Many market observers are convinced that the ongoing surge in risk assets and risk appetite will ultimately end in a huge bubble in the emerging market asset class broadly, and the BRIC economies in particular. I also happen to subscribe to this view, and believe that India will see significant inflows into equity markets as the momentum builds. Drilling down further, as equity investor, one needs to think about which sectors will lead the market? Where can a valuation bubble build at a sectoral level? Which sectors will be the new darling of the markets?
My contention is that the one sector which is a leading candidate to lead the market, and where we will see bubble like investor behaviour and valuations (arguably already so), is the power generation space. This whole theme of merchant power is one where we already see a lot of activity and action, but it is just the beginning.
As to why I think we will see a huge bubble in merchant power, there are many characteristics of the sector which make it very ripe for market hype and hysteria.
First of all on a macro level, there is no denying that India is hugely deficient in power capacity, and demand will continue to outstrip supply for years. It is very easy to see the macro opportunity, it is, in fact, obvious.
Secondly, in Jindal Steel and Power, we have proof of concept that merchant power works and is hugely profitable. JSPL earns an ROCE (return on capital employed) of over 80 per cent, and is a cash machine. Every developer will point to JSPL’s economics and extrapolate the same.
Third, a majority of power companies (with large merchant power portfolios) which are floating IPOs today, have all long-tailed projects coming on stream only three-to-four years down the road. It will thus not be obvious until they actually go on stream as to what are the true economics of these projects. Today they are only project reports and analyst DCF (discounted cash flow) models, implying that you can arrive at any valuation you want depending on your modelling assumptions. It will not be possible to debunk these assumptions for the next three-to-four years, till such time as this capacity comes on line.
Fourth, given the amount of equity and debt issuance expected in the sector, all investment bankers and analysts are incentivised to put as positive a spin as possible on the sector, its growth and profit potential. Ultimately, a huge pool of investment banking fees are dependent on markets backing the sector and the major players within it. It would be a surprise to see any major brokerage come out with a strong negative view on these companies at this stage.
While the whole merchant power theme is going to be huge, I think investors must be careful in not getting carried away. One cannot take today’s spot merchant rates of Rs 6-8 per unit and extrapolate this beyond the next 18 months. Execution is also critical, completing billion-dollar projects on time and in budget in India is not trivial. Land acquisition, environmental clearances, these are all serious issues. Companies will need to be sensitive to financial risk and the percentage of power capacity kept merchant.
Current spot rates are based on a total merchant capacity of at best 3,000 MW. It is actually quite a thin market. It is not at all clear that when 25,000-30,000 MW of potential merchant capacity comes on line, will we have the evacuation infrastructure or payment capacity to handle this quantum of merchant sale? Demand for the power will be there, but at what price?
Power is the ultimate commodity, which can neither be stored nor differentiated. It is also very prone to price cutting as it has a high, fixed-cost structure and comparatively low variable costs per unit(just like airlines or telecom). A power plant also cannot be backed down easily or shut down, thus you are forced to produce, pretty much independent of demand or pricing. Even today with all the talk of Rs 10 pricing in spot power markets, there are periods of time when the power has to be sold at almost zero realisation due to lack of demand or evacuation capacity. Any marginal demand-supply mismatch even if seasonal can decimate pricing.
There is also the question of how much high-cost power can the industrial structure of our country or government finances absorb? SEBs are already bankrupt, and buying power at Rs 8 to sell it to consumers at Rs 3 is a guaranteed recipe for ruin. SEBs can absorb today 3,000 MW at this rate, not 25,000 MW.
We also have the question of regulation. The industry is still quite young and the regulatory structures evolving. You already have states like Orissa imposing an emergency and not allowing units in the state to export merchant power (forcing them to sell to the SEB at lower rates), thereby compromising on realisations. The CERC has capped power trading margins and, for a brief period, had put a cap on power rates as well. There is a clear regulatory risk.
Today with the government keen to incentivise private power generation, and only about 3,000 MW actually merchant, we may not see much regulatory interference in terms of capping prices or financial returns. The picture may change with 25,000-30,000 MW of merchant, this quantum of power will be significant enough to affect the average tariffs in the country and thus may force the regulators to act.
Additionally, we have the issue that in most cases, these huge profits are only possible because of captive coal blocks handed out by the government. You are effectively giving a licence to print money to any power developer granted a captive coal block. Can our polity and country countenance private companies making billions of dollars in profits from exploiting state assets? I do not think India is Russia. When too much money starts being made, questions will be asked, and checks and balances put in place.
Ultimately investors should treat these power companies just like any other commodity producer. Focus on cost of production per unit of output, where the company is on the cost curve, and companies must maximise scale to reduce unit costs. Power prices will probably settle at a level high enough to give a decent return to the most efficient producer, but not windfall gains to everyone. Can the most efficient players get 25 per cent ROEs (return on equity)? Probably yes. But can every player, irrespective of its cost position, make a 50 per cent plus return as some think? Definitely not.
You will have a slew of equity issuances from this sector over the coming 12 months. One must take the time to question the assumptions in earnings models and figure out who can execute and who cannot. Money will be made in the sector, but one will need to be choosy. There is a real risk of valuations getting out of hand as bankers and companies try to extrapolate current windfall profitability achieved by one or two plants onto a much larger scale.