Attractively Valued

Rural Electrification Corporation (REC) is a public sector enterprise whose main objective is to finance projects in the power sector. These projects could be aimed at improving the overall integration of the system, adding generation capacity, promoting decentralised and non-conventional sources of energy, energy conservation, and maintenance and distribution. It is also responsible for the implementation of the Rajiv Gandhi Gramin Vidyuttikaran Yojna (which is a scheme of the government of India for electrification of rural areas).
The company has five subsidiaries: REC Transmission Projects Company Ltd., REC Power Distribution Company Ltd., North Karanpura Transmission Company Ltd., Talcher II Transmission Company Ltd., and Raichur Sholapur Transmission Company Ltd.

Sectoral outlook
Huge fund requirement. During the first three years of the XIth five-year plan, the country’s generation capacity increased from 132.3 gigawatts (GW) in FY07 to 159.4 GW in FY10, an addition of 27,068 megawatt (MW). The government is targeting capacity addition of 78,700 MW during the XIth five-year plan.
A report issued by the central government’s working group on power for the XIth plan estimates that the power sector will require Rs 10,31,600 crore of funds during the current plan period.
For the XII plan period, the Central Electricity Authority (CEA) estimates that in order to meet projected demand by 2017, capacity addition of 1,00,000 MW will have to be undertaken. Including the funds required for expanding transmission and distribution systems, the total fund requirement for this plan period is estimated at about Rs 11,00,000 crore.
Concerns. In recent times, the financial health of state electricity boards (SEBs) has deteriorated. The Prime Minister’s Office (PMO) has appointed a high-level committee to review the financials of SEBs. Their massive losses have raised concerns regarding the asset quality of power finance companies. The key reason for the deteriorating financial health of SEBs is that tariffs have not been revised for the past several years, especially in states like UP, Rajasthan and Tamil Nadu.
The power sector also faces a demand-supply imbalance vis-a-vis its key raw material, coal. While the power sector’s generation capacity has gone up, especially with the entrance of a number of private players into the power generation segment, Coal India has been unable to meet the higher level of demand. According to a recent report from Kotak Institutional Equities, the problem is compounded by the lack of logistics infrastructure — both railways and ports — that hinders the transport of imported as well as domestically-produced coal.
Outlook. In 2011, the going might be difficult for hydropower projects in the wake of some high-profile projects being scrapped due to environmental concerns.
The transition to a new regime under which power projects will be awarded through competitive bidding is expected to usher in greater competition. This is expected to eventually translate into lower electricity bills for customers.
In 2011, one is also likely to see more solar power schemes being set up, thereby providing impetus to the trend of green electrification.

Strengths
Dominant player. REC is India’s dominant player in the field of power financing. In FY10, its sanctions increased by 11 per cent to Rs 45,360 crore, while disbursements increased by 23 per cent to Rs 21,130 crore.
The composition of the company’s loan portfolio has changed with generation projects gaining pre-eminence over transmission and distribution projects in recent years. From 26 per cent in FY08 the proportion of generation projects has increased to 36 per cent in FY10. Over the same period, the proportion of transmission and distribution projects has declined from 63 per cent to 56 per cent.
Support from GoI. GoI owns around 66.8 per cent stake in REC. This company is its main vehicle for channelling credit to rural electrification projects, primarily through SEBs. The company derives significant financial and operational support from GoI. The government has provided funding support to REC via multiple channels: equity infusion, loans, and by allowing it to issue special tax-free bonds and capital gains exemption bonds.
Diversified resource profile. The company borrows funds from a variety of sources to get competitive rates. It borrows from both domestic and international sources, including banks, financial institutions such as Life Insurance Corporation (LIC), and by issuing debt instruments such as taxable bonds, infrastructure bonds, and capital gains bonds. REC also takes foreign currency loans from international banks and multilateral funding agencies.

Growth prospects
Analysts at Motilal Oswal Securities expect REC’s loan growth to remain strong at 22 per cent from FY11-13 due to a strong pipeline of projects for which funds are to be sanctioned. Moreover, the company plans to raise US $750 million by October 2011 for which it has already obtained approvals from the Reserve Bank of India (RBI) and the finance ministry. It plans to approach RBI for approval to raise a second tranche of US $750 million by March 2012.

Concerns
Asset quality. In the current macroeconomic environment, asset quality is a bigger concern than the fear of slowdown in growth. A large proportion of REC’s outstanding loans have been given to SEBs. According to a report from Motilal Oswal Securities, rising losses of SEB are driving up REC’s risk quotient due to its higher exposure to the transmission and distribution segment.
However, the government is now focusing on reforms on the distribution side of the power sector. It has also provided for collection of SEBs’ dues through an escrow mechanism. SEBs are themselves taking steps to cut down their losses. All this should help improve the situation in future.
Stiff competition from banks. Stiff competition from banks is affecting REC’s business growth in the transmission and distribution segment. By offering loans at competitive rates, banks have been taking away market share from REC. Further, various government schemes such as RGGVY and R-APDRP have lent funds to SEBs. As a result, the latter need fewer loans from REC.
Finally, growing competition in power sector financing has the potential to impact REC’s profitability. The company’s future growth will depend on its ability to compete effectively while being able to raise funds at cost-effective rates.

Financials
Healthy financials. The company’s total income has grown at a five-year compounded annual growth rate (CAGR) of 23.8 per cent while profit after tax has grown at 20.7 per cent. Its free cash flow has grown at a CAGR of 35.2 per cent between FY05 and FY10. Its return on net worth (RoNW) has registered a five-year average of 19.12 per cent. However, its return on capital employed (RoCE) has registered a not-so-impressive five-year average of 9.6 per cent, though it has grown consistently over this period.
Declining NPAs. REC’s gross non-performing assets (GNPAs) had shot up to 2.4 per cent in FY07. But since then it has gradually declined to just 0.03 per cent in FY10. According to a report from Motilal Oswal Securities, the spike in GNPA was chiefly due to delay in receipt of state grants by SEBs in the north-eastern states, which affected their ability to service debt.
Even in Q2FY11, there was delay in debt servicing by a private developer, as merchant prices had corrected, impacting its project cash flows. However, as the instalment was paid before the quarter ended, provisioning was not necessary. Peer comparison. REC is better placed compared to its close competitors such as Power Finance Corporation, IDFC and IFCI in terms of margins and profitability. In FY11, it registered the highest net profit margin of 31.1 per cent and highest RoNW of 21.5 per cent among its peers.

Valuation
REC got listed on the bourses on March 12, 2008. For two years between November 2008 and October 2010, the stock rallied from a low of Rs 53 to a high of Rs 410, which amounts to an appreciation of 674 per cent. Since touching this peak, the stock has been constantly on the decline. Currently it is trading at Rs 175 (as on August 22, 2011), a decline of 57.3 per cent from its October 2010 peak.
The stock is currently trading at a trailing 12-month price-to-earnings (P/E) ratio of 6.72 which is significantly lower than its three-year median P/E of 10.4 times. Based on its three-year earnings per share (EPS) CAGR of 31.8 per cent, its price-earnings to growth (PEG) ratio stands at 0.18.
REC’s long-term prospects are strong. Investors with at least a three-year perspective may interest in the stock. If you decide to buy the stock now, stagger your purchases in order to take advantage of the on-going decline in prices.