Intense competition from Chinese/Korean manufacturers and domestic EPC players has forced companies to choose between growth and profitability over the last few quarters. The stocks have
de-rated with EPC companies trading at P/E multiples of 6-8x (historical average of 10-12x) and equipment manufacturers trading at 15-16x (historical average of 20-22x). Though the macro opportunity remains robust, will the orders translate into profitable growth?
Competitive intensity is unlikely to ease across segments with Power Grid Corporation Of India Limited (PGCIL) further relaxing domestic component requirement for Chinese/Korean manufacturers. Companies with competitive advantages of diversified revenue streams and disciplined approach to maintaining margins are best placed to deliver returns.
XI plan performance reasonable; XII plan more promising
Transmission line and transformation capacity achievement for XI plan is 60% of target (March 11). This lends confidence for execution of the XII plan as well. Growth in generation capacity, high capacity power transmission corridor orders worth $13 bn, and National Grid capacity expansion should continue to drive growth for the industry. Current estimates suggest XII plan investment in the transmission sector to be $53 bn (growth of 71% over XI plan). Of the
total spend, PGCIL is likely to invest $22 bn in the XII plan (growth of 81% over XI plan). Increased investment from PGCIL, State and Private sector, are expected to provide order inflow and revenue visibility for the companies.
PPP mode catching up in Transmission sector
Over the last three years PPP in the transmission sector has seen good traction, with over 15 projects under development. T&D BOOT projects have seen immense interest with 20 private parties bidding for the projects. These projects offer stable annuity based revenue streams in addition to captive orders of EPC/ products for the bidding entity, providing additional revenue stream. We expect PPP to take a larger share in the XII plan with a strong pipeline of UMTP and intra-state projects.
PGCIL has also formed JVs with the private sector in a bid to give shape to its huge project pipeline. It is also envisaging private sector participation for ultra mega transmission projects for evacuation of upcoming UMPPs. While PGCIL is likely to undertake evacuation for Sasan and Mundra UMPPs, Krishnapatnam, Tillaya and other upcoming UMPPs (Ultra Mega Power Plants) would be developed based on the PPP model. REC, the nodal agency for the Krishnapatnam power evacuation project, has invited international bids for setting up the power evacuation system for the Krishnapatnam UMPP. It has awarded one package of transmission line linked to Krishnapatnam UMPP to a consortium of Simplex, Patel and BS Transcomm and we expect other 10-12 packages for the UMPP to be awarded in the next two years. This project is the first UMPP to have a private transmission link.
Competition – way of life for Power T&D sector
PGCIL’s conscious effort to increase its vendor base has resulted in intense competition across segments. Our primary data suggests overcapacity in the low voltage segment and five players with EHV capabilities in China. With the presence of four players in the Indian market and price correction by 20-25%, we do not expect competitive intensity to further worsen. PGCIL has also placed domestic manufacturing requirement for foreign suppliers and non-compliance of the same could potentially ease competition.
Transformers – Chinese/ Korean players up the ante
Chinese/Korean players like Hyosung, TBEA and Baoding amongst others have made significant in-roads in the PGCIL transformer segment. From no presence in FY08, these players have 45% market share in PGCIL’s orders during FY08-11. This is primarily on account of (a) Price competitiveness – expected to be 20-25% cheaper as compared to domestic manufactured, (b) PGCIL’s relaxation of entry restrictions for foreign players – from mandatory 50% domestic components to just one transformer requirement and (c) huge capacity – 3mn MVA (manufacturing value add) as compared to installed capacity of 0.3-0.4mn MVA in India.
Industry reports suggest the total transformer manufacturing capacity in China to be 3mn MVA, as against annual demand of 1.3 mn MVA. While there are 1,000 manufacturers, there are only 5 players with production capability of over 500kV transformers. The same implies overcapacity to be a bigger concern in the low voltage segment than the EHV segment in China. The real threat to Indian manufacturers has been in the EHV segment with conscious effort on the part of
PGCIL to increase its vendor base. China is expected to resume its investment in the EHV segment after a hiatus in 2010. With domestic market providing reasonable growth opportunity for large Chinese manufacturers, we think that competitive intensity is unlikely to worsen in the Indian market.
Prefer companies with sustainable competitive advantage
We are positive on the investments in the T&D space given future generation plans and target achievement in the XI plan. In such a scenario, companies with sustainable competitive advantage like diversified product profile and geographical reach are better placed to manage growth and maintain margins.
Sector underperformance on concerns of intense competition
Power T&D sector has underperformed the BSE200 index by 30-50% since last year. The sector has undergone a de-rating and most of the companies are trading at valuations closer to October-08 levels, despite significantly higher revenue visibility and growth potential. The underperformance has been on account of fear of the companies inability to maintain margins, return ratios and register EPS growth in a competitive environment. Over the last three years,
competition in the industry has come from both Chinese/Korean players in the Transformer segment and domestic players in the EPC segment. Additionally, concerns surrounding environment approvals and coal linkages have raised concerns on execution of Power plants in the country.
Competitive intensity has suppressed margins; some fare better than others :Increase in Power generation capacity in India and subsequent capex in Power T&D infrastructure has attracted domestic and international players. Incumbents like ABB and Areva aggressively expanded and nearly doubled their capacities over 2007-10 (from 12,000 MVA to 24,000 MVA for ABB and 15,000 MVA to 30,000 MVA for Areva). Relaxation of PGCIL’s entry requirement for international players also saw Chinese/Korean players entering the Indian market. With excess capacity in the transformer segment and 15-20% cost differential from international players, the transformer segment saw severe pricing pressure and in order to utilise excess capacity, companies like ABB and Areva took orders at significantly lower margins. Crompton Greaves refrained from aggressive bidding and introduced increased localisation drive of products, product re-engineering and adopted cost rationalisation measures. Its exposure to domestic power T&D capex is also limited to 25% and it was able to improve its overall margins through turnaround of subsidiaries, despite the competitive environment. With the sustained improvement in margins, Crompton Greaves outperformed its peer Areva by 12%. Similarly, in the Transmission line EPC segment, with promising Power T&D opportunity, no risk of commodity inflation (price variation clause in the domestic orders) and perceived low barriers to entry, many EPC companies forayed into the segment. Increased number of players resorted to undercutting in this segment too. Incumbents like Jyoti Structures (JYS), KEC International (KEC) and Kalpataru Power (KPP) focussed on profitability and refrained from aggressive bidding. KEC International, on account of its significant contribution from international markets (55- 70% over FY07-11) and lower competitive intensity in these geographies, outperformed JYS and KPP by 25% and 22%, respectively.
(Krishnakant Thakur is an infrastructure analyst with Execution Nobel, a boutique investment bank.)