BHEL versus China

BHARAT Heavy Electricals (BHEL) is now battling the dragon at its door; Chinese companies are trying to capture the Indian power generation equipment market. BHEL has grown used to fighting local contenders such as the Larsen & Toubro-Mitsubishi Heavy Industries (L&T-MHI) joint venture, the Bharat Forge-Alstom tie-up, Siemens India, and ABB, and settling for a steady two-thirds market share. However, the last five years have seen a sharp rise in the number of projects going to Chinese companies, especially the three largest—Dongfang Electric, Shanghai Electric, and Harbin Power.

Martin Daniel, editor of global energy consultant Platts’s Power in Asia report, warns of China’s rising strength. “China’s competitive threat to BHEL is real,” he says. “Chinese vendors are aggressive, and they have huge capacities. Besides, they get strong support from China Exim Bank and China Development Bank.”

China’s timing is immaculate. Over the next five to seven years, the Indian power ministry plans to add 75,000 MW to 100,000 MW. This plan includes the Ultra Mega Power Projects (UMPPs), a series of plants with a minimum capa­city of 4,000 MW each. These will be based on newer and more expensive—but ultimately heat-efficient—supercritical technology. Coal-fired power plants are categorised by output level, and supercritical ones start at 600 MW. Ultra-supercritical ones are above 1,000 MW. Plants that produce under 600 MW fall in the subcritical category.

Chinese firms have been aggressively reaching out to growing markets in the ASEAN region, elbowing out Japanese heavyweights Toshiba, Hitachi, and Mitsubishi Heavy Industries. In Indonesia, which is in a similar phase of development to India’s, Chinese firms bagged nearly 95% of equipment contracts during the fast-track programme to produce 10,000 MW through coal-fired plants. The situation is similar in Vietnam. Neither Dongfang nor Shanghai Electric responded to Fortune India’s queries.

There’s anxiety on the street about Chinese plans. For the past three quarters, analysts on conference calls with BHEL chairman and managing director B. Prasad Rao have opened nearly every conversation with questions about China. This is reflected in BHEL’s stock, which has fallen 15% over the last 12 months, despite the 10% rise in the Sensex during this period. BHEL officials declined to speak to Fortune India.

A Kotak Securities November 2010 report on BHEL raised concerns about Chinese competition. “Larger customers such as Adani, Sterlite, and Reliance Power prefer Chinese vendors, while smaller utilities such as DB Power and Visa Power lean towards BHEL,” the report says. “This may not be positive for BHEL, as smaller utilities may lack the bandwidth to procure quality Chinese equipment.” Kotak has lowered BHEL’s stock rating and cut its price target.

What has helped the Chinese firms is cheap credit. In Indonesia, Chinese banks provided about 45% of the investment for the first 10,000 MW programme, outbidding customary lenders Asian Development Bank and Japan Bank for International Cooperation. The Chinese are now the largest lender to Indonesia’s national power utility.

Chinese banks lend to their vendors at 4% to 5% a year, while the corresponding rate in India is 8% or more. For a 1,000 MW project that costs Rs 4,000 crore and is funded at a 3:1 debt-to-equity ratio, this differential could mean annual savings of Rs 60 crore to Rs 70 crore in interest costs. This is a huge draw for private-sector developers such as Reliance Power and Lanco Infrastructure.

BHEL CAN'T CURRENTLY MATCH these numbers, but it is sitting on a pile of cash—around Rs 9,500 crore—with which it plans to set up a non-banking finance company that will fund equipment purchases, much as an in-house car finance company helps an auto maker sell more cars. A decision on this plan, likely this month, could increase BHEL’s competitiveness.

Another Chinese strategy is the willingness to settle for low margins, according to a January 2011 report by Bank of America Merrill Lynch. For the next three years, the Ebitda margin of Dongfang Electric is estimated to range between 8.9% and 9.5%, Shanghai Electric’s between 7% and 8.1%, and Harbin Power’s between 5% and 5.6%. In comparison, BHEL’s Ebitda margin is estimated in the range of 20.1% and 20.9%.

Beyond finances, Chinese firms are taking advantage of BHEL’s limited production capacity. In the last four years, the Indian market has more than tripled from between 7,000 MW and 8,000 MW in 2007 to 25,000 MW a year. During this period, BHEL’s manufacturing capacity increased from 6,000 MW to a mere 15,000 MW, resulting in customers choosing Chinese firms that are positioned to deliver: Dongfang Electric’s capacity is 30,000 MW.

While the equipment BHEL supplied accounted for 74% of all power generated in the country in 2009-10, the company indicated at a June 2010 investor conference organised by Morgan Stanley that its market share in projects during the 11th Five Year Plan had declined to slightly over half. It also became clear that 47% of projects during the same plan were bagged by BHEL’s competitors: 15,430 MW went to Chinese firms, a significant difference from five years ago, when the Chinese had a marginal presence.

Chinese equipment vendors are also moving up the value chain, says Platts’s Daniel. For instance, Shanghai Electric recently developed reactor vessel internals for a 1,000 MW nuclear power station, a feat shared by only two other companies in the world. In comparison, BHEL has only recently signed up with Alstom, France, and Siemens, Germany, for a technology transfer arrangement.

Kunal Sheth, who tracks the capital goods sector at Prabhudas Lilladher, a Mumbai-based brokerage, says: “BHEL remains competitive in the subcritical segment, and is on par with the Chinese costwise. However, in the supercritical segment, the Chinese are 15% to 20% cheaper.” Since BHEL entered the segment belatedly, it is still scaling up operations, so Chinese firms have the edge in large projects that use supercritical technology.

But BHEL has another advantage. “It beats the Chinese hands down in the life-cycle cost (maintenance and operations cost) of the equipment,” says Sheth. Daniel concurs, saying the average plant load factor or PLF (the rate of capacity utilisation) of coal-fired plants in China, which use Chinese equipment, is around 75%. NTPC, which primarily uses BHEL equipment, averages around 80%. A March 2011 report by research firm JM Financial notes that Chinese equipment consumes 12 times as much specific fuel oil (SFO) as BHEL equipment. At the current average SFO rate of Rs 33 per litre, the report says, the cost would be 17 paise to 22 paise higher for a Chinese unit than for a BHEL unit, over the lifespan of the equipment. Besides, Chinese equipment has to be shipped to China if there are technical irregularities, and it has longer lead times to synchronise with local conditions. So, despite the initial 15% saving on capital costs, the life-cycle cost is lower for BHEL equipment.

Plant and machinery repair accounted for 3% of NTPC’s variable and fixed costs in financial year 2010. In comparison, capital cost (interest payment and depreciation allowance) was 11.6% of the total cost. Such savings of a few percentage points in maintenance expenses over 25 years to 30 years—the typical life of the equipment—translate to hundreds of crores of rupees. Obviously, BHEL has been emphasising these advantages to private-sector developers. “Our (equipment) performance edge is driven by lower power consumption and boiler efficiency, leading to lower heat rate, and a better plant load factor,” BHEL’s Rao said, when discussing third-quarter results with analysts.

However, touting one’s strengths is not enough; BHEL has long failed to put its house in order. “It has possibilities for cutting costs,” says Shobhit Agrawal, managing director, Protiviti, a consulting and internal audit firm. “It needs to internalise R&D, reducing dependence for critical technologies. Raising workforce productivity would also help.” With nearly 50,000 people on its payroll, BHEL is one of the biggest employers in Indian manufacturing.

Then there’s the sluggish pace of capacity expansion. At present, annual demand is for equipment generating around 25,000 MW. Despite being the country’s biggest vendor, BHEL commissioned projects worth only 4,258 MW in the first nine months of 2010-11. Its factories are running overtime but still can’t meet deadlines. A senior NTPC official, who asked to remain anonymous, said BHEL’s inability to deliver on time led to delays in NTPC projects. The government has actually scaled down capacity addition for the 12th Plan by 18,000 MW, partly due to BHEL’s slow execution.

“BHEL is partly responsible for creating openings for its competitors by being conservative in capacity expansion,” says Dhirendra Tiwari, senior vice president, Motilal Oswal Securities. He adds that, in the long term, the biggest issue for BHEL will be the availability of coal, which has slowed all power projects in the country. “While the coal issue may be sorted out in the next five years, in the near term it will continue to hurt all thermal projects, which may bring down BHEL’s earnings growth,” he says.

Tiwari also questions the costs quoted by Chinese companies. “Their record suggests that by the time the equipment is finally installed, the cost usually goes up by 30% to 40%.”

But Protiviti’s Agrawal says competition from Chinese firms will only intensify. “Chinese vendors may look at even more aggressive prices in the future, as capacity addition in their home market slows down,” he says. The total installed capacity in China crossed 950,000 MW in 2010, and in 2007, roughly two plants were opened every week. In 2011, China plans to add only 70,000 MW. By contrast, India’s entire installed capacity is currently only around 174,000 MW.

HOWEVER TIWARI IS OPTIMISTIC about BHEL’s prospects, and has a buy rating on the stock. BHEL’s Rao sounded bullish, too, when announcing results for the December 2010 quarter: “We’re aggressively working on capacity expansion, ramping up manpower, particularly at sites, strengthening project management systems, and enhancing site capability. You will see improvements in our execution capabilities.”

BHEL plans to increase capacity from 15,000 MW to 20,000 MW a year, and has hired nearly 12,000 people in the last three years. It has the advantage of being the incumbent, with a strong manufacturing footprint and balance sheet. The former is crucial for NTPC tenders and other public sector projects, as they can source equipment only from vendors who manufacture locally, such as L&T-MHI, Siemens India, and BHEL. Chinese manufacturers, who have yet to invest in India, are ineligible. “The Chinese model is to bring everything, equipment to manpower, from China,” says Daniel.

BHEL’s management seems aware of the threat. Recently, it signed a 10-year wage agreement with unions to check manpower costs and raise productivity. It is also lobbying for duty on imported equipment.

Some large orders have gone to Chinese firms under a framework agreement at lower initial costs. “We’re not sure about the sustainability of these agreements, especially if import duty is imposed on capital goods,” says Sheth.

“Recent ‘mega orders’ by some private sector developers have been announced to please the market, rather than to do anything concrete,” says Tiwari. “Right now, they’re just pieces of paper.” In the near term, he expects BHEL to grow at around 20% to 25%, as it did last year, but adds: “In the long term, it will be tough to beat the market, and it can grow at 10% to 15% a year on a sustained basis.”

Arvind Mahajan, partner and executive director at KPMG India, says BHEL needs to reassure the private sector that it can deliver on time and at competitive prices. BHEL has got the message: In 2009-10, private sector utilities accounted for 14,689 MW out of the total orders of 16,489 MW—nearly 90%—that BHEL received.

“The market expects the company to indigenise products, which will lead to substantial savings,” says Sheth of Prabhudas Lilladher. “They have enough orders to grow their top line and bottom line in the medium term.” On Dec. 31, 2010, BHEL’s order book stood at close to Rs 1.6 lakh crore—nearly five times net sales in 2009-10.

After the disaster in Japan and the resurgence of doubts about the safety of nuclear power, things may actually look up makers of equipment for coal- and gas-fired power plants. This could be BHEL’s opportunity to scale up its presence in supercritical and other emerging clean coal technologies. It could face renewed pressure from the government to invest in technologies for solar and wind power generation.

BHEL will continue to grow. But if the pace remains slow and the delays continue, Chinese companies may win, as they have in Vietnam and Indonesia.