Monday, 13 August, 2007

Bharat Heavy Electricals

Buy BHEL; target Rs 2000: Merrill Lynch

Merrill Lynch has recommended buy rating on Bharat Heavy Electricals Ltd with the target of Rs 2000, based on 1-year forward PER of 22.5x - 10% discount to peak PE in the last cycle (94-97) & 17% discount to
its current multiples.

Merrill Lynch report on BHEL:

Pricing Pressure Concerns Led By Misunderstanding; Buy

After our meeting with BHEL CMD, we re-iterate that concerns on the pricing pressures on BHEL led by the recent Damodar Valley Corporation's (DVC) orders is driven by lack of understanding on the facts of the situation. Concerns surfaced from a 1,000MW order in May '07 valued at Rs 32 billion vs a similar size order in Dec '06 at Rs 34.5 billion. However, on doing the due diligence, we find that the pricing of the second order was ex-duties (8-10%) as Utility got tax
concessions, whereas in the first order it didn't get exemption (mega status). Buy - PO Rs 2000.

DVC orders provide economies of scale

We believe that the concerns of pricing pressure on BHEL are overdone - after adjusting for the excise duty (8%); both DVC order wins have
similar realizations (Rs 32 million/MW). On the contrary, we believe that BHEL would enjoy better margins on scale economies for 2,000MW order for a single customer in the same state.

Order backlog >Rs 700 billion; Competitiveness likely improve

As per our on-ground research, BHEL has had a dream run at tenders opened in last 12 weeks, where it has beaten its Chinese, Czechoslovakian & European competitors. Consequently, we expect continued momentum in order intake in FY08E as well. We note that BHEL order book last week crossed a historic Rs 700 billion, +86%YTD. Further, CMD informed us that BHEL's capacity expansion plans to 15GW (+130%) by 2009 is on-track and that will be done at existing
locations with only 20% increase in work force, boosting its competitiveness further. Also its 600 MW boiler with 8-10% lower price/ MW is ready to compete.

Reiterate Buy on improving pipeline and competitiveness

We expect stock to outperform as company address key concerns on Chinese competition, super-critical orders likely in 2007 and improve competitiveness.

Price objective basis & risk

Our Price Objective of Rs 2000 is based on 1-year forward PER of 22.5x - 10% discount to peak PE in the last cycle (94-97) & 17% discount to
its current multiples. BHEL currently trades at 20.4x FY09E PER vs BSE Sensex at 15.6x. However, we believe, that premium valuation is justified given BHEL's superior market position, earnings growth (30% for BHEL vs market at 15%) and RoE (31% v/s market 22%). Regionally,

BHEL trades at 20.4x FY09E v/s Asian comps at 16.8x. However, we believe, that premium valuation for BHEL is justified given its superior RoE (31% vs regional average at 18%) and consistency & its
sustainability of growth.