Utilities the next big theme to watch out for: Top 8 stock picks from brokerages

The S&P BSE Utilities index has rallied by over 60 percent so far in FY21 and experts feel that the rally in the sector is likely to continue as it is still trading cheap. Investors are therefore looking at the sector as a catch-up play.

Utilities as a sector consist of companies that handle power generation and distribution, gas distribution, infrastructure development and operation, as well as the capital goods involved in non-electrical equipment. The index fell over 30 percent in FY20, data from the BSE showed.

As India’s economy steadily reopens after the Covid-induced lockdown, the country’s power demand has also recovered. Most experts expect this to continue in FY22, which will be positive for companies in the utilities space.

Power demand has been consistently improving over the last few months. All-India power demand increased 5.2 percent YoY in January 2021, and based on high-frequency indicators, the daily average electricity consumption in February 2021 was 3 percent higher than in February 2020, data from Kotak Securities showed.

The sector trades cheap at 1 times forward Price-to-Book Value with some stocks trading at 0.6-0.7 times forward Price-to-Book Value, data showed.

“Most of the economy-driven sectors have rallied on a rotation basis and slowly most pockets of undervaluations have been filled up. Utilities as a sector is still trading cheap hence investors are looking at it as a catch-up play,” Rusmik Oza, Executive Vice President and Head of Fundamental Research at Kotak Securities, told Moneycontrol.

“Utilities is not a high-growth sector as it is annuity play and there is a transition phase wherein companies are reducing their expansion on coal-based power plants and going more for renewables. We expect earnings of utility companies under our coverage to grow at a CAGR of just 7 percent for the next two years,” he said.

“Investors can look at utilities only as a tactical play and as prices go closer to their respective target prices, one should look at exiting from them. This is not a buy-n-hold kind of sector where investors can take a long-term view due to poor earnings growth,” explains Oza.

India’s power demand has now been consistently clocking >3,500MUs daily v/s <3,000MUs posted during the lockdown (Pre-lockdown: ~3,400MUs daily), data from a report of Motilal Oswal showed.

Data for January 2021 indicates power demand has recorded its fifth straight month of a year on year increase. The domestic brokerage expects this to continue, leading to a YoY demand decline of just 0.5 percent for FY21.

Growth in renewables presents an opportunity for utilities players as most of the companies covered by Motilal Oswal have comfortable leverage positions to build their presence in this space.

Why Utilities?

Utilities as a sector might not turn out to be a wealth generator, but it is a good dividend play as companies in the sector generate high cash flows, have stable growth rates and comparatively attractive valuations.

“Within the utilities sector, the government’s clear focus is on providing clean drinking water to the people of India and replacing polluting fossil fuel with cleaner natural gas,” Jyoti Roy, DVP Equity Strategist, Angel Broking Ltd told Moneycontrol.

“Utilities companies tend to be de dividend yield plays given the very high cash flows, stable growth rates, and moderate valuations. Most of the utility companies such as Powergrid, GAIL, MGL etc. have dividend yields that are well above the Nifty dividend yield of 1.05 just 0.5 percent,” he said.

Roy added that utility companies are typically defensive plays with high dividend yields given their steady growth and the stable nature of their business. However it has to be noted that many of the utility companies are PSU stocks where valuations have been depressed for many years due to constant supply of paper by the Government, and hence dividends yields are well above the Nifty yield.

Here is a list of top picks in the utility space from various global brokerages:

Expert: Jyoti Roy, DVP Equity Strategist, Angel Broking Ltd.

GAIL, Mahanagar Gas, IGL and Gujarat Gas:

Within the utilities space, we are currently positive on gas transmission and distribution companies given the government’s thrust on natural gas. Within the gas space, Angel Broking has a positive outlook on GAIL and Mahanagar Gas, IGL and Gujarat Gas.

While Gujarat Gas and IGL have relatively lower dividend yields, investors can look at GAIL and MGL, which have dividend yields of 4 percent and ~3 percent, respectively.

MGL is Angel Broking’s top pick in the gas sector given its very high margins, strong cash flows, and decent growth rates along with a very high dividend yield.

Expert: Rusmik Oza, Executive Vice President, Head of Fundamental Research at Kotak Securities

NTPC:

In the case of NTPC, Kotak Securities estimates regulated equity to grow at 11.6 percent CAGR between FY20 and FY23E to Rs 86,000 crore as the company adds 12 GW of incremental capacity in the next three years.

NTPC has incorporated a new subsidiary, NTPC Renewable Energy, to increase the push towards renewables and have a 25 percent share of renewables in its overall generation capacity.

Earnings growth has strong visibility over the next three years as 12 GW of under-construction coal-based capacities will likely be commissioned. Our Fair Value stands at Rs125/share, noting inexpensive valuations of 0.8x Price/Book Value and 7.2x P/E on March 2022 earnings.

CESC:

CESC’s consolidated profits increased 23.2 percent YoY in 3QFY21 to Rs 320 crore, led by profits of Rs 28 crore reported in Dhariwal (a subsidiary) compared to losses of Rs 15 crore in 3QFY20. Distribution circles in Rajasthan reported a profit of Rs 21 crore in 3QFY21.

The company is looking to transfer all the distribution assets into a separate entity. Our key investment thesis on the stock is the stability of the regulated business, moderating losses from new distribution circles, and improving utilisation for Dhariwal.

A healthy interim dividend of Rs 45 per share shows the intent to increase payout. Kotak Securities expects earnings to grow by 10.9 percent in FY22E and 10.5 percent in FY23E. Valuations offer comfort as the stock trades at just P/E of 5.9x and Price/Book Value of just 0.58 percent on FY22E.

Brokerage: Motilal Oswal

Torrent Power:

Covid-19 had impacted Torrent Power (TPW)’s Distribution Franchise business at Agra and Bhiwandi amid lower volumes and higher AT&C losses.

However, demand and collections have recovered and profitability should also bounce back in FY22. The company has made provisions of Rs 1.4 billion for the business. As collection efficiencies improve, the company expects to recover and reverse these provisions as well. The target Motilal Oswal has set is Rs 463.

Tata Power:

Over the past year, Tata Power (TPWR)’s deleveraging process has been accelerated by 1) the sale of Cennergi, 2) sale of shipping companies and 3) the preferential issue to Tata Sons.

As a result, net debt has reduced to Rs 395 billion (from Rs 471 billion in FY20), and the benefit should start to reflect in the form of lower interest costs.

Furthermore, the company plans to continue its asset monetisation plans by exiting non-core assets and a Renewable InvIT.

The InvIT transaction is expected to be completed this year, which could further reduce its net debt to the Rs 250 billion level by the end of FY21. The target set by the brokerage firm is Rs 123.

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