Prefer PSU power cos; Power Grid, NTPC, NHPC top bets: IIFL

At a time when power prices in the country are affected by domestic and global events, Harshvardhan Dole, IIFL believes the electricity sector regulator, CERC will give compensation to power companies.

Last week, CERC passed a landmark order allowing both Tata Power and Adani to charge more for the electricity they produce. This move by the regulator has led to a hike in eight states and one Union Territory. Also read: Adani Power, Tata Power, Rel Power up on CERC ruling However, Dole believes the compensation wouldn’t be far too significant. Quoting Tata Power and assuming coal prices don’t increase much, he said the company would have to hike rates by 40-45 paise only in order to get a profit before tax (PBT) neutral. "So, purely based on the economics, the power that Tata Power would offer will still be competitive," he adds in an interview to CNBC-TV18. Dole prefers PSU power companies over private ones. He is betting big on Power Grid, followed by NTPC and NHPC. Below is the edited transcript of Dole’s interview to CNBC-TV18. Q: Do you see this only as a temporary or an interim relief for these power companies or do you think it’s a substantial move? Have you had to upwardly revise your EPS estimates? A: It is not temporary relief. What is most important is the recognition by the regulator that there has certainly been some change in the business circumstances which has posed significant risk to the viability of these ultra mega power projects (UMPP)/large power plants for which they would need to be adequately compensated. If one reads the tariff order in detail, they have made several comparisons and given several instances as to how the scenario has changed and how the power prices in India are getting influenced by the domestic and international events. Considering all these aspects, there is recognition that one should be ready to compensate these companies on incremental basis which is of course over and above the Power Purchase Agreement (PPA) tariff. So, that’s a good beginning. With respect to the EPS forecast, we haven’t materially changed the EPS either for Adani Power or for Tata Power because a lot will depend as to how these negotiations fructify over the next 30-35 days. We will await those and certainly look forward to change these numbers once the final numbers are out. Q: We are actually in a state of limbo. The argument seems to be that either the power consumers or competitors who lost the bid could perhaps come and take the case apart. How confident are you that we are actually going to see higher tariffs? A: There is a fair amount of certainty that these companies could end up getting compensation. I wouldn’t say that the end level tariffs would need to be increased significantly. If you look at the numbers in reality and if one believes that the coal prices will remain here for a prolonged period of time, then actually the tariff increases that specifically that Tata Power would need to be profit before tax (PBT) neutral is something like 40-45 paise. This is still significantly lower than what the competitive prices are prevailing in the market. So, purely based on the economics, the power that Tata Power would offer will still be competitive. But yes, legality of the argument and firstly the morality would always get tested in several forums. _PAGEBREAK_ Q: When if at all do you think the increases might come in because in the Tata Power case where perhaps the legal problem seems less according to the lawyers, there are five states involved. Technically, do you see this getting counted at all in FY14? A: That is the reason why despite having a strong buy on Tata Power, we think that the asset value of Mundra UMPP will not unfold overnight. This is a gradual process and the value creation from this particular asset will accrue over the next 12-15 months and that is the genesis of us retaining a buy on Tata Power. Q: If nothing were to come at all in terms of tariff hike, how would your buy/sells be in this space - Tata Power, Adani Power, Reliance Power? A: Frankly, our earnings estimates don’t assume any change in the Mundra UMPP tariff. Our earnings estimate remains unchanged. The earnings trajectory remains more or less muted for the next two years. Given the fact that this is one of the most integrated utility and is still reporting profits despite one of its key assets bleeding down, I think at current market price (CMP), these concerns are in the price. So, even if there is no tariff increase, price to earning multiples may not see a substantial expansion. However, there is no reason for it to compress significantly from here on, specifically for Tata Power. So, we will wait for these developments probably over the next three-six months and then look forward to change price to earnings multiple. With regards to the other private sector utilities, if one looks at the entire spectrum of utilities and then takes a holistic view, I think PSUs like National Thermal Power Corporation (NTPC), National Hydroelectric Power Corporation (NHPC) and specifically Power Grid offer far more value with respect to the risks that one is taking right now at this juncture. So, as a house, we are more optimistic or rather bullish on the PSUs vis-à-vis the private sector companies on a risk reward matrix. Power Grid continues to be our top pick followed by NTPC and NHPC.

Q: The standard bidding documents for case two were expected to be finalised before March. Any word on that and there is a new notification from the RBI which says that loans to infrastructure sector would be considered a secured loans. How much of a positive impact would that have if that be the case? A: I am not sure what has caused the delay in finalisation of case two biddings. What is most relevant from the earnings of the power companies is certainly not the case to biddings but how the case on bidding actually fructifies over the next 12-15 months. Certainly, the media articles and the informal discussions with the industry/regulators do indicate that some of the regulators are looking forward to introduce MoU based power procurement which is part of the electricity act given the delays in the case on biddings. So, I think that is one key event that one needs to watch out for rather than the finalisation of case two biddings from the holistic view. On the RBI notification, I think certainly it should be taken in a positive manner. Most importantly, what has also been happening is the state electricity boards (SEB) have started to revise tariffs which has led to improvement in the cash flows for some of these distressed distribution company (discom). In totality, over the next 12-15 months, with the help of the regulators and banking system and of course the discipline that the discoms are exhibiting, certainly cash flow in the system should materially improve. Q: At the moment, these power companies are paying a benchmark price that Indonesia sets. How have these global coal prices been going? As it is, we saw in the arguments itself that the coal prices although they are much higher than the USD 32 that they had agreed to in terms of long term contract went up to USD 90 but had since fallen to about USD 67. Have they fallen further? Is there anything to be gained from the global commodity crash which might make these plants less loss making even if the tariff hikes didn’t come? A: That is a very valid point because the prices that one keeps on tracking on the standard indices are the Newcastle, Richard Bay and the Indonesian HBA marker. But there are several qualities or grades of coal which are higher moisture content and therefore these are not actively traded. Thankfully, some of these Indian utilities have configured their plants to process the high moisture content coal whose quotes are not freely available either on Bloomberg, Reuters or any public traded forum. If the coal prices sustain where they are or even weaken from here on, there is a good chance that Indian utilities may end up gaining over the next 12-15 months by procuring this high moisture content but low value coal over the next 12-15 months. I think that is one key element that one needs to watch out for.