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Power stocks: Valuations at all-time low

Only low-cost power producers would generate positive returns as further tariff hikes look unlikely

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Stocks of power companies have fallen out of favour over the last one year, as fuel costs soared and demand began contracting. The has fallen 26 per cent over the last year. The last three months have particularly been bad for power stocks, with the Power Index falling 29 per cent. Except Power Grid, the sector has underperformed the Sensex by a wide margin.

While the overall health of the sector has been a big overhang, a major reason for this underperformance has been the decline in margins due to rising costs. Shortage of domestic coal and the poor financial health of state electricity boards (SEBs) have been a big reasons for the sell-off through FY12. While the government has taken measures, such as improving the coal supply and raising tariffs in 23 states, thermal generators continue to see a sharp decline in the operating profit margin to sales ratio. According to a report by HSBC Global Research, “Key generators, such as and Tata Power, have reached critically low margins and we do not expect a significant improvement in this trend over the next few years.”

The market does not see the issues pertaining to SEBs being resolved before three to four years. And, with retail tariffs in India higher than those in China and the US, another round of tariff hikes is also ruled out. This implies only those who can cut costs would be able to improve profitability.

Though coal prices have declined 15-20 per cent in the first quarter of FY13, analysts don’t expect power producers to benefit as a weak rupee has nullified the gains. Apart from high fuel cost, companies with high foreign debt are also likely to be hit by the falling rupee. An analysis done by HSBC shows the worst-affected by a high interest burden are Jaiprakash Power, Lanco Infra, Adani Power and Tata Power.

Analysts believe only those companies which can cut costs and supply power at relatively lower rates would be able to sustain profitably. According to Emkay Global, “The breakeven cost of power purchase for SEBs is Rs 2.3/unit and at Rs 2.8/unit (FY13-16) subsidy is maintained. We would look for a utility, which can supply power at these rates, making decent profits.” Some analysts are, therefore, positive on Reliance Power as it has the cheapest cost of power and huge asset values. This is followed by KSK Energy, with greater clarity on fuel supply leading to a decent project portfolio and better certainty on returns.

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