Research Report - Tata Power Company Ltd - Target Price: Rs.140

Market Data Price on reco. date (Rs) 105 (BSE) CMP - BSE / NSE (Rs) 105 / 105 Change since reco.  0.0% 52-week High/Low (Rs) 133 / 81 NSE Symbol TATAPOWER BSE Code 500400 No. of shares 2373.0 m Free float 68.3% Market cap (Rs m) 249,165   Rs 100 invested is now worth Stock price performance Tata Power Index* 1-Yr -23.1% -7.7% 3-Yrs -5.2% 4.8% 5-Yrs 9.4% 3.2% Returns over 1 year are compounded annual averages * BSE Sensex Shareholding (Mar-12) Category (%) Promoters 31.7 Banks, MFs and FIs 26.5 FIIs 21.9 Indian public 15.5 Others 4.4 Total 100.0

Investment Rationale UMPP losses no reason for despair: Blue chip stocks are known to resist economic downturns better than smaller peers. However, we have come across quite a few fallen angels over the past few months. Ones that displayed some uncertainty in fundaments especially invited investor fury. But nothing beats the pessimism that surrounds the power sector. Execution delays and fuel shortages were already factored into valuations. But some unforeseen charges that eroded the bottomline in FY12, caused investors to dump most stocks in the sector. That some of these are power sector players of repute with assured return profile did not console investors. Tata Power is one such stock that has borne the brunt of not just sector risks but unexpected losses at the consolidated level. The 4,000 MW Mundra ultra mega power project (UMPP) being executed by subsidiary Coastal Gujarat Power Ltd (CGPL) incurred losses at the operating and net level in FY12. The losses are ascribed to the tariff structure under the UMPP’s power purchase agreement (PPA) and higher global coal prices. The tariff has an escalation clause for fixed costs and 45% of the total fuel costs. The project is an imported coal based plant that has a fuel supply agreement (FSA) with Indonesia's Bumi Resources (in which Tata Power has 30% stake) to supply 10.7 MTPA of its coal requirement. Earlier, 3.2 MTPA was to be supplied at a fixed price. However, Indonesian laws stipulated in September 2011 that coal produced in the country will be pegged to prevailing international prices. As per the management of Tata Power, with the revised fuel cost, the cost of power generated at the Mundra project is likely to be Rs 2.9 per kwh while the power purchase agreements (PPAs) have been signed with SEBs at Rs 2.26 per kwh. This was due to nearly 40% rise in international coal prices since the agreements were signed. As a conservative measure, Tata Power has provided for a one time diminution in the value of investment in CGPL to the tune of Rs 18 bn in FY12. Also in order to protect CGPL's cash flows, the parent company will transfer 75% of its equity interest in Indonesian coal companies to the subsidiary. While some further near term losses in the Mundra project cannot be ruled out, we believe that the worst is over for Tata Power in this regard. Notwithstanding the fact that Tata Power boasts of the maximum number of long term contracts in the power sector, the company also has sufficient upsides to its regulated returns (refer table 1). The interesting part is that unlike its peers, Tata Power does not have a very aggressive growth plan. With a turnaround in the UMPP business we believe that Tata Power's consolidated return ratios will see significant upsides in the next three years. Hence despite the possibility of some near term hiccups (our estimates and target price have been revised accordingly), we believe that investors have enough reasons to Hold on to a blue chip stock like Tata Power in their portfolio from a three year perspective. Table 1: Upsides in the offing Model Capacity MW % of total capacity Type of returns Contract (years) Upside Operational capacities Regulated returns 2,552 55% Fixed return on equity Till FY18 PLF incentives Regulated tariffs (renewables) 405 9% Fixed tariff +PLF Till FY21 - FY29 Savings on capex Captive Power Plant 668 14% PPA driven (14-19% RoE) Till FY27 - FY41 Merchant sale + saving on PPA terms PLF incentive Merchant 140 3% Market driven N.A No cap on returns MOU / Bilateral 20 1% PPA driven Till FY18 As per PPA Others 881 18% Bid driven PLF incentives Capacities under execution Projects Capacity Completed Power offtake Fuel linkage Mundra UMPP 4,000 92% PPA driven Signed for 3,800 MW Imported coal Maithon 1,050 95% completed PPA driven Signed for 1,050 MW Coal linkaged Dagacchu 126 Tata Power trading company Hydro Data source: Company presentation Majority funding already arranged: The funding for the planned capex over the next 2 years of Rs 104 bn will take place in a debt to equity ratio of 70:30. This means that Tata Power would require Rs 33.2 bn of equity money. While 70% of this money will come through internal accruals, the company has already raised Rs 6 bn through an FCCB issue in FY11. This completes its equity funding for the said capex. As for the debt requirement of Rs 70.8 bn (70% of Rs 104 bn), the company has already arranged 60% of the money through issue of hybrid securities and perpetual debt. In short, the company has already tied up a large part of its funding and is thus not likely to face any issue on this front. Positive strides in related areas: Apart from its power generation plans, Tata Power is also progressing steadily in other related areas like power distribution, trading, and coal mining. Its distribution business in Delhi, North Delhi Power Limited (NDPL), where it has a 49% stake and Tata Sons has 2% stake, was the company's first venture in retail distribution outside Mumbai. NDPL is performing extremely well. In must be noted that at the time of privatisation of NDPL, the target for aggregate technical and commercial (AT&C) losses was set at 20% for FY09 (from levels of around 50% then). NDPL, under Tata Power, met the target ahead of schedule. The AT&C losses stood at just around 14% at the end of FY12. Based on this success of NDPL, Tata Power applied for parallel distribution licenses in seven areas of MSEB (Maharashtra State Electricity Board) and also expressed interest in taking franchises in Gujarat for power distribution. In fact, in 2009 the Supreme Court allowed the company to supply power to its distribution arm, which holds a license in the lucrative Mumbai circle. Subsequent to that, the company has acquired over 1,00,000 retail customers in Mumbai, and has been resorting to buying spot power to service this customer base (the company is however fighting a legal battle against Reliance Infra, which is disputing Tata Power's license to supply directly to Mumbai consumers). Overall, the company is making positive moves towards establishing itself as a major player in the distribution segment. This we believe will contribute positively to its long-term growth. Secured fuel supply: Despite some uncertainty over fuel supply from Indonesian coal mines (where it holds a 30% stake), Tata Power is reasonably secured as far as it's near term coal requirements are concerned. Further, it is also looking for mines in Australia, South Africa and South-East Asia to ensure fuel security for future projects. Besides the equity stake in the Indonesian coal mines, Tata Power also has stakes in two captive coal blocks in India. It has a 33% share in the 7.5 MTPA Mandakini coal block in Orissa. It plans to start coal production from these mines during this fiscal (FY12). The company also has a 40% stake translating into 2.3 MT in the 5.75 MT tubed coal block in Jharkhand. Tata Power has also tied up with Tata Steel for supply of coal to the captive power plants in Jojobera and Jamshedpur. We see these coal assets as holding tremendous importance for Tata Power, given the company's expansion plans.

Investment Concerns Data source: Company presentation Earnings sensitive to coal supply and prices: The Indonesian coal assets contributed to around 35% of Tata Power's consolidated revenue and 49% of consolidated profit (before interest and taxes) in FY12. This share increased from 33% and 44% respectively in FY11. The rise in coal prices in FY11 and FY12 boosted the contribution of the coal business to overall profitability and even shielded the margin pressures in the power business. Tata Power's overall profitability would have been in danger but for the buoyancy in coal business' margins. A high dependence on this business therefore makes the company's overall business sensitive to changes in coal prices, which have been very volatile over the past few years. While the coal prices for the Indonesian mines fell from US$ 78 per tonne in FY09 to US$ 60 in FY10, they again went up to as much as US$ 110 a tonne in FY12. This volatility in coal prices is of concern to us. Further recent reports suggest that the Indonesian government may be looking to ban the exports of low-grade thermal coal by 2014. This move, if undertaken, could aggravate the coal supply shortfall in India. Debt rating downgrade possible: International rating agency Moody's has recently threatened to downgrade Tata Power's corporate debt rating, primarily due to breaches in debt service coverage ratio related to the company's Mundra UMPP. The rating action, though not indicating payment default, could impact Tata Power's financial profile. However, changes to Mundra's tariff structure and transfer of 75% equity stake in the Indonesian coal mines to CGPL could thwart the rating downgrade risk. Background Data source: Company presentation Tata Power is the largest private player in the power sector with a generation capacity of around 5,000 MW, which is around 20% of the total power generation capacity of the private sector in India. The Mumbai region constitutes around 85% of the company's power supply business. Apart from power generation, the company also has interest in areas like transmission and distribution, power trading, and coal mining. During the period between FY06 and FY12, Tata Power's consolidated sales and generation capacity grew at average annual rates of 29% and 12% respectively. Key management personnel Mr. Ratan Tata, Chairman, has been on the board of Tata Power since 1989. Mr Tata holds a B.Sc. (Architecture) degree with Structural Engineering from Cornell University, USA and has completed the Advanced Management Programme at Harvard University, USA. Mr Cyrus Mistry, Deputy Chairman, joined the Board of Tata Sons in 2006 and was appointed Deputy Chairman in November 2011. He is a graduate of Civil Engineering from Imperial College, UK and has a M.Sc. in Management from London Business School. Prior to becoming deputy chairman of Tata group, he was the Managing Director of Shapoorji Pallonji Group since 1994. Mr. S Ramakrishnan is the Director (Finance) of Tata Power since 2004. He graduated with a degree in mechanical engineering and has a post graduate degree in business management from IIM Ahmadabad. He served as Managing Director of Tata Teleservices Ltd at Tata Sons Limited since October 1999. He has been associated with the Tata Group for more than 30 years Industry prospects The Indian power sector has been characterised by peak power shortages, with demand of electricity exceeding supply by nearly 15% in terms of requirements. While the government had envisaged setting up around 62,000 MW (revised lower from 78,000 MW) of generation capacity during the eleventh five-year plan (2007-12), the actual implementation was around 55,000 MW. The capacity addition target for twelfth five-year plan (2012-17) is about 76,000 MW. If the government intends to increase installed power generation capacity, it must also facilitate an expansion of the transmission network and inter-regional capacity to transmit power. Inter-regional transmission networks are required because power generation sources are unevenly distributed in India, and power needs to be carried over large distances from areas where power is generated to areas where load centers and demand exist. With the strengthening of inter-regional connections during the Eleventh Plan, the inter-regional capacity has been enhanced from 13,700 MW to 37,150 MW. This shall facilitate transfer of power from surplus regions to deficit region. However, the shortage of coal supplies (necessary fuel for power generators) is predicted to double to around 242 m tonnes (MT) in the five years to 2017. In response to this, a top government advisory body has proposed that the government should allow private firms to mine coal to plug supply shortages. At present, India does not permit commercial mining of coal by private firms. However, it allows power producers to access 'captive blocks' for their fuel needs. The country has 267 bn tonnes of coal reserves, of which 40% of these have been proven. But social and environmental issues have slowed down the pace of production. Risk Analysis Sector: Despite being the focal point of investments during consecutive 5 year plans, the power sector in India has had an appalling track record in terms of execution. Corporatisation of SEBs and linking profitability to the state government's plan outlay are likely to give some sort of fiscal strength to the key sector participants in the long run. We are enthused by the direction as opposed to the pace of progress, as this can be unpredictable. We are also wary of some short term concerns like shortage of coal supplies, poor health of state electricity boards (SEBs) and non revision of tariffs that are rendering projects unviable. As per the Power Ministry's latest reports, coal shortages will force the newly commissioned power plants to operate at just 40% capacity. Important to note that power plants otherwise operate with a capacity utilization of 90%. During the 11th 5-year plan, just 89% of the targeted capacities were put up. But with the coal crisis mounting in the coming fiscals, the 12th 5-year plan (2012-17) power capacity additions may also be impacted. We assign a 'medium' risk rating to the sector. Company standing: Tata Power is India's largest private sector power generator and has been more regular in expanding capacities than its peers. We assign a ‘strong' rating to the company on this parameter. Sales: Tata Power generated average revenues to the tune of nearly US$ 3.3 bn per annum in the past five years. In the latest completed fiscal (FY12), the company generated consolidated net revenue of US$ 4.7 bn. Based on our parameters, we assign a low-risk rating of 9 to the stock. Operating margin: Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as raw materials, wages, sales, marketing and administrative costs. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. The higher the margin, the better it is for the company as it indicates its operating efficiency. Tata Power's average operating margins for the past five years has been around 22%. We assign a medium-risk rating of 6 to the stock on this factor. Long term EPS growth: Tata Power grew its consolidated net profits at an average annual rate of 31% between FY06 to FY11. As we mentioned earlier the consolidated profits of FY12 were hurt by the losses of CGPL and a one time write off of investment in the subsidiary. However, we do not expect any additional write-offs going forward. As such, the rating assigned to the stock on this factor is 5. Return on capital invested (ROIC): ROIC is an important tool to assess a company's potential to be a quality investment by determining how well the management is able to allocate capital into its operations for future growth. A ROIC of above 15% is considered decent for companies that are in a growth and expansion phase. Tata Power has earned an average ROIC of almost 11% over the past five years. The rating assigned on this parameter is 3. Dividend payout: A stable dividend history inspires confidence in the management's intentions of rewarding shareholders. Tata Power's average payout ratio has been a healthy 18% over the past five years. Thus, we have assigned a medium-risk rating of 5. Promoter holding: A larger share of promoter holding indicates the confidence of the people who run it. We believe that a greater than 40% promoter holding indicates safety for retail investors. At the end of March 2012, the promoter holding in Tata Power stood at 31.7%. We have assigned a medium-risk rating of 5 to the stock. FII holding: We believe that FII holding of greater than 25% can lead to high volatility in the stock price. The FII holding in Tata Power at the end of March 2012 stood at 21.9%. The rating assigned is 5. Liquidity: The average daily trading volumes of Tata Power's stock over the past 52-weeks stand at around 4.1 m shares (combined volumes of BSE and NSE). These are adequate and offer ample liquidity levels for a large cap stock. The rating assigned is 9. Current ratio: Tata Power's average current ratio during the period FY07 to FY12 has been 1.3 times. This indicates that the company is comfortably placed to pay off its short-term obligations, which gives comfort to its lenders. We assign a medium-risk rating of 4. Debt to equity ratio: A highly leveraged business is the first to get hit during times of economic downturn, as companies have to consistently pay interest costs, despite lower profitability. Especially for power sector companies, who generally fund capex through 70:30 ratio of debt to equity, any deviation in execution can cost heavy. Considering the company's average debt to equity ratio of 1.7 over the past five fiscals (2.2 times in FY12), we have assigned a high-risk rating of 3 to the stock. Interest coverage ratio (PBIT/Interest payment): It is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period. The lower the ratio, the greater are the risks. Given Tata Power's average interest coverage ratio of 4.7 times over the past five years, the rating assigned is 5. EV / EBIDTA Ratio: The enterprise value to operating margin (EBIDTA) multiple of a stock is a measure of cash return on investment. This multiple can be used to value companies with high levels of debt and therefore appropriate for valuing power utilities. This is one of the important metrics to judge the attractiveness of a stock, and thus gets the highest weightage in our risk matrix. Tata Power's FY12 EV/EBIDTA stands at 6.4 times. As such, we have assigned a rating of 6 to the stock on this parameter. Considering the above analysis, the total ranking assigned to the company is 65 that, on a weighted basis, stands at 5.4. This makes the stock a medium-risk investment from a long-term perspective. Risk Matrix Rating accorded Rating Weightage* (A) Rating# (B) Weighted (A*B) Sector risk - Medium NA Company's standing - Strong NA Performance parameters Revenue growth (%) 5.0% 9 0.5 Operating margin (%) 10.0% 6 0.6 Long term EPS growth (%) 10.0% 5 0.5 Return in invested capital (%) 10.0% 3 0.3 Technical parameters Dividend payout (%) 10.0% 5 0.5 Promoter holding (%) 5.0% 5 0.3 FII holding (%) 5.0% 5 0.3 Liquidity (52 weeks) 10.0% 9 0.9 Safety parameters Current ratio (x) 5.0% 4 0.2 Debt to equity ratio (x) 10.0% 3 0.3 Interest coverage ratio (x) 10.0% 5 0.5 Price to earnings ratio (x) 10.0% 6 0.6 Final Rating** 65 5.4 # Rating has been assigned on the basis of the company's performance over the past five years and expected performance over the next 3 to 5 years. Rating is on a scale of 1 to 10, with 1 indicating highest risk and 10 indicating lowest risk. * 'Weightage' indicates the relative importance in percentage terms of the parameter. For instance, for an investor, given all the performance metrics, return on equity should be the foremost criteria for buying/not buying stocks. ** The final rating has been arrived at by multiplying the rating/points given on each parameter with the respective weightage. Valuation rationale Notwithstanding the fact that Tata Power boasts of the maximum number of long term contracts in the power sector, the company also has sufficient upsides to its regulated returns. Also, unlike its peers, Tata Power does not have a very aggressive growth plan. Hence its capacity execution record is likely to be better. With a turnaround in the UMPP business we believe that Tata Power's consolidated return ratios will see significant upsides in the next three years. Hence despite the possibility of some near term hiccups (our estimates and target price have been revised accordingly), we believe that investors have enough reasons to Hold on to a blue chip stock like Tata Power in their portfolio from a three year perspective. Also, if an investor would like to 'Buy' this stock at the current levels, then with the target price of Rs 140, the upside is about 33% point to point (11% on an average annual basis). Investors could take the investment decision based on this premise. Valuations (Rs m) FY12UA FY13E FY14E FY15E Total Revenues (Rs m) 260,014 292,356 342,853 360,323 Net Profit (Rs m) (10,874) 19,753 30,644 33,693 Fully diluted EPS (Rs) (4.4) 8.0 12.4 13.6 Book value (Rs) 46.1 52.3 62.8 76.9 Price to earnings (x) N.A 13.1 8.5 7.7 Price to book value (x) 2.3 2.0 1.7 1.4 Price to sales (x) 1.0 0.9 0.7 0.7 Financials at a glance (Rs m) FY12UA FY13E FY14E FY15E Net Sales 260,014 292,356 342,853 360,323 Sales growth (%) 33.7% 12.4% 17.3% 5.1% Operating profit 64,264 56,980 71,055 71,036 Operating margin (%) 24.7% 19.5% 20.7% 19.7% Net profit (10,874) 19,753 30,644 33,693 Net profit margin (%) -4.2% 6.8% 8.9% 9.4% No of shares (m) 2,373.0 2,373.0 2,373.0 2,469.4 Diluted earnings per share (Rs) (4.4) 8.0 12.4 13.6 Balance Sheet Fixed Assets 289,477 355,418 343,448 364,020 Current assets 181,561 137,096 180,743 182,094 Investments 29,831 31,322 32,888 34,533 Deferred Tax Assets 68 68 68 68 Total assets 500,936 523,904 557,147 580,715 Networth 109,276 124,023 149,105 189,835 Loan funds 245,009 229,446 215,744 188,087 Current liabilities 117,450 141,225 163,079 173,572 Other liabilities 29,201 29,211 29,220 29,220 Total Liabilities 500,936 523,904 557,147 580,715

 

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