The power sector in India has been in the dog house for many years. High distribution losses and unbilled power has resulted in bankrupt SEBs (State Electricity Boards). For many SEBs, the only way to cut losses has been to reduce purchase of power from Generators as effective realization/unit is lower than the cost of power purchased. Many SEBs have stopped signing new PPAs as unless distribution losses are plugged, buying and selling incremental power is digging a deeper hole.
Bankrupt distributors have caused the problem to migrate upstream to Generators. In the last quarter, NTPC reported a PLF of 72% against a PAF of 86% – the difference of 14% was explained by poor draw down from SEBs. (PAF – Plant Availability Factor denotes % of plant ready to supply power and PLF denotes what % of capacity the plant actually operated at). The Supreme Court order cancelling arbitrary Coal allocations has collapsed the economics for those with such Captive Coal mine linkages as their input costs have increased dramatically while they have fixed price contracts with SEBs.
It is not surprising the BSE Power Index is down 33% over the past 5 years vs approx. +55% for the broader market Index, a relative underperformance of approx. – 88%. Many generation companies are trading, deservedly so, at a fraction of their book values reflecting that further losses are in store which will erode the Equity of the company.
We believe the sector sentiment should improve over time.
- Power plays a very central role in the economy. Inability to reform the sector is not an option.
- “Made in India” is a distant dream without reliable and competitively priced power
- Loss financing to SEBs is slowly but surely more difficult to obtain
- The Modi Govt has a very strong focus on renewable power. This is far more expensive for SEBs than power from Conventional sources and hence with far less incentive for SEBs to draw down.
- Further, poor investment in new manufacturing orders will have spill over effects on many down-stream Engineering sectors.
- There is visible progress on many actions taken by the Govt. to improve the health of the sector – faster project clearances, increased Coal production, attempts to restructure SEBs and privatize distribution, allowance for increase in tariff for projects needed imported Coal where Coal India has not met commitments
Even as aggregate sector sentiment should improve over time, our research suggests that there are a few companies even today who have not been tainted by rent seeking behaviour and which seem to be trading at attractive valuations for long term investors.
Here is a list of questions to help identify such “diamonds in the rough”
- Is the project Coal based, Gas based on Hydro?
- A coal based project has the lowest cost of power production and is hardest to switch on and off.
- It is therefore likely to have the highest PLFs as SEBs will source the cheapest power first
- Has the company got a firm Coal Mine allocation from Coal India?
- No Mine allocation suggests trouble as the project is unlikely to be able to sign a PPA on favourable price terms
- Does it have a signed PPA (Power purchase agreement) with SEBs which are rated either A+ or A by the Ministry of Power?
- The rating of SEBs suggests which ones are in better health and hence more likely to pay on time and draw down on committed units in the PPA
- Does the PPA/regulator permit incremental RM price pass through in the event Coal India cannot supply committed quantity of Coal?
- Are the Generators using world class suppliers or have resorted to Chinese Equipment? Have they hedged FX loans?
- Does the Capital cost per MW compare with that of NTPC?
- Have the promoters been pulled up for rent seeking behaviour by the Supreme Court in the past? Can their governance track record be trusted?
- Has the Asset got all environmental approvals and access to land/water for future expansion?
- It is a travesty that many analysts are modelling India as a power surplus country when many of our villages still don’t have access to power, most cities in Northern India bear long power cuts during the summer and when many manufacturing companies officially run a 6 day week because of lack of access to grid power.
- Companies who have not indulged in rent seeking behaviour will therefore enjoy growth opportunities over time as SEBs are forced to return to health. Many State Govt. have taken huge tariff hikes in the recent past.
- What is the margin of safety at current prices?
- Power Generation is a Utility with capped ROEs (15-17%). Fair equity valuations should not be more than a slight premium to book values.
- It costs about 5.5 Cr/MW to set up a Coal based power plant of which equity is about 30%, hence about 1.65 Cr/MW.
- Any company which desires to set up a new Asset –which is legitimate with all clearances and PPAs – should therefore trade at about 1.65 Cr/MW and with a premium for companies whose plants are now on stream (execution risk has been eliminated). Let us say about 2 Cr/MW for companies with newly Operative plants and say 2.25-2.5 Cr/MW for companies with older plants with debt paid down. These are indicative figures which will vary based on other variables such as Discom with which PPA has been signed etc.
- Given that fair valuations for the company can be calculated based on the mix, age of plants, vs valuations they are trading at present, calculations for margin of safety at the current price can be performed with some effort.
Investment wisdom tells us that “we need to skate to where the puck is going, and not where the puck is”. Hence, we should not wait for sentiment to turn as prices at that time may not offer an attractive entry point. Likewise, sentiment is not turning tomorrow… so one needs to be mindful that things could get worse before they get better. In conclusion, Investors should keep in mind that power generation companies (who have followed the law) have predictable economics as profits have very low vulnerability to business cycles, RM fluctuations or other forces of creative destruction seen in most industries. These companies offer stable returns, a couple of % points above long term debt and pay good dividends. Being able to buy these companies at significant discount to fair prices could result in above market returns for the patient investor if one is prepared to have at least a 3 year view