Why BHEL could dip 20 percent from here on

With no issues in the power sector being actually resolved and slack demand for power generation capacity, Bhel - the market leader for power equipment manufacturing is bound to take a hard hit. Going by Morgan Stanley estimates, Bhel’s net profit could come down by 38 percent over the next three years. And with this basic argument, MS has downgraded the stock to Underweight with a target of Rs 206. And that’s a fall of almost 20 percent from the current valuations.

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In the last four years, the boiler-turbine-generator (BTG) domestic capacity in India has gone up by 4 times. And even one leaves out the foreign players, the market is plagued by oversupply. Since various issues like fuel supply to power plants, land acquisition for big projects, environmental and land acquisition clearances for coal projects are not in place, MS says Bhel and other domestic peers will be able to utilise only 30-50 percent of the capacity for the next couple of years. This is a huge set back after these companies have enjoyed 100 percent capacity utilisation in the last two years.

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Bhel’s balance sheet did not suffer majorly till now because it was mainly executing past order backlogs. The massive fall in order inflow in 2012 will start reflecting in the profit and loss account in 2013. MS expects an annual decline of 6 percent in revenues over the next three financial years.

The situation will be worsened by declining margins amid higher competitive intensity due to over supply situation. MS prices in a a negative compound annual growth of 15 percent in net profits over the same period.

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During the last down cycle in 1999-2001, when Bhel faced a similar situation, valuations bottomed at stock trading at 4.9 times the earnings expectations of next year. This is at a 50 percent discount over the current levels of 10.3 times. According to MS, the stock must trade at 8 times the expected earnings of financial year 2013 which gives a target price of Rs 206.

The research house recommends switching over to Adani Ports for which it predicts strong earnings growth in near term.