Bull or bear: Is BHEL about to enter a cyclical upturn?

Below is the transcript of the interview on CNBC-TV18.

Sonia: You have a fairly positive view on BHEL, why do you think the stock has rallied so much and when do you expect to see any kind of fundamental earnings recovery in the company?

Tiwari: You need to understand what Bharat Heavy Electricals (BHEL) is all about. There is the case for strong revival in power equipment market today. So two things, one BHEL is fundamentally strong company with very strong management and products. The problem with the stock performance and de-rating was the market was bad.

Now there are two aspects to the market, the near term revival is obviously visible. The second aspect is that if one looks at the long-term trend in the power market in India, we are of the opinion that there is likely scenario of acute shortage of power three-four years down the line. So what happens that policy makers in power business take a very holistic view. So today if one has to look up and see what is the power environment in 2018-19, one has to plan from today.

So based on my meetings with the top bureaucrats and the policymakers in Delhi, there is serious realisation that there is acute shortage waiting for India in next four-five years. So there is policy action towards that and therefore the market is expected to revise significantly. BHEL being the strong contender in the boiler-turbine-generator (BTG) market will benefit meaningfully from that as well.

Latha: When do you see orders coming in for BHEL?

Tiwari: The important thing is to understand what power is. Today there are three aspects of the power producers, there is an independent power producer (IPP), there is state electricity board and there are central PSUs. When you say there is surplus power or the power producers are in bad shape, you are talking about IPPs. So that is one segment of the market and state generation companies, they were not in the market. So why should I assume that if IPP is struggling, then the whole power sector is in a mess.

What I believe is there is a particular cycle, there was a cycle of IPPs for last four-five years and there is going to be a cycle for the central PSUs and state PSUs for next four-five years.

You will be surprised to know that in last seven months about 10000 megawatt power projects have already been awarded. I know for sure that there is a pipeline of 15000-16000 megawatt from mainly state and central PSUs to be awarded in next six-seven months. So the basic argument that where are the power projects, is already busted because we already have seen awarding of really 10000-11000 megawatt power projects in last seven-eight months. So that point is already taken care of.

The issue today with BHEL is that can we see the sustained growth and I believe that there is a likelihood of sustained growth in this particular market now.

Sonia: Last quarter the management already expressed that hope of recovery. If you look at what they mentioned in their conference call, they stated that as against 6.2 gigawatts of orders finalised in FY14, they expect 16 to 18 gigawatts by the end of FY15. So they had expressed that improvement in orders. How much of that do you think is already priced into the stock in this run-up or do you see more to go on the upside?

Tiwari: It is not priced in at all. If you look at what can result into. When you look at 16000-18000 megawatt of power projects, there is one state Telangana, this state has no power plants. There is new CM, new project and basically they are looking at significantly making state power.

Now if you go through the news of recent times you will understand that BHEL has signed an MOU with Telangana state government to set up 6000 MW power projects. Now that is not included in the 16-18000 mw that we are talking about.

Since this is an MOU this kind of order can straightaway come to BHEL over next five-six months. Understand the value of that, it is Rs 30,000 crore order value for BHEL. So what can happen to the stock. So today when we see at BHEL there is concern of ordering which is probably being taken care of, there is concern of margin which I think is going to be a bigger surprise. I firmly believe that BHEL can go to 15-16 percent margin and therefore it can result into meaningful earnings recovery. So if I look at this year definitely no earnings growth, probably there will be a degrowth but next year definitely is going to be at least 10-12 percent kind of earnings growth. But FY17 could be a year where one can look at 50-60 percent kind of earnings growth.

Now if you look at BHEL stock price it is a long gestation business so typically if you have studies BHEL for last 10-12 years you will realise that the market value discounts at least three years ahead of earnings. So if I see earnings recovery in FY17-18, I would definitely look the stock will start reacting today itself. So that is the reason I am saying that it is not discounted fully. So it is just Rs 50,000 crore market cap stock.

Latha: What do you say to these orders that could come from Telangana state or even from the central PSUs which are the solvent elements? Do you think that is priced in or there is still a little way to go?

Rao: We are neutral on the stock because if you look at BHEL’s performance over the last two cycles, you will see that it has always gone through a survival phase, which it has in the last two-three years. It goes into a consolidation phase where it streamlines its own operations, its peers consolidate and there is a shake out in the industry -- even its consumers or its customers get shaken up and then it is followed by high growth phase.

I think the consolidation phase is on and its going to take another two-three years for definitive orders to come in, everybody has priced in 6,000-7,000 megawatts of orders coming in. The bull case comes in once that 8,000 MW scenario gets breached and that’s still some time away.

Let us not forget that unlike what Mr. Tiwari said, customers for BHEL get payments down the line from distribution companies, the transmission losses and distribution losses especially in India are 20-22 percent so they are not able to pay for power they are buying. A lot of state governments are now strengthening that and raise their capacity utilisation in generation and that is going to take another year-year-and-a-half.

Latha: Have BHEL’s margins at least bottomed out. It was couple of quarters of low single digits. Have they bottomed out? Dhirendra spoke about even 15-16% happening. What is your view of the margins and what is the downside in the stock. Is that at least blocked?

Rao: The downside is limited because the stock has moved more on expectations of projects getting cleared but being a long tail sector and there have been a lot of stakeholders. Let us not forget the banks are also involved in this because the banks are the ones funding the projects. So the banks are involved, a lot of government authorities are involved, many of them being state government authorities. So, it’s going to be a long drawn process. So one-one-and-a-half year is where we see this whole process taking.

To answer your question specifically – on the margin front we are going to see at least six-eight quarters of fairly flat to fairly ordinary margins because that is the nature of the industry, its long tail. I would not be surprised if you saw another couple of quarters of subnormal margins in the first half of next year because the second half is usually when the deliveries come in, the margins improve. So, going forward there could be a bout of low margins but it should bottom out by the end of FY16 and that’s where we believe that the meaningful pickup will come up in the stock.

Sonia: There are many growth opportunities that are now picking up in the non-power space as well like non conventional sources of power, solar power, there is T&D etc. In your bullish case are you factoring in any of this as well because we are seeing a change in government policies? Do you think BHEL could be a beneficiary of this?

Tiwari: It can be. But I do not factor those things because BHEL is a large power equipment company, so typically the impact may be minimal but if they get 4,000 MW of solar power plant that will be significant, they have MoU but investors will be looking at power as the main business which will be driving the re-rating and that is going to be the driver, of course they can benefit from defence, they can benefit from solar power and they can benefit from wind power. So, all those opportunities will provide additional growth but may not be the key reasons to move the needle. The needle will be driven by lot of orders which are expected and the profitability which is likely.