Power Grid Corporation: Buy

Fresh investments with a three-year horizon can be considered in the stock of Power Grid Corporation (Power Grid).

Power Grid, which wheels more than 50 per cent of India’s power requirement, is among the best placed to benefit from India’s rising power demand. The cost-plus model which assures a certain return (15.5 per cent return on equity on projects) with no fuel supply risks, provides stability to earnings.

On the macro front, restructuring of State electricity boards, which may improve their financial standing is a positive. Also, Coal India signing fuel supply agreements with power generation companies will give clarity to Power Grid’s expansion plans.

The company managed to meet its 11th Plan (2007-12) capital expenditure target of Rs 55,000 crore. The 12th Plan capex target for Power Grid is pegged at Rs 1 lakh crore.

The company is a defensive play in the power sector with attractive valuations. At the current price of Rs 116, the stock trades at 10.8 times its estimated FY14 per share earnings and 1.84 times its likely book value (adjusted) as of March 2014. On price-to-book value basis, it trades at a premium to NTPC and Neyveli Lignite — the other two listed players in the power sector with an assured return model. The higher multiple is justified, given the higher possibility of earning incentives for on-time execution, shorter gestation for project execution that results in lower locked-up capital, and better growth prospects.

Prospects

A Rs 1 lakh-crore capex translates into 16 per cent growth in the sales for the next eight years (assuming a return on equity of 15.5 per cent). As the earnings growth of Power Grid historically tracked the growth in revenues, net profit growth could match this pace. The company has already awarded contracts worth Rs 73,000 crore as of September 2012, providing revenue visibility.

Rising leverage helped profitability : The company’s increased leverage coupled with higher regulated return on project equity led to shareholder’s return improving from close to 10.7 per cent in 2007-08 to 13.9 per cent in 2011-12.

The return on equity is expected to further improve once the capital work-in-progress (close to 46 per cent of the gross block) transforms into operational projects. In addition to 16 per cent ROE it earns on projects executed on time, Power Grid also earns incentives due to its superior operational efficiency.

For the first half of the current fiscal, the system availability was 99.92 per cent as against the normative 98 per cent which led to higher incentives. Higher power transmission through the short-term open access route also aids profitability. The net profit of Power Grid grew at 22 per cent compounded annually during the period 2007-08 and 2011-12.

Funding requirement : At a normative 70:30 debt equity, the company has to invest Rs 30,000 crore equity in the 12th Plan. The company may not be able to meet this requirement with internal accruals alone and may have to come up with a follow on offer. This may lead to dilution of earnings per share. The company may however increase leverage on projects which it bid through competitive bidding to reduce equity requirement.

Thanks to its access to lower cost funding and lower operating costs, the company has already managed to win two competitive bids on transmission projects in 2012. These projects may aid ROE on the back of higher leverage. The company has already tied-up debt of Rs 26,500 crore with ECBs and domestic loans. Low-cost external borrowing accounted for 30 per cent of the overall borrowing.

Strong visibility : Power Grid has already signed power transmission agreement with majority of the projects slotted for the 12th Plan. In the current Plan, only one-fifth of the investments are towards strengthening of the grid. Therefore, there is risk of delay in power generation capacities leading to transmission projects being stalled.

This may hamper growth for the company. But some of the risk can be mitigated given that a chunk of the assets cater to central and state projects which get priority in terms of fuel supply.

Ultra-mega power projects such as Mundra and Sasan are also on schedule in terms of commissioning.

The company on its part is focussing on transmission to multiple projects rather than single project to reduce risk of being stranded.

Power Grid is planning 11 High Capacity Transmission Corridors for wheeling power inter-state and inter-region. The inter-regional transmission capacity helps transmit power from power surplus States (such as Jharkhand and Orissa) to deficient ones. The inter-regional capacity as of March 2012 is 28,000 MW which is estimated to rise to 63000 MW by 2017.

Inter-regional capacity provides immense scope for Power Grid to make money from short- and long-term open access. The company also makes money from consultancy assignments and telecom business (thanks to vast network of towers). The company has been adding new clients in its consultancy business in India and abroad.

Risk : The company faces huge risk in the form of Central Electricity Regulatory Commission reducing the regulated return on equity from the current 15.5 per cent in 2014. It was last revised upwards from 14 per cent.