BHEL: Pain to continue in near term

Issues of slowdown are visible as both power and industrial segments reported drop in revenues with industrial segment reporting a 28% y-on-y drop in Q3

After order book concerns, the Street's fears over revenues of India's leading engineering company BHEL are coming true. During the December quarter, BHEL reported a 16 per cent year-on-year drop in revenues at Rs 8,462 crore, much lower than Rs 8,965 crore estimated by analysts. It would fall short on the net profit front, too, but better-than-expected operating margins (which though fell 460 basis points) helped post net profit of Rs 695 crore versus expectations of Rs 679 crore. Profit, though, was down 41.2 per cent year-on-year, its sixth straight drop.

The results, however, were not comparable with the corresponding financial numbers in the same quarter last year as they reflected the impact of the merger of Bharat Heavy Plates & Vessels (BHPV) with the Company on August 30, BHEL said in a filing to the Bombay Stock Exchange (BSE).

Nevertheless, issues of slowdown and execution are visible as both the power and industrial segments reported drop in revenues. While the power segment revenues fell 12 per cent to Rs 7,319 crore , industrial segment revenues at Rs 1,599 crore were down 28 per cent year-on-year in Q3, reflecting the overall sluggish growth in new project activity in the sector.

The company managed to pull down total expenses by 10 per cent to Rs 7,890 crore during Q3, helped largely by a 11.5 per cent decline in cost of raw material consumed and engineering expenses. However, the effort was partially dented by an over six per cent jump in employee benefit expenses to Rs 1,525 crore.

The drop in margins was nevertheless largely expected. The company had earlier augmented its capacities in the two segments, which at present are hugely underutilised, leading to pressure on the margins. The fixed cost incurred on these capacities and other related expenses have started to eat into profitability, which comes at a time when the sector is facing competition and prices have been lowered. Some of the low margin orders which BHEL booked earlier to utilise its capacities have started to kick in and has also impacted margins. Besides, cancellation of projects has added to its woes, and has impacted profits during the quarter.

Q3 is not an exceptional quarter. Even for the nine months ended December, net profits are down 52 per cent year-on-year. Hence, analysts do not have much expectation for FY14; most expect 50-60 per cent drop in profits.

The capital goods company has been grappling with high receivables from its customers, which have held back payments owing to the liquidity crunch in the power utilities sector. BHEL did not disclose the quantum of dues at the end of the December quarter, but its trade receivables stood at Rs 29,760 crore on September 30.

Apart from the income statement, analysts are keeping an eye on BHEL’s balance sheet as well, considering that a lot of slow moving projects and the ones facing severe execution issues are up for cancellation. In that case, the receivables booked as revenues and shown in the balance sheet will have to be written off, denting profits and return ratios further.

"We have been arguing for a while now that a lot of BHEL's order book could be cancelled, with accompanying pain on receivables. In our earlier note, we had estimated Rs 37,800 crore as potential cancellation of orders for BHEL," said Amar Kedia of Nomura in a recent report. In that case its current order book which stood at Rs 1,00,600 crore at the end of December quarter, could come under pressure.

Meanwhile, BHEL’s stock has run up in the recent past in the hope of revival and because of the lower valuations. However, as some of these crucial issues remain and could impact BHEL’s financials over the next one year, the Street is cautious, especially in the light that the valuations too now have less room to provide comfort. By 2015, BHEL’s EPS is expected to fall to around Rs 10 as against Rs 27 in FY13. Based on FY15 estimates, the stock (currently at Rs 161) is trading at 16 times and 1.2 times its book value, which is not cheap.