Sunday, December 18, 2011

>POWER FINANCIERS: Power Finance Corporation (POWF) & Rural Electrification Corporation (RECL)

Light at the end of the tunnel

 POWF and RECL are best placed to leverage on the massive investment opportunity: Over the next five years, c.$236bn is estimated to be invested in the power sector as India scales-up infrastructure in generation, transmission and distribution. REC and POWF are best positioned to leverage on the massive investment opportunity given a) IFC status which gives exposure limits advantage, easier access to ECBs. IFCs have a competitive edge over banks given better asset-liability profile. Further, most banks are approaching their sectoral limits for infrastructure sector which should reduce competitive intensity for specialised power financiers like POWF and RECL.

 SEB default unlikely – losses may have peaked, tariff hike trend encouraging: SEBs have been under financial distress due to non-revision of tariffs, non-payment of subsidies and high merchant power rates. However, recent measures offer hope that their finances will improve going ahead led by a) 5-40% tariff hike across states over the last 18 months (Exhibit 2). Further, 3 of the 4 states (TN, UP, MP, Rajasthan) that account for c.70% of cash losses have already raised/proposed to raise tariff while UP will raise tariff post election early next year. b) APTEL facilitating suo-motu tariff increase by the regulator. c) Increasing pressure from lenders to improve finances by raising tariffs/improving efficiency. d) Declining power purchase costs which would provide much needed relief to SEBs. These measures are a step in the right direction and we believe financial position of SEBs will improve going forward, implying that default from SEBs for POWF and RECL is unlikely.

 Fuel availability - A key risk: Coal and gas availability, in our view, is a significant threat which could restrict power supplies and impact financial viability of projects. Coal supply has been severely hampered due to a) Coal India unable to achieve sufficient production growth, b) delayed environmental clearances, c) infrastructure bottlenecks, d) blending limitation in existing plants, e) pricing issues on imported coal from Indonesia and Australia. However, recent steps by government to scrap go and no-go policy and granting environment clearances to some delayed projects should reduce this concern over the medium term (3 years); though fuel availability remains a key near-term risk which could lead to restructuring of projects (especially IPPs in the capacity range of 50Mw-100mW) and result in some NPV loss for power financiers.

 Initiate coverage on POWF and RECL – BUY with TP of `205 and `220 respectively - recent SEB/government measures and decline in wholesale rates should act as key catalysts: POWF and RECL have de-rated significantly over the past 12 months due to concerns over financial health of SEBs (POWF currently trades at 0.95x 1yr fwd book, down from a peak of 2.9x; while RECL at 1.1x 1yr fwd book, down from a peak of 2.9x. Going ahead, we believe recent SEB/government measures and decline in wholesale borrowing rates from 1QFY13 (which will impact spreads positively) should act as key catalysts for stock outperformance. We initiate coverage on POWF with Mar’13 TP of `205 – current valuations are attractive at 0.9x FY13E book with dividend yield of c.5% (based on FY13E dividend). We value the stock at 1x FY14P/B (at 1.05x Mar’14 ABV - adjusted for bad and doubtful debt reserves) Initiate coverage on RECL with Mar’13 TP of `220 - current valuations are attractive at 1x FY13E book with dividend yield of c.5% (based on FY13E dividend). We value the stock at 1.1x FY14P/B (at 1.15x Mar’14 ABV - adjusted for bad and doubtful debt reserves).

To read the full report: POWER FINANCIERS