NHPC â a better option than a fixed deposit
Let me make it clear at the outset that I am invested in NHPC (and SJVN too), so my views are bound to be biased. In my view NHPC is not for people who wants to buy only those stocks that beat stock market returns (though that not ruled out completely at current price). It is only for those, who want to earn decent returns (more than fixed deposit on post-tax basis) and are more concerned with protecting the downside than aiming for upside.
**Rationale for investment: **I have invested in NHPC treating it as a bond which provides tax free return of 4% pa (post tax yield of around 5.5%, with growth possibilities and possibility of capital gain when the current pessimism ends). It also falls under the theme âHeads I win and tail I do not lose muchâ. Father of value investing Benjamin Graham has classified investment securities into the following types
Class I â Securities of the fixed value type (High grade bond) , Class II (A) Senior securities of the variable type â well protected issues with profit possibilities (a high grade convertible bond or preferred stock) Class II (B) - Senior securities of the variable type â Inadequately protected issues (a lower grade bond or preferred stock) Class III â Common-stock type â A common stock (I know a table would have been better but unfortunately not able to paste picture)
In my view NHPC is a class II security â a high grade convertible bond as its profits are well protected (by law NHPC is guaranteed ROE of 15.5% on post-tax basis, provided it meets certain operational parameters) and it provides dividend yield of around 4% (post tax yield at 30% tax rate is 5.7%)
_Reasons to buy : _
__
1). NHPC is guaranteed by law a ROE of 15.5% on a post-tax basis and all the cost incurred by it on construction of hydro power plants and generation of electricity is fully recoverable (provided it meets some operational parameters) as part of the tariff.
2). In the last twelve years, it has never reported a decline in operating profit and net profit. The worst year was 2010 when itâs operating profit and net profit was flat.
3). NHPCâs new hydro plants have been exempt from a newly introduced tariff-based competitive bidding regime up to December 2015, in view of complexities and construction risks involved.
4). Even though companies operation of building Hydro power plants are highly capital intensive, it was able meet almost 80% of its capex needs over 2003-11 from the operating cash flow.
5). Its current net debt to equity is less than 0.4x, so it will be able to fund its large capex without diluting equity in the near future.
6). The companyâs operating and net profit margins have remained above 67 per cent and 35 per cent, respectively, in the past 10 years.
7). Current earnings yield (inverse of PE) is around 9% and dividend yield 4%, with growth prospects. Moreover this yield is on depressed earnings as large amount of capital is tied up Capital Work In Progress (CWIP, around 60% of shareholders funds).
8). Current valuation factors in a very pessimistic scenario (see valuation section)
Reasons not to buy:
1). Current policy paralysis in power sector. __
2). Even on four year trailing basis, Return on Capital Employed (RoCE) for 2010 and 2011 is merely 9-10%__
_3). _Financial conditions of its main customer viz SEB is currently very poor. Even after some restructuring it improves, it will for sure deteriorate again under political interference and pricing electricity at a lower price. __
4). Project cost overrun more than 40% in many cases. (many of which are due to uncertain geology condition and a large part of it have got approved in the past as per management)
5). There is a risk that what happened in telecoms with BSNL and MTNL happens with PSU companies under Hydro and PSUs may not be able to compete with the onslaught of private sector.
6). Since 2003, ROE for most times is around 6-7%. Only in 2010 & 11 it touched around 9%. (But this is because of high CWIP)
7). CWIP on average is more than 60% of shareholders fund for the last three years (Company does not earn any return on CWIP)
8). Installed capacity is flat over the last four years.
9). Contingent liabilities for disputed sales tax: 2,500 cr.
10). About 20% of the current projects are in the state of J&K. Exposed to tail risk of terrorist attack and attack from Pakistan.
_Valuation _
__
1). Market is assuming that its ROE (Return on Equity) will stay at 7% for ever which is highly unlikely. (This is using justified price to book value method, Formula ROE-G/(R-G), where ROE is return on equity, G = Growth and R = discount rate, G= 3% pa and R= of 8%).
2). When the earnings stability is as certain as bond with a growth prospect, it cannot be valued below book value. Currently it is trading approximately 20% below book value.
3). At current price, dividend discount model implies that dividend will grow at 4% p.a in future (taking R= 8% and DPS of INR 0.7).
When to sell
1). Ultra long term holding â So sell only when you want to reduce your allocation to debt. Else keep it in place of a bond.
2). Company business model changes from current model of assured equity and cost plus model. (though competitive bidding will kick in from 2016, it will be long before the it derives substantial portion of its income from competitive bidding tariff)
3). Valuation above 2.5x book value._ _(Because that will imply that its sustainable ROE will be more than 14%)
Note: I have also posted this on another website. My aim is to get some views of senior members (preferably contrary views) to my investment approach. I hope Donald is fine if the same stuff is being posted on multiple websites.