs investment in the solar technology. The company already exports Solar Photo Voltaic Modules to Germany, France and Italy. BHEL has formed a JV with BEL JV to produce Polysilicon ingots and wafers. This will help the company to indigenize the technology faster. Indian railways (IR) has set an ambitious target of adding 25,000 Km of new lines by 2020, taking the total to 89,000 Km. Also the plan intends to electrify 33,000 Km of lines during the same period. To achieve the same IR will have add 4281 electrical locomotives, 280,000 wagons and 50,880 passenger coaches by 2020 which will spur the demand for players like BHEL. Out of the presently deployed capacity (176 GW) in the country, 30 GW is reasonably old and is expected to come up for renovation & modernization (R&M) depending on the cost of renovation. Though the uncertainty looms over R&M segment we expect it will continue at its current pace (10% of TO).

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hence we expect company should comfortably grow at 13.2% CAGR in next 5 years

The topline has grown at a CAGR of 25% in the last 5 years with stable operating margin. We remain cautious and hence expect the topline to grow at 13.2% in FY11-FY16E on the back of reduced order inflow and challenging business environment. GoI intends to increase the proportion of supercritical power plants from current 45% (in FY11) to 60% in 12th Plan and further 100% in 13th Plan. This would result in shrinkage of margins in the near term until indigenization process completes.

600 450 300 150 0 2005 2006 2007 2008 2009 2010 2011E 2012E 2013E

40% 30% 20% 10% 0%

Net Sales (in Rs. bn)

Sales Growth

EBITDA Margin

Source: Company, Destimoney Research

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We initiate coverage with ACCUMULATE rating and a target price of `1,964 per share

We expect order book to grow in near term with the help of bulk NTPC orders (11x660 MW, 9x800 MW) and fresh mandate from established JVs. The stock is trading at 12.6 and 11.4 times its FY12E and FY13E earnings. In light of the recent correction in the stock, we initiate coverage on BHEL with a ACCUMULATE rating and a target price of `1,964 per share.

Relative Stock Performance (Aug'10=100)

120 110 100 90 80 70 Aug-10 Oct-10 Dec-10 Jan-11 BHEL Apr-11 NIFTY May-11 Jul-11

FY10 EPS (`) CEPS (`) P/E (x) P/B (x) ROE ROCE EV/EBIDTA (x) 88.1 97.3 20.3 5.5 27% 38% 12.7

FY11 122.8 133.9 14.5 4.3 30% 41% 9.4

FY12E 144.2 158.0 12.4 3.5 28% 38% 8.0

FY13E 159.0 175.0 11.2 2.9 26% 34% 7.2

Source: Destimoney Research, Bloomberg

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Financial Summary

Income Statement
(In ` m n) - S ta nda lo ne Net Sales Operating expense EBIDTA Depreciation EBIT Interest EBT Other Income
PBT Tax PAT Margins Sales Growth % Operating Margin % Net Margin % 24.8% 17.7% 12.9% 24.7% 19.4% 14.5% 18.1% 19.2% 14.4% 12.0% 18.9% 14.1%

Balance Sheet
FY12E 491,117 396,635 94,482 6,755 87,727 550 87,177 18,171
105,348 34,765 70,583

FY10 333,549 274,348 59,200 4,580 54,620 335 54,285 11,549

65,834 22,800 43,034

FY11 415,788 335,328 80,460 5,441 75,019 547 74,472 15,585

90,057 29,945 60,112

FY13E 550,210 446,010 104,200 7,860 96,339 550 95,789 20,358

116,147 38,329 77,819

(In ` m n) - S ta nda lo ne Liabilities Equity Share Capital Reserves & Surplus Loans Deferred Tax Liability Current Liabilities (CL) Provisions Total Assets Gross Block + CWIP Accumulated Depreciation Fixed Assets Investments Current Assets (CA) Total

FY10

FY11

FY12E

FY13E

4,895 154,278 1,278 (15,272) 280,237 44,180 469,596

4,895 196,643 1,634 (21,636) 313,466 75,968 570,970

4,895 245,794 1,634 (21,636) 370,257 89,731 690,675

4,895 299,982 1,634 (21,636) 414,807 100,528 800,211

81,097 41,505 39,450 798 429,348 469,596

98,577 46,946 51,631 4,392 514,947 570,970

112,577 53,701 58,876 4,392 627,407 690,675

131,002 61,561 69,441 4,392 726,378 800,211

Source: Company, Destimoney Research

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Peer Valuation

Company BHEL L&T Siemens Crompton Greaves Thermax BGR Energy

CMP Market Cap (Aug 4, 2011) (in ` mn) 1,785 1,649 902 160 512 379 873,818 1,006,552 306,878 102,671 60,996 27,382

PE 14.5 22.8 40.1 11.6 16.0 8.5

EV/EBITDA 9.4 13.4 19.5 8.7 8.5 5.0

EV/Sales 1.8 1.9 2.5 0.9 0.9 0.6

ROE 30% 20% 26% 21% 28% 30%

ROCE 41% 19% 28% 34% 32% 18%

Dividend Yield (%) 1.7% 0.9% 0.6% 1.4% 1.8% 2.6%

Source: Bloomberg, Destimoney Research

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Key risks & challenges

Delay in financial closure, securing coal linkage or execution delay Fluctuations in raw material cost Delay in capacity addition may result in performance below our expectation. Pressure from Chinese electrical equipment suppliers Hiring and retaining skilled manpower Adverse political or regulatory developments Delay in receivables from SEBs, which continue to face tumultuous times over the past several years due to Their inability to increase tariff rates as they are controlled by state government High aggregate, technical and commercial losses. Power theft & pilferages, low metering efficiency and poor billing & collection processes have led to high AT&C losses. Rising power cost coupled with longer payment cycle results in companies charging a premium from SEBs

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ANNEXURES

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Energy demand is highly co-related to GDP growth

Co-relation between GDP and demand for energy

9.5% 8.5% 7.5% 9.3% 4.4% 5.7% 3.8% 2.4% 6.9% 7.0% 4.7% 6.7% 7.2% 9.8%

9.0% 7.4%

2003

2004

2005 Real GDP growth

2006

2007

2008

2009

2010

Source: NHPC IPO, 2009

Growth in demand for energy

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With GDP growth expectations at 8%-9%, energy demand is a secular growth story

Demand at GDP growth at 8%

880 660 440 220 0 201112 201617 202122 202627 203132 Projected Peak Demand (LHS) Total Energy Required (RHS) 4,800 3,600 2,400 1,200 0 Installed Capacity Required (LHS) 1,120 840 560 280 0

Demand at GDP growth at 9%

6,000 4,500 3,000 1,500 0 201112 201617 202122 202627 203132 Projected Peak Demand (LHS) Total Energy Required (RHS) Installed Capacity Required (LHS)

Source: Integrated Energy Policy (IEP) Report

In order to sustain a 8% to 9% GDP growth rate, India needs to add power generation capacity to adequately match with this pace. The Planning Commission, in its Integrated Energy Policy report estimates that, India would require additional capacity of about 71-84 GW by 2012, 157-188 GW by 2017 and 276339 GW by 2022.

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Thermal power continues to play a dominant role in India

Total Capacity of 176,990 MW (as on June 30, 2011)

Nuclear 3%

Total Capacity addition planned in 11th plan = 78,700 MW

Capacity added in FY11 = 10,370 MW

Nuclear 4%

Nuclear 2%

Hydro 22% Thermal 65% Thermal 76% Hydro 20% Thermal 92% Hydro 6%

Wind 10%

Source: CEA

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The Indian power sector is characterized by increasing energy shortages

All India actual power supply position

140,000 0%

105,000

-5%

MW

70,000

-10%

35,000

-15%

0 2001 2002 2003 2004 2005 2006 2007 2008 Deficit- RHS 2009 2010

-20%

Demand (MW)-LHS

Availability (MW)-LHS

Source: Ministry of Power, Annual Report 2009-10

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despite low per capita consumption of energy in the country..

Global per capita consumption of electricity

20,000 17,053 15,000 11,174 10,000 6,067 5,000 2,232 734 0 India Brazil China UK Russia Germany France Japan Australia US Canada 2,453 6,443 7,148 7,703 8,072 13,647

Source: IEA, Key World Statistics 2010 (RoW), CEA (India)

India ranks among the lowest in the world, in terms of per capita consumption of electricity, largely due to inadequate supply and distribution infrastructure and rapid increase in population.

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(KWh)

which has resulted in large energy deficit

Energy Deficit in India

18 16.6 13.8 13.0 11.8 12 % 12.2 11.2 12.3 11.7 11.9 12.7 9.8 11.1 9 8.8 6 7.8 2000-01 7.5 2002-03 2001-02 7.1 2003-04 7.3 2005-06 2007-08 2009-10 2010-11 2004-05 2006-07 2008-09 2011-12E 8.4 9.6 9.8 10.1 8.5 10.3 12.9

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Peak Defi cit Source: CEA

Energy Deficit

The energy and peak deficits have been in double digits lately and could widen further, considering the huge demand for power from Indias rising population and rapid industrialization and urbanization. And the shortage would worsen with electricity requirement expected to soar by 55.5% by the end of 12th Plan.

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