India-based Power Grid's management succession deemed risky: Nomura

But there's a silver lining.

Over the past 3-4 years, India-based Power Grid’s (PWGR’s) cohesive senior management, led by its Chairman & MD (Mr Nayak), has instilled the DNA of unrelenting ‘execution focus’ in the organisation, which is reflected in the robust growth of the company’s earnings and asset base.

According to a research note from Nomura, as the Government of India (GOI) identifies and appoints a successor to Mr Nayak, who superannuates in September 2015, Nomura believes that continuity of execution focus under the new leadership will be critical to gauge PWGR’s ability to stay steadfast on the growth path with the same vigour in the longer term.

Although management succession is admittedly more of a risk as opposed to a catalyst in the case of PWGR, Nomura believes the core management team appears well entrenched to continue to deliver growth in the medium-term and PWGR’s competitive strength in the transmission space will be sustainable.

As transmission capacity startup peaks in FY16 and capex-commissioning remain in tandem (as was the status up to mid-February in the current financial year) at least in the medium term, the outlook for core earnings growth and cash flows continues to appear healthy.

Accordingly, Nomura continues to view PWGR as a robust defensive growth story and a ‘hedged play’ on prospects of improving fuel security, electricity demand and regulatory/policy regime for power utilities in India.

Here's more from Nomura:

We revisit our earnings forecasts for PWGR to factor in 9MFY15 financials + takeaways from the February investors meet and our subsequent interactions with management. While transmission capacity startup up to mid-February and management commentary on the outlook was more bullish than our forecast, our calculations suggest that the effective return on regulated equity (RoRE) for 9MFY15 was a bit below par (management has reiterated no under-recovery of fixed costs in the current tariff regime, but we hope to get further clarity on the same).

Capturing the same, we raise our transmission capacity startup forecasts for FY15F/16F/17F by 12%/20%/9% to INR215bn/INR243bn/INR220bn and FY15F-17F core transmission capex (cash outgo) by ~5%. We continue to build in zero returns on the ~INR20bn equity investment (which we build into our earnings model for FY15F-18F) in transmission JVs with state governments and SPVs housing bid tariff-based transmission projects and as timelines/earnings profiles are still sketchy.

Furthermore, while the outlook for its consultancy business seems sanguine, the uptick in contribution for 9MFY15 has been below our forecast; accordingly, we lower EBIT contribution from the non-core business by 36%/31% in FY15F/16F. Overall, our FY15F/16F EPS forecast for PWGR gets tweaked by -2%/+2% and FY15F-17F EBITDA/EPS CAGR remains robust at 18%/19%; we expect reported RoE to rise from 14% in FY15 to 16% in FY17.

Our revised TP of INR174 – sum of fair value of operating assets using a Residual Income model (INR167) and FY16F book value of investments in JVs/subsidiaries and unrestricted financial assets (INR7) – implies 18% potential upside (excluding 2% dividend yield) from current levels.

Our valuation methodology is unchanged; the 16% rise in our TP emanates from our higher core earnings forecast in the medium-term, roll forward to FY17 (first year of discounting) and a 30bp reduction in cost of equity (drop in risk-free rate from 8.5% to 7.7%, partially offset by a marginally higher beta).