SUNDAY, JUNE 27, 2010

Reliance Power - reduce exposure

Investors can consider reducing exposure to the stock of Reliance Power, given that the
recent gains in the stock have placed it at a stiff valuation relative to peers in the sector.
The stock is trading at a 38 per cent discount to its issue price.

With the stock gaining 21 per cent over the last month on account of the truce between
the two Ambani brothers, investors have an opportunity to cut losses or book profits
(depending on when they entered the stock).

The stock gained on expectations that gas supply to the company's projects would now
be secured (the price has to be negotiated).

In addition, the company, over the last couple of months, commenced sale of power in
its second Rosa Phase I power project with capacity of 300 MW, acquired Indonesian
coal mines and added 433 MW of power capacity from the holding company Reliance
Infrastructure.

EXPENSIVE Valuations

Despite positive developments, the stock appears over-valued, as benefits from

ambitious capacity additions may only begin to reflect in earnings beyond FY14.

By FY12, Reliance Power is expected to add around 2,893 MW or less than 10 per cent
of its projected additions while other private players are expected to see much higher
additions — there is a 6,600 MW addition by Adani Power, Lanco Infratech's 4,699 MW
addition and JSW Energy's 3,140 MW addition. Despite promising fundamentals over
the medium term, Adani Power, Lanco Infratech and JSW Energy trade at discounts to
Reliance Power's valuations. This, even as the latter has lower proportion of merchant
power capacity compared with these peers.

However, Reliance's capacity additions will go up multiple times during the second half
of the decade. At the current price of Rs 168, the stock trades at around 42 times its
estimated FY12 earnings (inclusive of earnings from newly acquired 433 MW units).

The market cap-to-MW ratio of the company works out to Rs.4.2 crore at a premium to
Rs.3.9 crore of Adani Power and Rs.3.5 crore for Lanco Infratech. Only projects that have
achieved financial closure are considered in this computation (Reliance Power estimates
include the Krishnapatnam Ultra Mega Power Project (UMPP) as the company is close to
attaining financial closure).

AMBITIOUS additions

Reliance Power has also extended the expected commissioning dates for some of the
projects from the time of IPO. By setting up the 600 MW Rosa Phase I nearly on
schedule, the company has demonstrated its execution capabilities.

However, meeting future deadlines could be even more challenging, given that the
projects are very huge.

Reliance Power, after acquisition of the holding company's 433 MW gas-based units, has
1,033 MW of thermal power plants under its fold today. In contrast to this, the company
plans to add over 29,000 MW (including the three UMPPs) over the next decade, aiming
to become the second largest power generator in India.

Brownfield expansion at the existing gas based projects which it recently acquired from
Reliance Infra would allow it to add more capacity. The company also plans gas-based
power capacities of 7,000 MW at Dadri and Shahapur (it has scaled down its gas-based
Dadri project to 4,200 MW from 7,480 MW due to land acquisition hurdles).

Even as many of the Sasan UMPP units may get commissioned by FY13 and units of
Chitrangi and Krishnapatnam UMPP projects with 4,000 MW each will be set up by FY14,
these projects will only be fully operational beyond 2015. Reliance Power may thus reap
the full benefits of the major chunk of its portfolio of power projects only from 2014-15.

Fuel not a concern

Reliance Power has secured domestic and imported fuel through captive sources for
most of its coal-based power projects and may have excess coal from Tilaiya for future
projects as well. Surplus coal in Sasan UMPP is used for the Chitrangi project which
significantly reduces the variable cost for this 4,000 MW project, enabling it to earn
higher ROEs. The company has coal reserves of almost 2 billion tonnes and coal linkages
for its projects. Additionally, it also acquired coal mines in Indonesia for the
Krishnapatnam UMPP and the other coal-based projects. The high proportion of captive
mines enables the company to reduce the overall variable cost component significantly,
allowing it to earn decent returns despite the low tariffs bid.

Gas-based projects have been delayed mainly owing to the dispute between RIL and
RNRL. With this now settled, new contracts are expected to be negotiated for the gas-
based new projects, reviving prospects for the Dadri and Shahapur power projects.

LONG-TERM Offtake

Unlike other private power producers, Reliance Power's existing power capacities are all
subject to regulated tariffs (cost plus) allowing it to earn regulator determined returns
(14-16 per cent post-tax return on equity).

Of the additional 1,860 MW expected to come up over the next 21 months (assuming no
delays) only 600 MW is expected to benefit from short-term merchant rates. The
funding and equity are comfortable but the same cannot be said about debt

Reliance Power, in order to execute in excess of 29,000 MW of power projects, is

expected to require nearly Rs1,18,000 crore of funds with around Rs 33,000 crore of this
funded by equity.

With Rs 11,500 crore funds raised from its 2008 IPO, Reliance Power can fund projects
with around 9,400 MW capacity (Rosa, Butibori, Sasan, Krishnapatnam). It has also
acquired 433 MW from Reliance Infra for Rs 1,095 crore.

While high interest costs and depreciation would dent profits over the next three years,
profits are expected to multiply from FY14 onwards; this will generate sufficient internal
accruals to fund future projects.
While equity funding is taken care of, raising debt in excess of Rs 85,000 crore may
remain a challenge, especially with interest rates set to rise. Only Sasan UMPP, Butibori
and Rosa have achieved financial closure with Krishnapatnam expected to achieve it
near-term.

Other concerns

While project delays are the norm in the Indian power sector, Reliance Power's choice
of Chinese vendors for key equipment combined with Reliance Infra's expertise in EPC
could reduce execution risk due to equipment delays. However, Chinese equipment has
come under the scanner for operational glitches (especially with domestic coal as a fuel)
from time to time.

With many of Reliance Power's projects bunched up, execution challenges will be
higher. The company will be particularly vulnerable to execution risks due to the higher
leverage in its projects. Any delay in captive coal development too could increase the
cost of generation.

The company (with promoter holdings at 85 per cent) is impacted by the new 25 per
cent public shareholding norm and thus may have to either tap the markets or dilute
stakes in favour of non-promoter investors in the next one year. Given the comfortable
equity position of the company, the latter appears more likely.

via BL