Investing in public sector companies could be rewarding as the government is speeding up the divestment process and taking measures to give them a free hand

Many would have reservations about investing in public sectors companies (PSUs) due to reasons such as government interference and so on. However, the public sector as a category (and despite having laggards) has done better than the broader markets over the long-term. In the last ten years, the BSE PSU index has given an annual return of 20 per cent as against the Sensex’s 13.85 per cent.

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“I think it is a nice theme to play as many of the PSUs offer good value. And, since now, the government is focusing on the disinvestment there could be more re-ratings. Post disinvestment these companies will become more accountable and responsible,” says Ramesh Damani, Member BSE.

The PSU edge
Apart from higher stock returns in the past, an important fact is that most of these companies have a strong advantage in their core business and enjoy leadership position. Today, companies like BHEL, Power Grid, NHPC, NTPC, ONGC, Indian Oil, State Bank of India, BEML, Bharat Electronics, Shipping Corporation and Concor are the largest players having a lion’s share in their respective industries. Some of these companies have created huge entry barriers in the form of their manufacturing capacities, distribution networks and consumers, which cannot be easily replicated. This gives them a clear advantage, particularly in a growing economic and increasingly competitive environment. Notably, most of these companies operate in industries like power, engineering, banking, logistics and so on, where the growth prospects are enormous. All this will help them not only grow their businesses bigger and generate huge cash, but also distribute the latter in the form of dividends, which makes PSUs an attractive investment.

Analysts also believe that many listed PSUs are trading at low valuations compared to their private peers, while a few of them are also available at below their intrinsic value.

What’s changing for the better
An important indication that is available from the government’s actions is its intension to provide higher flexibility to PSUs and strengthen the sector. Recently, the government announced a new policy under which selective top-performing PSUs will be given more flexibility in terms of financial and managerial powers. In this direction, the government has also created a new category of ‘Maharatna’ under which PSUs with an annual net worth of Rs 15,000 crore or more and net profit of over Rs 5,000 crore in the last three years will get the Maharatna status. This will allow such companies to take investment decisions to the tune of Rs 5,000 crore without prior approval of the government, and help them act fast on their business decisions an essential in a fast changing environment.

While it is no secret that the government needs funds, its move to divest its stake in PSUs will provide some help in this direction. However, experts also believe that companies (and its shareholders) will also benefit through higher accountability and transparency, which should lead to better performance and stock returns.

To start with, the government has decided to lower its stake to at least 90 per cent in all the listed companies. This trend is expected to gain momentum with about 50 unlisted companies likely to come out with an IPO. Among companies that are expected to tap the market by March 2010 include NTPC, Engineers India, REC, NMDC and SJVNL among others.

With many PSUs lining up an initial or follow-on public offer (IPO or FPO), it would also mean higher participation of institutional and retail investors. Also, today public sector companies have a combined 28.58 per cent weightage in the S&P Nifty in terms of market capitalisation, but their actual weightage (based on free-float) is just 14.18 per cent. Analysts believe that this anomaly will get corrected once the free-float of PSUs improves as a result of divestment.

How to grab this opportunity
Despite all the positive changes taking place, investors need to be careful while selecting stocks. “Within the PSU theme, I think one can approach in three ways – one investing in some of the new PSU IPOs; second, investing in those PSUs where there are opportunities unlocking due to deregulation like in the case of oil companies; and third, PSUs companies which have large land bank and could benefit when the same is monetised to unlock the shareholder’s value,” says Damani.

As experts suggests, there are opportunities on account of deregulation – in sectors like oil and gas, banking, power, insurance, mining and so on. Similarly, many companies also have huge cash, investments or land bank in their books, which the government is now willing to monetise. Analysts say companies like RCF, MTNL, BPCL, HPCL and FACT have significant land bank. But, should you merely buy into this theme, wherein there is uncertainty regarding the timing (of monetising such assets) and quantum of gains?

“Investors will have to look at the core business and its strength rather than just focusing on the value. Look at MTNL, despite people talking about value, its stock price has not moved anywhere. That is more to do with the problems in the core business and its growth. In comparison, consider the case of GAIL, whose prices have moved significantly in line with the growth in its core business,” says Vetri Subramaniam, head equity funds, Religare Mutual Fund.

Clearly, there are different themes to play in the PSU space. We looked at a host of listed PSUs to figure out companies that could deliver sustainable long-term returns on the back of growth in their core businesses, unleashing of reforms and so on, but are available at attractive valuations. Many of them also have a lot of cash in their books (and are virtually debt-free), which can be used to fund growth plans. Read on to know more.

BEML
BEML, which generates about 80 per cent of its revenue from the mining and construction segments, will be a major beneficiary of the economic growth and higher mining activities in the country. It also produces equipment for the defence and railways, which are equally growing business on the back of increased investments. Although at a nascent stage, BEML has also entered the aerospace business. With an order book of Rs 6,000 crore (2.2 times its 2008-09 revenues), revenues are expected to grow at 15-18 per cent over the next two years.

Bharat Electronics
Bharat Electronics (BEL) is the largest defence equipment supplier with 57 per cent market in India. Consistent growth, regular and growing dividends over the years coupled with large cash (about Rs 482 per share or 23 per cent of current share price) in the books make BEL a good investment. Besides, it is investing in new technologies to participate in new areas especially where the government wants to reduce its dependence on imports. BEL’s strong order book of Rs 12,500 crore, almost 2.7 times 2008-09 revenue, provides good visibility and analysts expects its revenues to grow at 17-18 per cent annually over the next two years.

BHEL
BHEL would benefit on account of multi-fold increase in investments in the power sector and pick-up in industrial capex over the next several years. It is apparent, BHEL, which is the leader in power and engineering equipments, currently has the largest order book of Rs 125,000 crore which is almost 4.6 times its FY09 revenues. To tap the opportunities, it is expanding equipment capacity from 10,000 mw to 20,000 mw by the end of 2012. No wonder analysts expect net profits to grow at 35 per cent annually over the next two years. Notably, with BHEL winning super-critical power equipment orders, the concerns over its ability to deliver such equipments (an area with huge potential) is also waning.
 

Concor
Container Corporation, the largest player in the domestic logistic industry, will benefit on the back of long term growth in India’s external trade. India’s external trade, which dipped in the recent past due to the global slowdown, is improving. The company’s advantage lies in it near-monopoly in the domestic container logistics segment, wherein it has 59 terminals at strategic locations supported by assets like 9,500 speed wagons, 11,745 containers and so on. Additionally, the company’s strong balance sheet (including Rs 1,800 crore of cash and equivalents) and consistent dividend paying record make it good long-term investment. Analysts expect its revenue to grow by 18-20 per cent over the next two years.

GAIL
Attributed to its monopoly status due to large irreplaceable network of gas pipelines across India, GAIL’s revenue and profits in last ten years have never dipped. As its pipe-network generates annuity revenue and requires one-time capex, expect free cash to be higher in later years. This will also lead to higher dividends – GAIL has been distributing 30-40 per cent of its profits in the last five years. GAIL’s forward integration into petrochemicals has helped diversify revenue-mix and gain from opportunities in the segment. Going ahead, India’s gas availability is expected grow at 23 per cent annually in next five years due to new discoveries in KG basin and other areas, which will drive GAIL’s volumes. GAIL is already doubling its transmission capacities to 14,000 km by 2012 which should help sustain revenue and earnings growth.

Indian Oil
Indian Oil (IOC) markets half of the retail fuels sold in India, owns a third of total refining capacity (60 mtpa), has the largest retail network (over 17,000) and owns 10,000 kms of pipelines. Thanks to the mandate to sell retail fuels at below cost, IOC (along with HPCL and BPCL) is faced with under-recoveries of Rs 45,000 crore this fiscal. Although the government is working out a compensation package, a sustainable long-term solution (free-pricing of auto fuels) would be positive for companies like IOC. While IOC’s long-term capex plans include setting a 15 mtpa complex refinery by 2012-13 and acquire E&P companies, its new naphtha cracker will go on stream by March 2010 aiding higher volumes in 2010-11. In a recent report, Deutsche Bank analysts have put a target price of Rs 436 – they believe IOC’s refining assets at a replacement cost are worth Rs 497 per share.
 

Nalco
Nalco is the leading player in the domestic aluminum industry with an installed capacity of 345,000 tonnes. The company will be the biggest beneficiary of the growing domestic consumption of aluminum as the economy grows at over 7 per cent annually. Nalco’s key strengths are its integrated manufacturing facility, which make it one of the low-cost aluminium producers globally with a cost of production of about $1,300 per tonne. This has helped it remain profitable through different commodity cycles. The company is now expanding its aluminium capacity from 3.45 lakh tonne to 4.60 lakh tonne and alumina capacity from 1.57 million tonne to 2.1 million tonne by March 2012. The ongoing global economic recovery is undoubtedly positive for Nalco, which should benefit from better realisations and margins.

NTPC
NPTC owns about a fifth (30,644 mw) of India’s installed power capacity but, better operating efficiencies (PLF) has translated into a 29 per cent share of total power generated. Since it earns a fixed-return on equity (RoE) of 14 per cent (plus incentives), addition of new capacity is the key driver of growth. Here, NTPC plans to commission 8,000 mw by 2011-12, and thereafter add 6,000 mw annually till 2016-17 to take its capacity to 75,000 mw. Its annual cash flows of Rs 10,000 crore are sufficient to fund these plans. NTPC is also planning to set up merchant power capacity of 5,000 mw. Additionally, the government’s proposal to allow NTPC to sell 15 per cent of its existing capacity at higher (merchant) rates could prop up its RoE by 200-300 basis points, and re-rate the stock. At Rs 2 32.50, the stock trades at 2.7 times estimated 2010-11 book value, which lower than most of its smaller private peers.

Power Grid
Power Grid (PGCIL), which is the nodal agency for most government sponsored power-related programmes, plays a critical role in transmitting power to different parts of the country and connecting villages through its vast network. It is the single largest company in the power transmission and distribution (T&D) and will benefit from the increasing expenditure planned in the space. For the 11th plan, PGCIL has targeted an investment of Rs 55,000 crore, including expansion of inter-regional grid capacity to 37,000 mw compared to 14,000 mw in 10th plan. With the government aiming to add 100,000 mw of power generation capacity during 2012-17, investments of at least Rs 300,000 crore will be required in the T&D space. Considering this, the company’s net profit is expected to grow in excess of 30 per cent in next two years, and at a healthy pace thereafter.
 

SBI
Due to near-term concerns over earnings prospects on account of higher provisioning cover requirement, rising yields and likely equity dilution, SBI’s stock has underperformed the broader market recently. In the medium-term, the ongoing economic recovery will help SBI sustain growth rates, lower NPAs and improve profitability. While the proposal to lower the floor government holding in SBI from 55 per cent to 51 per cent should improve sentiments, SBI’s ability to sustain growth rates and improve its return on equity (16-17 per cent currently) should help narrow the valuation gap vis-a-vis its private peers. As against the price to estimated 2010-11 book-value (P/BV) of 1.8-3.5 times that private banks are trading at, SBI is available at 1.6 times. Investors could use the current subdued sentiments to buy the stock on declines.

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