Friday, May 1, 2009

>Neyveli Lignite (KARVY)

Not lignitng enough value

Neyveli Lignite Corporation (NLC) is engaged in power generation (capacity 2,490 MW) with back ward integration of lignite mining. Though, it is adding significant capacity of 1750 MW, existing 600 MW (TPS-I) would be shut down gradually. Further additional 1000 MW capacity (coal based plant in JV) would be margin decretive without having captive mine, unlike existing plants. While, Public Sector Unit (PSU) pay revision to pressurize EBITDA margin in FY09 and FY10, higher interest and depreciation cost would penalize net profit growth. Hence, despite 16% sales CAGR, net profit is estimated to grow only at a CAGR of 9% during FY09-14. Moreover, due to high un-deployed cash we expect ROE ~ 9% in next two years, against achievable 16%. Therefore, we rate it as Underperformer with a price target of Rs 75, based on DCF valuation.

Capacity addition will be margin decretive: Though NLC is adding significant capacity, majority of those would be margin decretive as it would not have captive mine like existing plans. NLC is adding 1,750 MW by FY13; out of which 750MW would be lignite based integrated capacity with captive mines by FY11. However, existing lignite based 600 MW (TPS-I - the oldest power plant of NLC) is planned to shut down gradually by end of FY14 which would trim net addition (integrated units) to 150 MW. It is also adding a 1,000 MW coal based non integrated plant by FY13 where fuel (coal) would be sourced from outside (Orissa, ~1400 Km from Neyveli) unlike existing integrated plants. Hence new 1000 MW, is expected to fetch lower EBITDA margin of ~ 30% compared to ~40% in existing integrated plants. So, we expect most of the new capacities would be margin decretive.

Margin pressure leads to unimpressive earnings growth: We expect EBITDA margin to touch 32% and 36% respectively in FY09 and FY10, against ~40% previously. This is primarily on account of significant hike in staff cost stemmed from PSU pay revision. However, NLC is in the process of applying for tariff revision factoring current pay hike, which should help it to regain ~ 40% of EBITDA margin in FY11 and FY12. Nevertheless, it would not be sustainable; with commencement of coal based non-integrated plant from FY13. Moreover, higher interest and depreciation cost (lead by on going capex) would hinder in net profit growth. Effectively, despite a sales growth of (CAGR FY09-14E) of 16%, net profit to record a CAGR of only 9%.

High cash accumulation in balance sheet, to hurt returns: Though huge cash (Rs 48 bn) reserves of NLC could be seen as positive for a power company, we read it as inability of NLC to leverage the current high growth environment and deploy cash efficiently. We believe it carries opportunity cost as by deploying cash in projects NLC could earn ROE of 16%, much higher than earned by cash in bank. Current trend of net cash being ~20% of capital employed to continue in future, indicating one fifth of capital idle. Effectively it will drag ROE as assured ROE is earned only on core net worth (invested in projects). Hence, against achievable ROE of 14%, NLC has achieved 8-12% in history and expected to earn below 12% in future against achievable 15.5%.

Valuation: We estimate 9% net profit CAGR (FY09-14E) and ROE of ~9-10%, while it is trading at 20x FY10 EPS. Though there are some positives in the stock, we believe those are already factored in the current price. Hence, we initiate coverage on NLC with a target price of Rs 75 (based on DCF) and rate as under performer.

To see full report: NEYVELI LIGNITE