Equitymaster.com _ Identifying a Power Stock_ Do's and Don'Ts

8/13/2019 Equitymaster.com _ Identifying a Power Stock_ Do's and Don'Ts

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OUTLOOK ARENA >> SECTOR FOCUS >> SEPTEMBER 6, 2003Identifying a power stock: Do's and Don'ts

"When you think of digitizing India there will be a massive amount of power required and I pray to this government that you have to push and push andpush to invest in infrastructure - Mr. Jack Welch"

Profile

Power can be generated fr om water (hydro), t hermal (coal or naphtha), wind and nuclear. Since the Indian power sectorhas not been opened upfor private sector participation in its true sense, the centre and state governments have a major role to play. It is a politically sensitive sector i.e. tariffs

cannot be hiked as the vote bank could be affected.

A power company can be a generator, a transmitter, a distributoror a combination of all three. Barriers to entry are high because it is capitalintensiveand regulated . While technology in state government undertakings is poor, it will play a big role in the future, as consumers will require goodquality and uninterrupted supply of power. Currently, in India, we have 1,07,533 MW of generation capacity out of which private sector contributes 11%.Let's have a look at the revenue model for a power company.

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Total revenues = Revenues from g eneration + transmission + dist ribution.

Generation

For a company involved in generation of power, revenues will be a function of electricity generated and tariffs applicable. Generation of electricity is afunction of PLF (plant load factor) and the capacity installed. PLF, in simple words, is like capacity ut ilisation. The level of PLF varies depending uponthe kind of generation plant. Generally, a hydro power plant or a wind energy plant have low PLF (industry average 35%-50%). Thermal and nuclearpower plants have higher PLF (industry average 50%-65%), which ultimately results in higher production.

Investment in capacity in the power sector depends on various factors like: demand-supply gap (in simpler words we can say deficiency), availability of

funds, economic growth and regulatory fr amework. All these factors are inter-related to some extent.

Demand and supply

One critical factor when it comes to analyzing a power company is the fact that demand expands as per supply. There is nothing like a 'market size' perse. The level of the growth in the industrial sector, per capita consumption of consumer durable and electronic goods would indicate the growth potential.For instance, the penetration level of air conditioners in India is just 0.5%. If more people buy A/C or television or refrigerator, demand for power will

increase.Therefore, as far as demand-supply gapfor a developing economy like India is concerned, it is ir relevant. The country is power deficient.

Availab ilit y of f unds

As we had mentioned before, the sector is capital intensive. It costs almost Rs 40 m to Rs 45 m to set up one megawatt (MW) of capacity . If a


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company is planning to increase capacity by 1,000 MW, it requires Rs 40 bn. From a retail investor perspective, look at the cash balance and thecurrent debt to equity ratioof the company from the balance sheet. This will give an idea whether the company really has the muscle power to expandthe stated capacity in the time frame mentioned.

Economic Growth will lead to increase the purchasing power of the people, which will raise the living standard and in turn increase electricity demand.So, the circle starts again.

Regulatory framework

If a company is just into generation, it has to supply to a distributor for realising value for the quantity of power sold. If the distributor is a SEB (i.e. state

electricity board), the chances of delayed payment are high, as SEBs are in poor state. Failure to receive money from SEBs could hamper a company'scapacity expansion plans.

Having looked at the capacity side, consider factors involved on the tariffs front.

For a generation company that supplies electricity to a SEB, the respective state governments fix tariffs. However, a power generation company can alsosupply to the national grid at a specific rate. The national grid say, Power Grid Corporation, in turn could take the onus of meeting SEB requirements.While the advantage is lower risk of delayed payment and fewer losses on account of T&D, the disadvantage is that the tariffs are lower compared to aT&D player. To put things in simple terms, the generation company gets a specific rate on power supplied whereas it is not the case with a T&D playerwhere there is differential tariff structure.

For a distribution company (like Tata Poweror BSESin Mumbai), tariffs are different depending upon the customers. Usually, industrial units are chargedhigher as compared to households (cross-subsidisation). Agricultural sector is a mixed bag. While some states actually charge for power supplied (like

Tamil Nadu), in most other states, it is free. The advantage for a generation and distribution company is that it can pass a rise in cost to customers in aderegulated market. However, power theft and default rates are high for a distribution major. Watch out for this as well.

Transmission

There can be independent transmission companies as well (like backbone service providers in the telecom sector). The revenue model is similar. Atransmission company buys power from a generation company and hands it over to SEBs or a distribution company. When it comes to advantages, it islike less capital and technology intensive. But a transmission company faces the risks of default of payment by a distributor, high leakage losses and a capon transmission charges. Approximately 30%-35% or power generated is lost in transmission currently.

Distribution

The distribution company can also generate electricity in-house, but the process remains same. Distribution Companies have pre-defined areas called'circles' where they can supply electricity. For a distribution company, metering plays a vital role. Metered units = Inhouse power generated (if any) +Power sourced from a generator to meet additional requirement - T&D losses. A major concern for the Indian distribution companies is heavy T&D lossesdue to poor infrastructure. Due to weak anti-theft laws, 10%-15% of power supplied is lost in distribution.

Key operating and financial parameters to be looked at

Guaranteed return: A power company is guaranteed a certain return on capital employed on generation by the government. If input cost increases,a generation company passes on the cost through increasing the capital employed to maintain margins. Watch out whether there is a possibility ofthe government reducing the guaranteed return. If it does, it could affect profitability of a power company.

Valuing a power company: Since this sector is all about assets, arriving a NAV is important from a retail investor perspective. It is simple and


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Equitymaster.com _ Identifying a Power Stock_ Do's and Don'Ts