We reiterate ‘reduce’ rating on Bharat Heavy Electricals (BHEL) with a target price of R123 (earlier R118). In our view, the recent rally ignores severe concerns on fuel supply, which won’t correct even with quick reform.
We value BHEL at 0.8x FY16f P/BV (unchanged; roll-over from September 2015f) to arrive at our revised target price. With a deterioration in revenue and margin visibility, a P/BV methodology adequately captures interim volatility, in our view. We benchmark our assigned multiple to the traded average during 2000-03, which was the last similar down cycle period in which the company recorded ROE of 13-15%. We maintain our estimates which still build in an optimistic coal supply outlook, in our view, and do not build in receivable risks. We see a ~33% downside.
For a company that will generate <18-20% ROE sustainably and no-growth for almost a decade, one can assign a 2-2.5x P/BV value at best, as per our estimates. But then again this would be 5-7 years out, which means discounted to current value it would be close to 1x P/BV. In comparison, the stock is currently trading at 1.4x FY14f P/BV and 1.3x FY15f P/BV. Even as demand for power is unlikely to slow, we expect actual capacity to be constrained by land & fuel availability and environmental clearances. Meanwhile, new concerns on execution emerge as order book credibility for the sector is in question now.