Sector likely to witness earnings downgrades. We see projects being impacted due to: (1) fall in merchant tariffs, (2) fall in PLF and (3) rising cost of generation. Given the high sensitivity of a project's earnings to each of these factors, we believe the sector could witness substantial earnings downgrades across the street. We cut our merchant tariff and PLF assumptions across companies and continue to factor in higher cost of fuel for thermal projects in order to incorporate this impact. Consequently, we revise our target price for most stocks under our coverage.
Project PLFs have started to get impacted on several counts. PLF for most thermal power projects has been impacted severely over the last few months led by: (1) domestic coal deficits resulting in Coal India supplying only 60-70% fuel requirements of linkage projects – while some fuel needs are met through expensive e-auction/imports, entire coal needs are not met on account of cost, logistics and technical issues; (2) a fall in merchant tariffs and UI charges along with the rising cost of fuel, which has forced some projects to operate at lower utilisation. SEBs, too, are requesting high tariff projects to operate at lower PLFs in order to alleviate the impact on their already-stretched financials.
Merchant tariffs continue to correct, even sequentially. Merchant tariffs under bilateral contracts (over 50% of merchant sales) declined 16% QoQ in 2Q FY11 led by low seasonal demand and higher hydro power generation on better-than-expected monsoon during 2010. But, merchant tariffs were expected to rebound during 3Q FY11 on generally high seasonal demand during the Oct-Dec period. However, bilateral merchant tariffs have fallen even below the 2Q FY11 average by 15-18% during Oct and Nov 2010.
Merchant tariffs on power exchanges reveal a similar trend. Besides, the forward curve for bilateral tariffs point towards a declining merchant tariff trend during 4Q FY11. We believe weak SEB finances is the key reason for the continuing fall in merchant tariffs. Increasing merchant volumes from new merchant capacities have impacted SEBs' ability to sustain higher tariffs.
Expect merchant tariffs to remain subdued going forward. Excluding exceptional situations such as elections, we expect merchant tariffs to remain under pressure going forward led by: (1) rising merchant capacities –we expect merchant volumes to double by FY14; (2) augmentation of national transmission grid capacity, which should ease grid congestion, one of the key reasons for high merchant tariffs currently; (3) the regulator likely intervening to curb any sustained rise in merchant tariffs; and (4) the share of power exchanges in merchant sales increasing with the introduction of longer dated products (reducing the premium earned in bilateral merchant tariffs/OTC products for assuming counterparty risk)..
Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints.
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