Good stock, bad stock

It was a good day after a bad year. Investors holding Calcutta Electric Supply Corporation (CESC) shares must have cheered, even if only briefly, the day the Union Cabinet cleared the proposal to allow FDI in multi-brand retail. On November 25, the company’s stock rose valiantly by 8% to close at ₹272.5, which was quite a comeback after the long downward spiral from its high of ₹385 in January 2011. Of course, once the FDI proposal was put back on hold, the stock started sliding again. 

CESC, which generates and distributes power in Kolkata, Howrah and Noida, may not be such a recognisable name all over India but it owns Spencer’s Retail, the much seen, multi-format retail chain. The Spencer adventure (merged  in  FY08) has been a nightmare for CESC—its stock price is down 45% over the past year (see: Under Pressure) purely because Spencer’s is burning up ₹9 crore every month. “Though CESC is one of the most efficient power producers in India, it has not been able to get the valuation it deserves,” says Kashyap Pujara, Analyst, Enam Securities in his report. FDI, it was hoped, could rescue Spencer’s and, therefore, CESC. Alas, that is not to be, at least not anywhere in the near future. 

Sanjiv Goenka, Vice-Chairman, CESC, does not appear as perturbed as CESC’s investors. “The retail business in India, like anywhere in the world, is a long-gestation business that eventually makes profits with scale and operating efficiencies,” he says. “In FY11, Spencer’s losses were about ₹200 crore but they are expected to be substantially lower in the current year.” How justified is Goenka’s optimism? Let’s find out.

Grin And Bear It

Spencer’s is funded by fresh debt and internal accruals from the flagship company CESC’s power business. Analysts estimate that every year, out of the ₹500-600 crore profit made by the power business, around ₹150-200 crore goes into funding Spencer’s. This largesse is expected to continue till the retail business breaks even. Meanwhile, CESC is exploring alternative funding options for Spencer’s. Goenka says not only is he open to diluting a minority stake in the retail business, an IPO could also be considered.  

While it would make sense for CESC to get rid of its retail business, analysts say that it can’t, not till the retail wing turns profitable anyway. “CESC wants to sell a partial stake but it’s not easy to find investors for a loss-making business,” says Rohit Singh, Analyst, IDBI Capital Research.

So, instead, CESC is focusing its energies on turning Spencer around by increasing sales, shutting down unprofitable stores, stocking more high-margin private labels, lowering rent-to-sales, and expanding the hyper-market format in places where the Spencer’s brand has strong consumer support. “We hope to expand from 1 million sq ft to about 1.5 million sq ft in the next two years,” Goenka says. “We will fund it through a mix of debt and support from the holding company.” 

Some of the efforts seem to be paying off. “Spencer’s has already achieved the first milestone of consistent store EBITDA profitability for over 16 months now,” says Goenka (see: Turning around). Goenka is confident that losses will decline further in the current fiscal. Breakeven, he hopes, will happen in FY13 or FY14.

Will It?

PINC analyst Hitul Gutka is sceptical about that timeline. “I think the retail business will break even sometime in FY15 or FY16,” he says. “The problem is that if the economic slowdown worsens in the next one or two years, footfalls will drop and, along with them, revenues.” Gutka is not even sure if FDI in retail will make everything better. He notes, “If new players come in with the opening up of FDI in retail, there will be aggressive pricing and competition will increase.”

Novonil Guha, Analyst, BRICS Securities, agrees that a breakeven is more likely in FY15. “We think FY15 is when we will see a turnaround,” he says. Till then retail will see a cash outflow of ₹150 crore in FY12, ₹95 crore in FY13, ₹50 crore in FY14 and ₹25 crore in FY15, for funding losses and capex. 

Powered On

CESC’s power business is profit-making and operates under a regulated business model where all its power is sold to its consumers in West Bengal at a tariff that is determined by the West Bengal Electricity Regulatory Commission. In the transmission business, the company starts receiving payment from the state electricity board as soon as the transmission lines are made available and most of the costs are passed on to its consumers. CESC gets an assured Return on Equity (RoE) of 14% after tax on its power generation assets, and RoE of 15% after tax for its transmission and distribution business.

Analysts say there is decent growth in volumes and tariffs. The company is operating in a power deficit environment where demand outstrips supply—though India has a low per capita power consumption, power deficit in the country is high at 13.1% (October 2011), according to Central Electricity Authority data. 

CESC meets around 25% of West Bengal’s requirements. The company has four operational power plants in Kolkata with a total capacity of 1,225 MW and two 600 MW projects under construction—at Haldia in West Bengal and at Chandrapur in Maharashtra. The Haldia project is to be commissioned in FY13; Chandrapur in FY14. The biggest problem that could face both the plants is a shortage of coal. “Coal India has indicated its inability to supply more than 50% of the contracted quantity for new projects,” says Goenka. 

Assuming a coal shortage, Guha of BRICS Securities has lowered the plant load factor assumption for Chandrapur from 92% to 65%. “This assumption is conservative because the company should be able to compensate part of the fuel shortage with supplies from Australia-based Resource Generation (CESC has a 14.8% stake) which is expected to start production in 2013,” says Guha.  

The Real Risk

While Spencer’s losses are a burden on the holding company’s balance sheet, analysts say the correction in CESC’s stock price is overdone. Given CESC’s low-risk power business, the stock could give good returns from its current levels - it’s trading at an estimated FY12 price-to-book ratio of 0.7 times. Guha says, “CESC is available at a discount to its peers and given that losses in the retail business are declining, we think the stock is attractively valued.” Most brokerages have a ‘buy’ rating on the stock (see: Keeping the faith). 

Nonetheless, while it’s true that Spencer’s has cut its losses, the future of the retail business still looks shaky, especially in the event of an economic slowdown. If a slowdown sets in, instead of turning profitable, the retail business could be worse off, as it was seen in FY09, when Spencer’s losses climbed as high as a staggering ₹37 crore per month. The bottom line: until the retail business turns around, the risk that CESC’s stock price could see a further correction will continue to exist. 

It’s a risk investors must consider before buying the stock.