Saturday, March 28, 2009

Suzlon Energy - Buy on declines

Vidya Bala

Investors with an over three-year perspective can consider accumulating the stock of Suzlon Energy. While there is no denying that Suzlon is the least decoupled from the global slowdown and is also plagued by internal challenges such as the defective blade issue and funding for acquisition, its current valuations have clearly factored in more negatives than perhaps exist now.

The huge potential for renewable energy in the long term and the company’s sound business strategy to tap global opportunities strengthens the case for buying the stock at rock-bottom valuations. At the current market price of Rs 35, the stock trades at four times its expected earnings for FY-10. Investors may, however, have to be prepared for a sedate performance in FY-09. The high volatility in the stock warrants buying it in small quantities on declines.

Why the poor results

A good part of Suzlon’s recent stock decline occurred after the company’s December quarter results, when it posted losses mainly on account of exceptional items. On a consolidated basis, the company made losses of Rs 34.9 crore mainly on account of notional forex losses and a provision for blade retrofit also amounted to Rs 449 crore.

The defective blade issue: While the first is an accounting treatment to comply with accounting standards, the other expense amounting to Rs 233 crore was incurred as part of its retrofit programme for a particular version (S88 V2) of blades that were found to be defective. The provision made was on account of higher cost of replacement as a result of longer period to find the root cause before rectification.

The company has stated that most of the provisioning is done with and nothing significant may have to be provided for in the coming months. Further, as the company has already moved ahead to the next version (V3) and installed the same without any reported cases of defect over the past one year, we believe this provisioning is unlikely to extend much in to the future.

Acquisition-related debt: High interest costs, mostly on account of acquisition-related debt, have also resulted in a strain on profits. However, the company is likely to retire about Rs 250 crore of the acquisition debt in 2009 and one more tranche by June and September. The company intends to repay these amounts partly through the recent stake sale in its subsidiary, Hansen Transmission, which resulted in cash inflows of Rs 550 crore. With this, we expect the debt-equity ratio to reduce to at least 0.8:1 from 1:1 at present.

Leaving alone these two factors, the company’s operations have remained fairly healthy. The Suzlon group alone witnessed a good 53 per cent increase in operating profits for the December 2008 quarter compared to a year ago numbers.

Operating profit margins too expanded by a marginal 30 basis points to 12.8 per cent for the same group (the fully consolidated numbers are not comparable as a result of REpower’s inclusion in the December 08 quarter).

Working capital: Suzlon has accumulated huge inventories this quarter, further dragging its working-capital cycle. The build-up can be partly explained by the US slowdown and perhaps the quality concern overhang resulting from the blade defect issue.

Of its current order book of close to 2,200 MW, at least 800 MW is executable in the last quarter of FY09. Such an execution is likely to ease the working capital strain by way of inventory liquidation. The company may also resort to lower advance purchases of components given the global slowdown and reduced demand. Such a move too can improve working capital.

Acquisition concern

Another near-term concern that has been dragging the stock of Suzlon is the means of funding to pay €205 million (Rs 1,332 crore), for Martifer’s stake in REpower over April and May 2009. For now, the company has a three-pronged strategy for the same. One, it hopes to generate part of the amount through funds released from reduced working-capital requirements. Two, a further stake sale in Hansen (but retaining control) is an option. Three, external borrowings may be resorted to.

Plan 1 appears plausible given that reduced inventory and lower commodity prices could well be a reality in the fourth quarter. A stake sale in Hansen is also not impossible given that it can sell up to 10 per cent and yet maintain a 51 per cent stake. A similar stake sale recently brought in about £73 million (Rs 530 crore). Such a strategy would also not materially affect the earnings picture for Suzlon shareholders. The third strategy though may once again bring the debt to less comfortable levels.

That the company has strategies lined up to address the funding concern provides comfort to its ability to tackle adversity. More importantly, the persistence shown by the company in this acquisition, its success in negotiating for a longer payment period with Martifer and its willingness to carry the burden of low-profit margin foreign associates also suggests its seriousness in gaining a foothold in the robust EU wind market.

These moves, though beset with short-term risks, if overcome, could well generate high returns on integration. These are also clear indicators for an investor that the company is pursuing an aggressive growth model and is a high-risk high-return proposition.

Business opportunities

Suzlon has seen a revival in order flows with the recent projects bagged in Australia and China. The company expects to receive at least 1,000 MW of the 2,000 MW of projects that are currently in its pipeline. While markets outside of the US may hold better opportunities in 2009, the US market, once there appears a revival, could yet hold huge potential given the extension of the production tax credits unto 2012 passed by the US Senate. Other incentives include a $7-billion renewable energy loan guarantee programme, an additional year of bonus depreciation and incentives for small wind investments.

The potential in the Indian market too appears enhanced what with a few states offering higher tariffs for captive investment in wind energy. Further, a number of public sector companies such as ONGC, HPCL are starting to invest in renewable energy to meet the Central target.

Weighing the fortunes of the renewable energy based on price of crude oil alone, as the market appears to be doing now, therefore, appears short-sighted. Regulations, incentives and the planned wind energy programmes for various economies in the context of the slowdown, should instead be the deciding factors for assessing the prospects of the wind energy market.

businessline 08-03-09

Investment Strategy Now :

Our View :

The prices have run up in the last week too fast and with this speed it can
touch Rs.46. One should not invest at this high price but should start buying
around Rs.35 levels for a decent gain over a 12 months period.