Asia Pacific Equity Research

31 August 2004

Monopolies creating value

The new India power sector

Monopolies creating value: Exclusive distribution franchises of Tata Power (TPC) and Reliance Energy (REL) provide ROEs of 16%, and there are more such franchises to be granted. Each distribution franchise gives the companies the chance to predict and meet future power generation requirements (ROEs 14%). Together, they create the opportunity to build fully integrated power utilities. This growth option is not reflected in the share prices. Tata PowerCheap, and option worth +60%: We are initiating coverage on TPC with an Overweight rating and a 12-month target price of Rs300. The decline in FY05E earnings (due to tariff cut in Mumbai) has been overestimated by the market, in our view. A 40%+ correction in stock price and current cheap valuations imply relatively higher upside (60% against 30% for REL) from growth options, with limited downside. TPC remains our preferred pick in the immediate term. Reliance EnergyToo much cash, low 7% ROE: We are initiating coverage on REL with a Neutral rating and a 12-month target price of Rs660. RELs stock trading at around P/E 30x FY05E appears expensive at face value. This is due to surplus capital from its recent share issuestrategically cheap perhaps, but drags down ROE to a low 7%. We expect expensive valuations to constrain nearterm stock performance. A more aggressive management implies higher leverage to growth opportunities, though.
Table 1: Summary Earnings and Valuations
Rs in millions, year-end March FY04 5,232 25.2 2.3 11.5 18.9 10.3 1.1 2.7 Tata Power FY05E 4,401 22.2 -11.6 10.1 18.3 11.7 1.2 2.7 FY06E 4,890 24.7 11.1 11.1 20.1 10.5 1.1 2.9 Reliance Energy FY04 FY05E FY06E 3,671 4,140 4,504 20.9 22.0 22.8 76.5 5.2 3.4 9.6 7.2 7.0 10.1 8.9 10.3 31.2 29.6 28.7 2.2 1.9 2.0 0.7 0.7 0.7

India: Electric Utilities Gautam Chhaochharia

(91-22) 5639-3010 gautam.chhaochharia@jpmorgan.com

Head of Utilities Bill Laukka

(852) 2800-8576 Bill.Laukka@jpmorgan.com

Tata Power price chart

Rs

450 350 250 150 50 Jan-02 Jan-03 Jan-04 Jan-04 Jul-02 Jul-03 Jul-04 Jul-04

Reliance Energy price chart

Rs

800 600 400 200 0 Jan-02 Jan-03 Jul-02 Jul-03

Net profit EPS (Rs) EPS growth (%) ROE (%) ROIC (%) P/E (x) P/BV (x) Dividend yield (%)

Source: Bloomberg.

Source: Company data, JPMorgan estimates.

See page 8 for analyst certification and important disclosures, including investment banking relationships. JPMorgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Gautam Chhaochharia (91-22) 5639-3010 gautam.chhaochharia@jpmorgan.com Bill Laukka (852) 2800-8576 Bill.Laukka@jpmorgan.com

Asia Pacific Equity Research 31 August 2004

Tata PowerMore value to offer

The current share price does not seem to reflect (1) providing generation services to Disco, (2) investing in further state privatisations

We prefer Tata Power (TPC) over the next 6-12 months, given that trading ranges are less than half of Reliance Energys (REL) and new projects could have a larger impact on valuations and hence share price movement. Current share price trading levels do not factor in the expansion option values of (1) providing generation services into existing distribution franchisees and (2) investment in further state distribution franchises. Historically, TPC has traded at a discount to REL previously due to the lack of a distribution franchisee, and recently due to overhang from lower tariffs for its Trombay plant. Both these issues have now largely receded.
Figure 1: Tata PowerRelative P/E (relative to Reliance Energy)
x

1.2 1 0.8 0.6 0.4 0.2 0 Oct-01 Sep-97 Sep-99 Feb-01 Jan-97 Jan-99 Jun-00 Mar-03 Jun-02 May-98 Nov-03 Jul-04

Source: JPMorgan estimates.

Distribution entities should be considered effective monopolies

Indian power sector is characterized by practical monopolies in distribution. Exclusive distribution franchises of Tata Power (TPC) and Reliance Energy (REL) provide assured ROEs of 16%, and there are more such franchises to be granted through privatisation of state-owned utilities. Each distribution franchise gives the companies the chance to predict and meet future power generation requirements (ROEs of around 14%). Together, they create the opportunity to build fully integrated power utilities. The share prices of TPC and REL do not yet reflect the full potential or option value of these entities, in our view. The potential appreciation we believe is akin to what three Hong Kong utilities (CLP Holdings, Hongkong Electric, and Hong Kong & China Gas Company) experienced over 20 years ago. Being monopolies, these utilities were set to enjoy strong demand and earnings growth for several decades to come by providing better services. Each of the three Hong Kong utilities have provided share price CAGRs over the last 20 years of around 20-25%, placing them among the best performing stocks in the Asia Pacific region.

Like the HK utilities 20 years ago loads of earnings growth for decades

Tata Power: Higher upside from growth opportunity

Tata: 40% s/price correction creates better value. Expansion option could boost NAV 60%

The decline in FY05E earnings (due to tariff cut in Mumbai generation plant) has been overestimated by the market. A 40%+ correction in stock price implies higher upside from growth options. The potential growth in TPCs existing franchises and prospective ones to be awarded is worth a further 60% of its current valuation, which provides more upside in our view (for REL, this is only 30%, assuming the same market share). With the overhang of lower tariffs for its Trombay plant largely over, it is well-placed to tap growth opportunities. Annual cashflows of Rs7 billion from

Gautam Chhaochharia (91-22) 5639-3010 gautam.chhaochharia@jpmorgan.com Bill Laukka (852) 2800-8576 Bill.Laukka@jpmorgan.com

Asia Pacific Equity Research 31 August 2004

its existing business and a low debt-equity ratio of 0.37x reflect ample flexibility to fund future opportunities with further debt and bond borrowings.
Telco investments take up 18% of assets we value at 50% book value

The low disclosure level associated with the companys partly-owned Tata Group telco assets represents an annoying distraction to investors, in our view. These investments tie up around 18% of total assets in no-return investments, which we value at around 50% of book value in the absence of any substantive information provided by management. We initiate with an Overweight rating. Our 12-month target price of Rs300/share is based on a sum-of-the-parts valuation, plus 5% of the value of the expansion option (that could provide around 60% upside) with additional franchises.

Overweight: Target price Rs300 / share

Table 2: Tata PowerValuation summary

Estimated value Rs/share 169 29 90 JPMorgan comment Includes thermal 1350MW at Trombay in Mumbai, 3 hydro 447MW also in Maharashtra, together with captive/IPP power plants in Jojobera & Karnataka. Also includes other businesses (EPC etc) Delhi (NDPL) distribution business. We have not factored in any incentives The company has Rs138/share of investmentsincluding holdings in telecom, energy and other group companies. However, we have ascribed a 50% discount to book value for its investments in telecom & group companies, as there is no visibility on cashflows

Existing business Mumbai + CPP +IPP + others Delhi distribution Cash & investments at hand

Total Upsides: Generation option on Delhi distribution Option value of potential new privatisation in distribution
Source: JPMorgan estimates.

288 16 206 This represents the option value of setting up generation facilities to meet demand for its Delhi distribution business, assuming 51% stake This represents potential 60% upside over our base case analysis, being the ability for TPC to participate in future distribution privatizations that may take place. This is assuming TPC gets 20% market share in privatization of distribution circles in the 9 likely states

Reuters: TTPW.BO, Bloomberg: TPWR IN

Rs in millions, year-end March Sales Net profit EPS (Rs) Sales growth (%) Net profit growth (%) EPS growth (%) ROE (%) ROCE (%) ROIC (%) P/E (x) P / Op cash flow (x) P/BV (x) EV/EBITDA (%) Dividend yield (%) FY04 41,850 5,232 25.2 -1.8 -2.5 2.3 11.5 14.1 18.9 10.3 2.8 1.1 4.9 2.7 FY05E 38,091 4,401 22.2 -9.0 -15.9 -11.6 10.1 12.6 18.3 11.7 4.1 1.2 5.7 2.7 FY06E 38,834 4,890 24.7 2.0 11.1 11.1 11.1 14.0 20.1 10.5 4.6 1.1 5.5 2.9 FY07E 40,660 5,368 27.1 4.7 9.8 9.8 11.3 14.2 20.9 9.6 4.1 1.0 5.2 3.1 Company Data 52-week range (Rs) Market cap (Rs B) Market cap (US$ B) Shrs outsting (MM) Free float (%) Avg daily value (Rs MM) Avg daily value (US$ MM) Avg dly volume (MM shs) BSE sensex Exchange rate (Rs/US$) Performance Absolute (%) Relative (%) 1 mth -1.7 -2.1 3 mths -1.0 -9.3 428 159 51 1.1 197.9 67 615 13.4 3.93 5192 46.00 12 mths 34.3 9.8

Source: Company, Bloomberg, JPMorgan estimates

Gautam Chhaochharia (91-22) 5639-3010 gautam.chhaochharia@jpmorgan.com Bill Laukka (852) 2800-8576 Bill.Laukka@jpmorgan.com

Asia Pacific Equity Research 31 August 2004

Reliance Energy: Too much idle cash

Reliance: Idle cash, but close management focus

The current stock price trading at levels of around P/E 30x FY05E does appear expensive at face valuethe high level is attributable to surplus capital from its recent share issuestrategically cheap (raised at prices around 60% above the current ex-cash price) but it makes it difficult to boost the low resulting forward 7% ROE and low shareholder fund growth. The potential for growth in new franchises to be awarded is around 30% of current valuations (much lower than the 60% for TPC due to RELs idle capitaltoo much equity). A more aggressive management implies higher leverage to growth opportunities, however. Investors may need to monitor potential conflicts that can arise with parent companies in upstream operations, although this appears a low risk. Expensive valuations will constrain share price performance in the near term. We initiate with a Neutral rating. Our 12-month target price of Rs660/share is based on a sum-of-the-parts valuation, plus 5% of the value of the expansion option.

New franchises could add around 30% to Reliance NAV vs. 60% for Tata

Neutral: Rs600 / share

Table 3: Reliance EnergyValuation summary

Estimated value (Rs/Share) JPMorgan comment 326 Includes: Mumbai, presently RELs largest distribution business + 500MW coal fired plant in Maharashtra, 220MW gas fired plant in Andhra Pradesh, Goa 48MW combined cycle. 54 268 648 69 206 This represents the option value of setting up generation facilities to meet demand for its Mumbai & Delhi distribution business, assuming 51% stake. Dadri project is partly representative of this value This represents potential 30% upside over our base case analysis, being the ability for REL to participate in future distribution privatisations that may take place. This is assuming REL gets 20% market share in privatization of distribution circles in the nine likely states Includes Delhi distribution business, being BRPL (BSES Rajdhani Power) and BYPL (BSES Yamuna Power). We have not factored in any incentives being banked. This represents cash & cash-type investments which will be injected in upcoming opportunities. This is adjusted for investments in Delhi, Orissa and other associate companies

Existing business at Mumbai utility + AP + Goa + EPC Delhi distribution Cash + Investments Total Upsides: Generation option on Delhi, Mumbai & Orissa distribution Option value of potential new privatisation in distribution
Source: JPMorgan estimates.

Reuters: RLEN.BO, Bloomberg: RELE IN

Rs in millions, year-end March Sales Net profit EPS (Rs) Sales growth (%) Net profit growth (%) EPS growth (%) ROE (%) ROCE (%) ROIC (%) P/E (x) P / Op cash flow (x) P/BV (x) EV/EBITDA (%) Dividend yield (%) FY04 34,067 3,671 20.9 26.5 124.4 76.5 9.6 9.0 10.1 31.2 17.7 2.2 18.5 0.7 FY05E 33,637 4,140 22.0 -1.3 12.8 5.2 7.2 7.0 8.9 29.6 17.0 1.9 17.1 0.7 FY06E 34,657 4,504 22.8 3.0 8.8 3.4 7.0 6.4 10.3 28.7 12.5 2.0 16.7 0.7 FY07E 35,793 4,809 24.3 3.3 6.8 6.8 7.2 6.6 11.8 26.9 12.0 1.9 16.1 0.8 Company Data 52-week range (Rs) Market cap (Rs B) Market cap (US$ B) Shrs outsting (MM) Free float (%) Avg daily value (Rs MM) Avg daily value (US$ MM) Avg dly volume (MM shs) BSE sensex Exchange rate (Rs/US$) Performance Absolute (%) Relative (%) 1 mth 12.0 11.5 3 mths 34.4 23.2 817 304 129 2.8 197.8 49.8 201 4.4 0.62 5192 46.00 12 mths 96.1 60.3

Source: Company, Bloomberg, JPMorgan estimates.

Gautam Chhaochharia (91-22) 5639-3010 gautam.chhaochharia@jpmorgan.com Bill Laukka (852) 2800-8576 Bill.Laukka@jpmorgan.com

Asia Pacific Equity Research 31 August 2004

Power deficit clearly confirms expansion opportunities

New Government does not envisage changes to Electricity Act, privatizations to proceed

The recent uncertainty over reforms appears overplayed, following the recent change in the Government in Indias stand. One of the key issues was the proposed review of the Electricity Act. The new Power Minister, PM Sayeed, however, does not foresee any changes in the Electricity Act. The extension of deadlines for unbundling of the state electricity boards (SEBs) was the key issue. However, we note that some key large and developed states have already unbundled their SEBs. Recent announcements of free power to specific consumer categories (such as farmers) are also not helping sentiment for reforms. We do think that power shortages and weak state finances will mean that further privatizations are ahead. A full list is included in our detailed report to be published shortly. The key problem to be addressed in the Indian power sector is the current cash flow deficits being recorded within state electricity boards. This can be addressed by reducing the existing 50% line losses and encouraging private sector participation to induce efficiency (privatize power distribution, and insist on open access so new generators can participate). The average tariff in India is around US$0.055/kWh, which is around 30% below international averages. However, the inverted tariff structure does appear to put the industry at a cost disadvantagecheap agricultural and residential tariffs versus expensive industrial and commercial tariffs do appear out-of-whack compared to the rest of Asia. This has resulted in the share of the noprofit agricultural sector in total electricity consumption growing from 17.6% in FY81 to 35% in FY99 (while its share in GDP fell). Line losses of 50% plus in India are excessive relative to international and Asian averages of 8-12% respectively.
Figure 2: Global comparison of average residential & industrial end-user tariffs rates

How to address deficits: Cut line losses, address inverted tariff structure

20 18 16 14 12 10 8 6 4 2 0
UK on il i g pp in Au e s st r a li Si a ng ap or e Ta iw Ne an w Ze al an S. d Ko re a US A Ph an y rm Ja K In di a Ch in a
5

Average Residential US10 cts/Kwh Average Industrial US6.9 cts/Kwh

pa n

Ge

Sp

a in

Domestic (US cents/Kwh)

Ho

ng

Industrial (US cents/Kwh)

Source: Electricity Association (UK), companies and JPMorgan Research.

Gautam Chhaochharia (91-22) 5639-3010 gautam.chhaochharia@jpmorgan.com Bill Laukka (852) 2800-8576 Bill.Laukka@jpmorgan.com

Asia Pacific Equity Research 31 August 2004

Figure 3: Demand breakdownFY02

%

Commercial, 5.2 Others, 12.9 Agriculture, 29.7 Domestic, 22.0

Industrial, 30.2

Source: CRIS INFAC.

Demand growth rate expected around 6-8% medium term

The peak demand is projected to grow at a CAGR of 6-8% over the medium term, keeping in mind current shortages of 7-8% and peak shortages of 11-12%. Generally, only around half of all power generated is actually paid forthe rest is lost in the form of technical losses together with commercial losses or theft (experts estimate that out of every 100 units, only 55 are billed and 41 collected). As more power becomes available, we believe that there may be some pent-up demand evident as some levels of potential demand growth simply have not been tapped.
Figure 5: Average energy demand-supply and deficit
Bn kwh, %
600 550 500 450 400 350 300 250 200 1994-95 1998-99 1999-2000 2003-04 2002-03 1991-92 1992-93 1993-94 1995-96 1996-97 1997-98 2000-01 2001-02 Supply (L) Demand (L) Deficit (R) 12.0 11.0 10.0 9.0 8.0 7.0 6.0 5.0

Figure 4: Growth in average demand vs. GDP FY93 to FY04 (%)

12.0 10.0 8.0 6.0 4.0 2.0 0.0 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 2000-01 2001-02 2002-03 1999-2000 2003-04 GDP Demand grow th

Source: CRIS INFAC, CMIE.

Source: CRIS INFAC, CMIE.

Reform: End user gets power, pays a little less. Suppliers get paid. Win-win

Customers want power to be available, and customers are prepared to pay for it. Enduser tariffs are likely to fallso customers get power, the government and customers are happy because they pay a little less, and power suppliers are happy because they get paid. This is a genuine win-win scenario, but there are risks as well. In order to make money from power supply, power distributors need to achieve line loss targets (reducing line losses is partly manageable, while for the rest political will is required), and respective SEBs need to follow the guidelines established by the Central government.

Gautam Chhaochharia (91-22) 5639-3010 gautam.chhaochharia@jpmorgan.com Bill Laukka (852) 2800-8576 Bill.Laukka@jpmorgan.com

Asia Pacific Equity Research 31 August 2004

Figure 6: India Average costs and tariffs

Paise / kwh, %

400 350 300 250 200 150 100 50 0

A verage co sts (LHS)

A verage tariffs (LHS)

Reco very as % o f co st (RHS)

85 80 75 70 65

FY93

FY94

FY95

FY96

FY97

FY98

FY99

FY00

FY01

FY02

Source: Planning Commission.

Progress of reforms in the right direction, with encouraging progress

Previous reform initiatives were focused on generation and never really took off. The Central government had to provide guarantees to improve the credit of SEBs. This did not tackle the key problem of the SEBs finances. The tripartite agreement between CPSUs like NTPC, SEBs and the RBI, under which the previous dues of the SEBs were securitized and linked to future reforms milestones, has improved cashflows and the financial profile of key players. Some states have reported reduction in cash losses and NTPC has reported improved recovery levels of billings from the SEBs (from 76% to 100% over three years).

Figure 7: Structure of the Indian power sector

Generation SEBs (State Electricity Boards) Transmission Distribution Consumption

SEBs

SEBs

CPSUs (Central Public Sector Units)

POWERGRID (Pubilc Sector Tansmission Comoany)

Distribution Co.

End Consumer

IPPs and Private

Private Utilities

Private Lcensees

Captive

Captive Consumer

Power Traing Companies

Source: JP Morgan.

Gautam Chhaochharia (91-22) 5639-3010 gautam.chhaochharia@jpmorgan.com Bill Laukka (852) 2800-8576 Bill.Laukka@jpmorgan.com

Asia Pacific Equity Research 31 August 2004

Companies Recommended in This Report Reliance Energy (RLEN.BO/Rs649.50/Neutral), Tata Power (TTPW.BO/Rs258.35/Overweight) Analyst Certification The research analyst who is primarily responsible for this research and whose name is listed first on the front cover certifies (or in a case where multiple analysts are primarily responsible for this research, the analyst named first in each group on the front cover or named within the document individually certifies, with respect to each security or issuer that the analyst covered in this research) that: (1) all of the views expressed in this research accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst in this research. Important Disclosures: Client of the Firm: Reliance Energy is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-securities-related services. Tata Power is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company non-securities-related services.
Reliance Energy (RLEN.BO) Price Chart

1,260 1,050 840 Price(Rs) 630 420 210 0 Aug 01 Nov 01 Feb 02 May 02 Aug 02 Nov 02 Feb 03 May 03 Aug 03 Nov 03 Feb 04 May 04 Aug 04 MU UW N

Source: Reuters and JPMorgan; price data adjusted for stock splits and dividends. Break in coverage Mar 08, 2004 - Aug 31, 2004. This chart shows JPMorgan's continuing coverage of this stock; the current analyst may or may not have covered it over the entire period. As of Aug. 30, 2002, the firm discontinued price targets in all markets where they were used. They were reinstated at JPMSI as of May 19th, 2003, for Focus List (FL) and selected Latin stocks. For non-JPMSI covered stocks, price targets are required for regional FL stocks and may be set for other stocks at analysts' discretion. JPMorgan ratings: OW = Overweight, N = Neutral, UW = Underweight. Ratings prior to Sept. 25, 2002: B = Buy, LTB = Long-Term Buy, MP = Market Performer, MU = Market Underperformer.

Gautam Chhaochharia (91-22) 5639-3010 gautam.chhaochharia@jpmorgan.com Bill Laukka (852) 2800-8576 Bill.Laukka@jpmorgan.com

Asia Pacific Equity Research 31 August 2004

Tata Power (TTPW.BO) Price Chart

660 550 440 Price(Rs) 330 220 110 0 Aug 01 Nov 01 Feb 02 May 02 Aug 02 Nov 02 Feb 03 May 03 Aug 03 Nov 03 Feb 04 May 04 Aug 04 N

Source: Reuters and JPMorgan; price data adjusted for stock splits and dividends. Break in coverage Mar 08, 2004 - Aug 31, 2004. This chart shows JPMorgan's continuing coverage of this stock; the current analyst may or may not have covered it over the entire period. As of Aug. 30, 2002, the firm discontinued price targets in all markets where they were used. They were reinstated at JPMSI as of May 19th, 2003, for Focus List (FL) and selected Latin stocks. For non-JPMSI covered stocks, price targets are required for regional FL stocks and may be set for other stocks at analysts' discretion. JPMorgan ratings: OW = Overweight, N = Neutral, UW = Underweight. Ratings prior to Sept. 25, 2002: B = Buy, LTB = Long-Term Buy, MP = Market Performer, MU = Market Underperformer.

Explanation of Ratings: JPMorgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] The analyst or analysts teams coverage universe is the sector and/or country shown on the cover of each publication. Each analysts coverage list, showing full coverage universe, is available on the analysts page under the Research option on JPMorgans website www.morganmarkets.com, accessible to JPMorgans clients via password, or in the case of hard copy research or if no access to MorganMarkets, by calling this toll free number (1-800477-0406). Prior to September 25, 2002, our rating system was: Buy we expect the stock to outperform the market by a minimum of 5% within an investment horizon of one year; Long-Term Buy we believe the stock will outperform the market over the long run, but we lack the visibility of a catalyst for outperformance within a one-year investment horizon; Market Performer the stock is expected to perform in line with the market; Market Underperformer we expect the stock to underperform the market by a minimum of 5% within an investment horizon of one year.
JPMorgan Equity Research Ratings Distribution, as of June 30, 2004 Overweight (buy) 40% 39% 34% 59% Neutral (hold) 41% 42% 48% 54% Underweight (sell) 19% 31% 19% 40%

JPM Global Equity Research Coverage IB clients* JPMSI Equity Research Coverage IB clients*

*Percentage of investment banking clients in each rating category. For purposes only of NASD/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category, our Neutral rating falls into a hold rating category, and our Underweight rating falls into a sell rating category.

Valuation and Risks: Company notes and reports include a discussion of valuation methods used, including methods used to determine a price target (if any), and a discussion of risks to the price target. Analysts Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities and Investment Banking.
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Gautam Chhaochharia (91-22) 5639-3010 gautam.chhaochharia@jpmorgan.com Bill Laukka (852) 2800-8576 Bill.Laukka@jpmorgan.com

Asia Pacific Equity Research 31 August 2004

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