BHEL earnings cut by 10%; see OPM at 14-15%: Macquarie

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Due to project delays pressurizing BHEL's operating margins (OPM), Macquarie Capital Securities cuts earnings estimate for the capital goods major by 10% and says the decline could continue for two consecutive years.

Explaining the reason behind the cut, associate director at Macquarie, Inderjeet Singh Bhatia, tells CNBC-TV18 that the company will not achieve its target of Rs 60,000 crore orders, and that Rs 40,000 crore looks more realistic. "We expect BHEL's long term operating margins around 14-15%," he added.

According to him, the stock is likely to trade around 10 times of its FY13 earnings.

BHEL reported a flat growth in its profit to Rs 1432 crore and its order inflow for nine-months ending December stood at Rs 13,360. The company did receive significant orders either, and instead orders worth Rs 5850 crore were cancelled due to a tight business environment.

Within the capital goods sector, Macquarie says that it expects Larsen to outperform its peers in FY13.

Below is an edited transcript of the interview with Udayan Mukherjee and Mitali Mukherjee. Also watch the accompanying video.

Q: What went wrong with BHEL this quarter and how much have you scaled down expectations on that company now?

A: Regarding BHEL, rather than focusing more on the quarter, I think we are more worried about how the environment in terms of new projects awards on the power side continue to get held up which would mean that the order inflow in that space would remain extremely soft. Even going into FY13, whenever the revival happens, we have seen that whenever order starts up fresh, initially you get extremely highly well competed orders. So I think that can put pressure on margins for BHEL going forward.

We cut our earnings estimates by roughly around 10% for next two years because of the slip in orders in March 2012. The company had initially talked about close to around Rs 60000 crore of orders, but we believe that Rs 40000 crore is a realistic number to look at.

Q: Do you see the possibility of a further crunching down of earnings multiples for BHEL because it is trading at single digit PE multiples now?

A: In terms of FY12 earnings, you are right that it might be trading at single digit earnings. We are actually forecasting the earnings to decline for two consecutive years in FY13 and FY14 and that does not make the stock look like its trading on single digit earnings on FY14 terms. My sense is the stock would eventually come down to trade more like 10 times one year forward earnings and on much more realistic earnings.

Unless earnings come off more significantly, which will make it really look like a bearish case scenario, and the company or market starts to look at it more like a trough earnings and start to attach a higher multiple, I do not foresee a possibility of multiples expanding from these levels.

Q: Any thoughts on NTPC numbers? How did they go down with your house?

A: NTPC numbers were down mainly on account of other operational incomes. I think what we would like to hear from the management much more when speak today as to kind of what caused that number to come down.

But I think over a longer period of time, I think urea earnings, which are roughly around 2% points was their ROEs, were risk with SEBs, financial condition and more discipline coming into the grid, I think those other operational income anyways would keep coming down. But what happened extra in this quarter I think lets wait for management to talk about that.

Q: Your note also indicates that you are quite worried about how competitive the situation has become and how much more pricing pressure BHEL will see. What kind of margin deterioration are you expecting along with that order book problem?

A: We were looking at close to 300 basis point margin decline over next two years or so. We do not foresee a situation where those margins will bounce back to the current levels. I think at close to 20% operating levels, BHEL margins are significantly higher. If you hear some of the new entrants, I think they are more than happy taking projects at high single digits or low double digit kind of margins.

So I think BHEL's premium on those kinds of margins will remain restricted to 200-300 basis points. So I think even long term margins should remain at around 14-15% levels rather than see going back to 20% levels.

Q: What did you make of what L&T did and what do you expected to do?

A: I think if you look at L&T, this is one stock which had earning downgrades for last six quarters or so. Actually if you look at quarter three numbers, what they have done has clearly created a floor on those earnings. My sense is there might be some moderate upside to those earnings.

Another thing was if you look at the nightmarish kind of scenario which was being painted in the section of street which was 10-15% decline in order inflows, that clearly does not seem to play out. Unlike BHEL, L&T has exposure to number of other sectors which is making it hold on to those order inflows. If you look at the under ownership of L&T, our strategy team put out something which said that 300 basis point is the weight of L&T in the broader index while the FII ownership was to the tune of only 100 basis points.

So I think the under ownership in L&T is also making the stock kind of bounce back pretty hard from these levels. My sense is in a name like L&T, now it becomes like a situation of there is no alternative. You can't buy BHEL because of its structural issues. L&T because of its exposure to multiple sectors would be one stock which people would want to hold on especially in an environment where interest rates will start to come off in FY13. So there could be some pull back given the stock has gone up so much. But we still believe L&T would do much better than the sector in FY13.