Reliance Energy: Regulatory impact on margins:

Performance summary:

Reliance Energy has announced mixed results for the fourth quarter and year ended March 2007. For FY07, the topline has grown by 42% YoY. The company has taken a significant hit on its profitability on account of a MERC order in October 2006, whereby it has written off an amount of around Rs 1 bn from its electricity business profits. Consequently, the operating margins have declined from 17.8% in FY06 to 8.4% in FY07. However, the company has managed to pare this impact on its bottomline, duly aided by lower depreciation and tax expenses. Consequently, net profits have grown by 23% YoY during the fiscal. The board has recommended a dividend of Rs 5.3 per share (dividend yield of 1%). What is the company’s business? Reliance Energy is a leading private sector power company in the country and has presence in generation, transmission and distribution in Mumbai, Delhi, Orissa and Goa. The company has an installed generation capacity of 941 MW. The company also has a presence in the engineering, procurement and construction (EPC) business (36% of FY07 revenues). What has driven performance in FY07? EPC leads the way: The 42% YoY growth in Reliance Energy’s topline during FY07 has been led by a strong performance from the company’s EPC (engineering, procurement and construction) business, which has grown sales by 142% YoY during the fiscal. This business formed around 36% of the company’s topline during the fiscal, up from 21% in FY06. The company had booked some large orders during the fiscal, the initial execution of which have perked up this business’ sales numbers during the fiscal. The company had recently bagged a 1,200 MW project in Hissar (Haryana) to set up a 1,200 MW coal-based power project on a turnkey basis for Rs 38 bn. As reported, the project will be implemented in a schedule of 35 to 38 months. It also won a 500 MW project in Pariccha (Uttar Pradesh) for the EPC business. On the road construction front, the company had recently won two BOT projects - development of Namakklal-Karur highway (a stretch of 80 km in Tamil Nadu for Rs 5 bn) and contract for developing the Trichy-Dindigul National Highway four-laning project (stretch of 88 km for Rs 6 bn). At the end of March 2007, the company’s EPC order backlog stood at Rs 52 bn. As far as the electrical energy business is concerned, it grew by 15% YoY during FY07 and contributed to around 64% of Reliance Energy’s total revenues in FY07 (79% in FY06). The company sold 8,766 m units (MUs) during FY07, representing an 8.4% YoY growth. Its per unit realizations grew by around 5%, aiding the overall growth in the segment sales during FY07. The growth in volumes during the fiscal was mainly brought about by higher levels of plant load factor (PLF, or capacity utilization) at all of the company’s power plants. As a matter of fact, the Dahanu station (500 MW) improved its PLF to 101.8% during FY07, from 98.7% in FY06. Reliance Energy bought 4,454 MUs of electricity during FY07 (3,921 MUs in FY06), which formed almost 51% of its volume sales. This indicates the company’s high dependence on external sources. The cost of these purchases stood at Rs 3.4 per unit (Rs 2.8 per unit in FY06). In order to curb its dependence on external sources and also to grow otherwise, Reliance Energy has chalked out an aggressive capital expenditure plan, towards setting up large generation capacities in the next 4-5 years. These include a 4,000 MW gas-based project in Uttar Pradesh (one phase of the larger project of 8,000 MW) and a 2,000 MW gas-based project in Maharashtra (Shahpur). While the company has adequate financial muscle to take forward a large part of this planned expansion, fuel related issues (especially gas availability and pricing) is what we are cautious about. The company has also commenced work on the 620 MW Rosa project in Uttar Pradesh, which it had acquired from the Aditya Birla group. The total investment in the project will be to the tune of Rs 26 bn. According to the power purchase agreement (PPA) that the company has signed with Uttar Pradesh Rajya Vidyut Utpadan Nigam, this project will be completed in 44 months. ‘MERC’ effect on margins: Reliance Energy took a hit of around Rs 1 bn (on account of an order from MERC (Maharshtra Electricity Regulatory Commission)) on its electrical energy segment profit during the quarter, which was reflected in the sharp contraction in its EBIT margins. The management has indicated that this amount will be recovered over the next three years by way of tariff from customers.

The EBIT margins of the EPC business were also impacted during the fiscal, as these contracted to less than 6%, from 14% in FY06. Initial execution costs attached with some of the large projects without commensurate addition to revenues (as these contracts are still in their initial stages) has impacted profitability of this business segment. Lower depreciation, taxes pare pressure on bottomline: Despite the sharp contraction in operating profitability, Reliance Energy manages to pare the pressure on its bottomline during FY07. This was owing to reduction in depreciation (due to revaluation of plant and machinery at Dahanu) and tax expenses (due to tax write-backs from previous years) during the year. The company has outperformed our FY07 net profit estimates by 1%. What to expect? At the current price of Rs 526, the stock is trading at a multiple of 15 times its FY07 earnings. The results have been a mixed bag considering that while the strong topline performance was a positive surprise, the decline in profitability, both on the electricity and EPC business fronts was unexpected. We also remain cautious on the company’s expansion plans, given the hiccups that it is facing in terms of fuel (gas) supply and pricing.