I ndi a - PSUs

Prabodh Agrawal | prabodh@iiflcap.com

+91 22 4646 4697


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DD MMM YYYY
Modi Inc All the Kings Jewels
09 June 2014
Printed report
summary
Institutional Equities

Our 288 page printed report on Indian PSUs
titled Modi I nc All the Kings J ewels will
shortly reach your desks. PSU reforms are
likely to be among the first tasks for the
newly installed Modi Government, given the
new Premiers stellar track record in his
home state of Gujarat. The knock-on effect
on the economy can be significant, since
many PSUs operate in segments of vital
national importance. Our top six picks, Coal
India, SBI, REC, Power Grid, BEL, and
ONGC, are expected to deliver 70-100%+ returns in our bull
case scenario, over the next three years.

A lost decade: Indian PSUs lost their sheen in the past decade,
buffeted by unfavourable government policies, slow decision-making
and a cyclical downturn. PSUs share of market cap in BSE100 has
shrunk from 32% in March 2005 to 20% currently. PSUs in Gujarat,
on the other hand, have a different story to tell, with several of them
outperforming even well-managed private companies.

Analysing 16 PSUs: We analyse 16 PSUs covered in this report on
five criteria: 1) Disruptive competition from private companies, 2)
Beneficiary of higher economic growth in India, 3) Beneficiary of PSU
reforms and conducive policies, 4) Strong balance sheets to leverage
growth opportunities, and 5) Attractiveness of valuations.

Key expectations on reforms: Faster environment clearances,
easier land acquisition laws, increased availability of coal and gas,
speedier power distribution reforms, augmenting of railway logistics
for mines, and reducing fuel subsidies these are the most
common reform expectations of the 16 PSUs.




Figure1: PSUsversusSensexSignificantunderperformance

Source:IIFLResearch,Bloomberg

Figure2: ShareofPSUsandnonPSUsinBSE100smarketcapitalisation

Source:IIFLResearch,Bloomberg

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PSUs Sensex Rebasedto100
10
20
30
40
50
60
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80
90
Mar05 May06 Jul07 Aug08 Oct09 Dec10 Jan12 Mar13 May14
PSU NonPSU (%Sharein BSE100)





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A lost decade for PSUs

PSUs lost their sheen in the last decade
The lacklustre performance of PSUs was due to several factors: 1)
Adverse government policies such as heavy subsidy burden hurt
upstream and oil marketing companies (OMCs); 2) demand for
higher share of free electricity and levying of higher water charges
by state governments hurt NHPC; 3) government inaction such as
inordinate delays in environment clearances and railway logistics
constraints hampered mining operations and directly or indirectly
hurt BHEL, Coal India, NMDC, NTPC, REC, PFC and SBI; 4) lack of
progress on gas pooling hurt GAIL;

Figure3: GovernmentstakeinmajorPSUs
Mktcap GOIstake Freefloatmktcap
Company (US$m) (%) (US$m)
1 ONGC 54,742 68.9 17,003
2 CoalIndia 39,640 89.7 4,103
3 SBI 32,115 58.6 13,295
4 NTPC 22,393 75.0 5,598
5 IOC 14,794 68.6 4,650
6 NMDC 11,404 80.0 2,281
7 PowerGrid 10,800 57.9 4,547
8 BHEL 10,031 63.1 3,705
9 GAIL 8,109 56.1 3,559
10 PFC 6,521 72.8 1,774
11 BPCL 6,385 54.9 2,878
12 SAIL 6,115 80.0 1,223
13 REC 5,342 65.6 1,835
14 NHPC 4,646 86.0 652
15 HPCL 2,296 51.1 1,122
16 BharatElectronics 2,176 75.0 544
Total 237,507 68,769
Source:IIFLResearch,Bloomberg
5) bureaucratic delays hurt SAILs expansion plans; and 6) scam-
charged environment made bureaucrats cautious on defence orders,
hurting Bharat Electronics.

Net profit Cagr of 81 listed Central PSUs was 12.5% in the last
decade (FY03-FY13) versus 19.2% for BSE100 companies. Net profit
Cagr of 52 listed non-banking PSUs was 9.8% Cagr over the past 10
years and that of 29 listed banking PSUs was 18.0% Cagr.

.but not for PSUs in Gujarat

Gujarat State PSUs have performed exceptionally well
PSUs in Gujarat have performed markedly better than their Central-
level peers and even private companies. In this report, we provide
case studies on Gujarat State Electricity Board, Gujarat State
Fertilizers & Chemicals (GSFC), Gujarat State Petronet Ltd (GSPL)
and Gujarat Gas (GGAS).

Each of these companies has witnessed a remarkable turnaround in
the last decade. The state government provided complete autonomy
to the company managements, allowing them to take decisions
purely on business merit and without any political or social agenda.

Gujarat SEBs turnaround began in 2002 after Modi assumed power
as the states chief minister. Through focus on containing T&D
losses, and internal cost control alone, the Gujarat SEB achieved PBT
breakeven by 2005 within three years of rigorous efforts from the
state. Moreover, this was done without any increase in tariff.
Currently Gujarat SEB is the only one among large SEBs in the
country that is profitable.

GSFC is considered as one of Indias best-managed PSU fertiliser
companies. It is acknowledged even by private sector peers as a
shining example of the way a fertiliser company should be run. It
has consistently been profitable since FY04.






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GSPL is an efficient, fast growing and profitable PSU. It operates
around 2200kms of gas pipeline in Gujarat, the largest inter-state
gas pipeline network in India. During the past decade (FY03-FY14) it
delivered 35% net profit Cagr, average ROE of 14% and average
ROCE of 15%.

GGAS is a unique example in the history of corporate India where a
PSU took over a MNC enterprise and turned it even more profitable.
The takeover did not result in GGAS changing its focus from
maximizing shareholders returns to focussing on developmental or
social causes, as is the case with many PSUs.

Figure4: GujaratStatePSUs10yearPATCagr

Source:IIFLResearch,Prowess

Analysing the 16 PSUs

We analyse the 16 PSUs covered in this report on the following
criteria: 1) Disruptive competition from private companies, 2)
beneficiary of higher economic growth in India, 3) Beneficiary of PSU
reforms and right policy support, 4) Strong balance sheets to
leverage growth opportunities, and 5) Attractiveness of valuations.

1. Disruptive competition from private companies

Many of the 16 PSUs covered in this report are monopolies or are
among the largest players in their sector. Entry barriers are high
either due to regulations (Coal India, Bharat Electronics) or because
they are natural monopolies (Power Grid, GAIL). In other sectors,
although the private sector may be large and growing, both public
and private companies can co-exist profitably (NTPC, NHPC, NMDC,
ONGC, SBI, REC, and PFC) as growth opportunities are immense. Oil
Marketing Companies (IOC, HPCL, BPCL) have little competition but
have been burdened with sharing fuel subsidies and consequently
had to resort to large borrowings. Some PSUs have been hurt by
cyclical decline of their industry and competition from private
companies (BHEL, SAIL), but they remain inherently strong
companies and can bounce back.

Figure5: ManyPSUsaremarketleadersorareamongthelargestplayersintheirsector
Company Industry Shareof
domestic
production(%)
Competitors
BHEL Powerequipment 50
Imported(30%),L&T(10%),others
(10%)
CoalIndia Coal 80
SingareniCoal(9%),
Captive/importedcoal(11%)
SAIL Steel 16 JSWSteel(14%),TataSteel(11%)
NMDC IronOre 20 SesaGoa(610%)
NTPC Powergeneration 24 AdaniPower(5%),TataPower(5%)
NHPC
HydroPower
generation
18 Nosignificantpvtplayer
PowerGrid Powertransmission 51 Nosignificantpvtplayer
GAIL Gastransmission 85 GSPL(15%)
IOC
OilMarketing(share
ofconsumption)
53 Nosignificantprivateplayer
HPCL
OilMarketing(share
ofconsumption)
22 Nosignificantprivateplayer


33.1
28.1
26.0
21.9
12.5
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
GSFC GujAlkalies&
Chem
GujIndPower GujMinDev
Corp
GNFC
10yearPAT Cagr(%)





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Company Industry Shareof
domestic
production(%)
Competitors
BPCL
OilMarketing(share
ofconsumption)
25 Nosignificantprivateplayer
ONGC Upstreamoil 68 Cairn(16%),RIL(3%),OIL(10%)
Bharat
Electronics
DefenceElectronics 57
Foreignvendors(~40%),private
playerssuchasL&T,TataPower
SED(<5%)
REC Loanstopowersector 17 IDFC(3%),SBI(14%),PNB(4%)
PFC Loanstopowersector 21 IDFC(3%),SBI(14%),PNB(4%)
SBI
Banking(shareof
loans)
20
ICICI(4%),Axis(3%),HDFCBank
(4%)
Source:IIFLResearch
Basedon80BSE100Indexstocksthathavedatasince31Mar2005

2. Beneficiary of higher economic growth in India

The 16 PSUs operate in segments in which their growth is directly
linked to the well-being and growth of the Indian economy. Coal,
power, iron ore, steel, oil & gas, and banking and finance are core
industries in the economy. As we expect a pickup in economic
growth going forward, demand for products of companies in these
industries and pricing power are expected to improve. Banking and
finance companies SBI, REC, and PFC are expected to benefit from
reduced stress on their asset quality. The following table and charts
show the trend in growth of these industries vis--vis real GDP
growth. The growth for many of these industries has been
constrained due to lack of a supportive policy environment from the
government. As this improves, the correlation of their growth to GDP
growth is expected to improve.






Figure6: HistoricalgrowthofkeyindustriesandRealGDP
Period Avggrowth
(%)
AvgRealGDP
Growth(%)
Multiple
(x)
Coalconsumption FY08FY14 7.5 7.1 1.1
Powergeneration FY04FY14 6.1 7.6 0.8
Steelconsumption 20042013 8.7 7.9 1.1
Ironoreconsumption 20042013 5.6 7.9 0.7
CrudeOilconsumption FY06FY14 4.0 7.6 0.5
Gasconsumption FY06FY14 5.9 7.6 0.8
Bankloans FY04FY14 20.7 7.6 2.7
Source:IIFLResearch

3. Beneficiary of PSU reforms and right
policies/support

Most leading PSUs have recorded lacklustre performance due to lack
of conducive policies and support from GoI. Poor governance of the
central government has reflected in poor performance of these
PSUs. A combination of regulatory hurdles, slow progress on key
policy decisions, lack of strategic direction, frequent changes and
gaps in tenures of senior management, and government interference
are some of the key problems faced by PSUs. Poor management
exacerbated their woes during the cyclical downturn in the economy.


















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Figure7: KeyconstraintsfacedbyPSUs\
Company Keyconstraintsfaced
1 BHEL Lackoffuelavailability(coal/gas)anddistributionsidereformsimpactingnew
capacityadditionsinpowergeneration,therebyslowingorderinflows,
competitionfromimportedequipment,bloatedemployeebase,andrigidsalary
structure
2 CoalIndia Lackofenvironmentalclearancesandpollutioncontrolnormshampering
productiongrowth,lackofraillogisticscapacityconstrainingevacuation
3 SAIL Delayinexpansionprojects
4 NMDC Evacuationconstraintspartlyduetoinadequaterailwaylogistics
5 NTPC Limitedavailabilityofdomesticfuel(coalandgas),delaysinlandacquisition,
disputewithCoalIndiaonqualityofcoalsupplied
6 NHPC Delaysinlandacquisitionandenvironmentalclearances,localagitation(lawand
orderproblem),unfavourablestategovernmentpolicies,geologicalrisks
7 PowerGrid Securingrightofways(ROW),delaysbycontractors,anddelaysinthe
commissioningofassociatedgenerationprojects
8 GAIL Gasavailability,lackofprogressongaspooling,subsidyburden
9 IOC Subsidyburden,delayinreimbursementofsubsidiesfromGoI,inadequate
returnsonupgradationcapex
10 HPCL Subsidyburden,delayinreimbursementofsubsidiesfromGoI,inadequate
returnsonupgradationcapex
11 BPCL Subsidyburden,delayinreimbursementofsubsidiesfromGoI,inadequate
returnsonupgradationcapex
12 ONGC Subsidyburden,increasedcessonproduction,lackofclarityongaspricing,lack
ofclarityonsubsidysharingasaresultofhighergasprice

Company Keyconstraintsfaced
13 Bharat
Electronics
DefencecapexslowingdowntosingledigitsasGoIfacesfiscalpressure,
delayinbulkproductionclearancesfromthearmedforces,scamcharged
environmentmakingbureaucratscautiousandimpedingdecisionmaking,
slowdownindefencespendingchangingthemixinfavouroflowmargincivilian
orders,structuralfactorssuchashigherproportionofturnkeyprojectsand
competitionfromprivatesector
14 REC PoorhealthofSEBsandgencos,delaysinprojectexecutionleadingtoneedfor
loanrestructuring
15 PFC PoorhealthofSEBsandgencos,delaysinprojectexecutionleadingtoneedfor
loanrestructuring
16 SBI Assetqualityheadwindsfrominfrastructureandcorporatebook,pressureon
operatingprofitabilityduetosharpriseincosts
Source:IIFLResearch

The above constraints have remained unaddressed and in many
cases have worsened over time, despite the fact that these
companies operate in segments that are of vital national importance.
Coal, iron ore, electricity, oil & gas and banking and financial
services are fundamental for economic development of any country.
Hence, it is imperative for the new government to promote these
industries. Decline or slowdown in production of coal, iron ore,
electricity and oil & gas, in the past few years has been steep. This is
unsustainable and has to be reversed on an urgent basis.

Lack of Management autonomy - A malaise common to PSUs
Lack of functional autonomy is a factor common to all PSUs. Tenures
of CMDs are short, often there are prolonged vacancies at the top or
a successor is appointed at the last moment, reflecting lack of
succession planning. This lack of continuity in top management
obstructs long-term planning and commitment. As the table below
shows, the 16 PSUs covered in this report have had an average of
3.9 CMDs in the past 10 years or an average tenure of 2.5 years.








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Figure8: ShorttenureofCMDsatleadingPSUs
CurrentCMD Term
began
Termends NoofCMDsin
thelast10yrs
1 BharatElectronicsSunilKumarSharma Jan2014 NA 5
2 BHEL BPrasadaRao Oct2009 Dec2015 3
3 BPCL SVaradarajan Oct2013 Sep2016 3
4 CoalIndia Vacant 5
5 GAIL BCTripathi Aug2009 Jul2019 2
6 HPCL NishiVasudeva Mar2014 Mar2016 3
7 IOC RSButola Jun2014 May2017 5
8 NHPC GSaiPrasad(Addlcharge) Jul2012 Jul2014 6
9 NMDC NarendraKothari Apr2014 Apr2019 4
10NTPC Dr.ArupRoyChoudhury Sep2010 Sep2015 4
11ONGC DKSarraf Mar2014 Sep2017 3
12PFC M.K.Goel Sep2013 Sep2016 3
13PowerGrid RNNayak Sep2011 Jun2015 3
14REC RajeevSharma Nov2011 Oct2016 6
15SAIL CSVerma Jun2010 Jun2015 3
16SBI ArundhatiBhattacharya Oct2013 Sep2015 4
Average 3.9
Source:IIFLResearch

4. Strong balance sheet to leverage growth
opportunities

Strong balance sheets would allow these companies to leverage
growth opportunities. If GoI moves towards making PSU
managements more independent, these PSUs would be in the
forefront for such reforms, since they can very well charter their own
course and fend for themselves. Strong balance sheets reflect the
financial prudence and avoidance of unnecessary risk taking by
these companies. The past few years have been replete with
examples of companies hurting themselves by over-leveraging or
taking out-sized bets in the foreign exchange market.

Figure9: Balancesheetstrengthandprofitabilityratios
Company FY14
Net
Debt/Equity
(x)
Freecash
flow/shareholders'
funds(%)
ROE
(%)
ROCE/ROA
(%)
1 BharatElectronics (0.6) (6.9) 13.9 17.1
2 BHEL (0.2) 7.1 10.2 14.5
3 BPCL 1.5 18.1 21.1 15.3
4 CoalIndia (1.4) 54.4 34.8 47.4
5 GAIL 0.4 10.7 15.7 14.9
6 HPCL 3.3 5.1 7.9 5.9
7 IOC 1.3 (0.8) 8.1 8.6
8 NHPC 0.5 (0.6) 6.5 7.4
9 NMDC (0.6) 3.1 22.3 33.8
10 NTPC 0.6 (6.0) 12.4 10.7
11 ONGC 0.2 (11.0) 16.3 17.0
12 PFC NA NA 21.1 3.0
13 PowerGrid 2.2 (36.8) 12.7 8.6
14 REC NA NA 24.6 3.3
15 SAIL 0.5 (6.6) 4.4 4.8
16 SBI NA NA 10.4 0.6
Source:IIFLResearch,Prowess,Bloomberg











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5. Attractiveness of valuations

Figure10: ValuationmatrixoftopSixPSUs

Companyname CMP
(Rs)
MktCap
(US$m)
EPSCagr(%)
(FY1416ii)
P/E(x)
(FY16ii)
P/B(x)
(FY16ii)
ROE(%)
(FY14)
NetD/E(x)
(FY14)
BasecaseTP(Rs)
1yr
BullcaseTP(Rs)
1yr 3yr
1 ONGC 378 54,742 15.5 9.2 1.5 16.3 0.2 480 520 649
2 CoalIndia 371 39,640 11.3 11.7 4.0 34.8 (1.4) 405 473 816
3 SBI 2,542 32,115 20.0 9.3 1.1 10.4 NA 3,050 3,687 5,486
4 PowerGrid 122 10,800 16.5 10.7 1.5 12.7 2.1 150 182 249
5 REC 320 5,342 23.8 4.4 1.0 24.6 NA 408 461 812
6 BharatElectronics 1,608 2,176 5.9 12.0 1.5 13.9 (0.6) 1,927 2,042 3,219
Source:IIFLResearch,Bloomberg;pricesasatcloseofbusiness30May2014

Potential for earnings upgrade and valuation re-rating
Our current earnings estimate and valuation multiple targets assume
some recovery in earnings growth trajectory and higher valuation
multiple for PSU stocks over the next two years. We also present a
bull case scenario detailing areas of potential earnings upgrade, in
case demand recovery is faster and stronger. This is likely to result
in valuation re-rating too for most stocks, underpinned by greater
visibility of economic reforms and their impact on the projected
earnings of PSUs. Based on this bull case scenario, we present one-
year and three-year price targets for our top six PSU picks. The one-
year and three-year bull case targets for all 16 PSUs can be found in
the printed report.









































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Figure11: Oneyearandthreeyearbullcasepricetargets
Company Potentialforearningsupgrade
inFY15/FY16/FY17
Reasonsforpotentialearningsupgrade Potentialforvaluationrerating Bullcasetargetprice %upside
1year 3year 1year 3year
Bharat
Electronics
FlatinFY15,2%inFY16and6%in
FY17
RevenuegrowthinFY15/16/17canbe
15%/14%/14%vs.ourcurrentforecastof
15%/12%/12%.With3.8xbooktobillratio,
executionhasbeenthebottleneck.Withthenew
governmentfasttrackingclearancesand
empoweringbureaucrats,executioncanimprove.
Thestockcurrentlytradesat13xoneyear
forwardPE.Inthepreviouscyclepeak,it
touched20xandweexpectsomeamount
ofreratingto15xintheneartermand
17xovertime
2,042 3,219 27 100
CoalIndia 1%inFY15,5%inFY16and7.5%
inFY17
VolumegrowthinFY15/16/17canbe
5.3%/7%/7%vsourcurrentforecastof
4.7%/5%/6%asthenewgovtincreasespaceof
clearancesandworkonnewraillinesare
expedited
Thestockcurrentlytradesat12xFY16ii.
Thoughthelistinghistoryisshort,the
stockhastradedat1617xoneyearfwd
whentheoutlookonvolumegrowthwas
sanguine
473 816 28 120
ONGC 2.6%inFY15,5.9%inFY16and
8.6%inFY17
CompanygrowsFY16productionby1mmtYoY
againstbasecaseof0.4mmt,LPGunderrecoveries
fallhelpingONGCimprovenetrealizationfrom
$41/bblinFY14to$56/bblinFY16,$65/bblinFY17
Thestockcurrentlytradesat9.7xFY16ii.
WithlowersubsidyburdenfromLPG
reforms,volumegrowthand
improvementingasprofitability,
valuationshouldrerateto13x.
520 649 38 72
PowerGrid 1012%EPSupgradethrough
FY18ii
Restorationofincomefromshorttermopen
accessand10%higherprojectcompletion
ShouldimprovecoreROEandreported
ROEby12%;therebyimprovinggrowth
visibility
182 249 49 104
Rural
Electrification
5%inFY15,15%inFY16,20%in
FY17
Stablespreadsasagainstanexpected
compression,lowerprovisions;current
assumptionsloangrowthof18%/17%,NIM
changeof(27)/(24)bpsandLLPof20/30bpsin
FY15/FY16
Inanupturn,thestockcanrerateto
1.7x12monthfwdbook(peakof2.5xin
2007)
461 812 44 154
StateBankof
India
5%inFY15,15%inFY16,15%in
FY17
Lowerinterestreversalsandimprovementin
internationalNIMs,lowerexpenseratios,
lowerloanlossprovisionsasthecreditcycle
turns,bettercontributionfromsubsidiaries
Inanupturn,thestockcanrerateto
1.7x12monthfwdbook(peakof2.2xin
2010)
3,687 5,486 45 116
Source:IIFLResearch







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Published in 2014, India Infoline Ltd 2014
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Key to our recommendation structure
BUY - Absolute - Stock expected to give a positive return of over 20% over a 1-year horizon.
SELL - Absolute - Stock expected to fall by more than 10% over a 1-year horizon.
In addition, Add and Reduce recommendations are based on expected returns relative to a hurdle rate. Investment horizon for Add and Reduce recommendations is up to a year. We
assume the current hurdle rate at 10%, this being the average return on a debt instrument available for investment.
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Distribution of Ratings: Out of 180 stocks rated in the IIFL coverage universe, 103 have BUY ratings, 4 have SELL ratings, 35 have ADD ratings, 1 have NR and 37 have REDUCE ratings.
Price Target: Unless otherwise stated in the text of this report, target prices in this report are based on either a discounted cash flow valuation or comparison of valuation ratios with
companies seen by the analyst as comparable or a combination of the two methods. The result of this fundamental valuation is adjusted to reflect the analysts views on the likely course of
investor sentiment. Whichever valuation method is used there is a significant risk that the target price will not be achieved within the expected timeframe. Risk factors include unforeseen
changes in competitive pressures or in the level of demand for the companys products. Such demand variations may result from changes in technology, in the overall level of economic activity
or, in some cases, in fashion. Valuations may also be affected by changes in taxation, in exchange rates and, in certain industries, in regulations. Investment in overseas markets and
instruments such as ADRs can result in increased risk from factors such as exchange rates, exchange controls, taxation, and political and social conditions. This discussion of valuation methods
and risk factors is not comprehensive further information is available upon request.