NDB Stockbrokers recommends HPFL as Buy

NDB Stockbrokers is recommending the Initial Public Offering (IPO) of Hydro Power Free Lanka Ltd., (HPFL) as a “buy.”Following are excerpts from a brief overview done by NDB Stockbrokers on the HPFL issue, which is now open for subscription whilst its official opening is on 26 October:

Initial Public Offer

The company would be listed on the Main Board of the Colombo Stock Exchange subsequent to the Initial Public Offer. The minimum subscription per application is 2,000 shares, while applications exceeding minimum subscription should be in multiples of 1,000 shares.

The allotment of the shares will be decided by the Board of Directors.

Hydro Power Free Lanka Limited (HPFL) is engaged in sale of electricity to the national grid generated by using mini-hydro power plants.

Industry

Electricity generation in Sri Lanka is based on two main sources: hydro and thermal. Most hydro power plants are Ceylon Electricity Board (CEB) owned while mini-hydro power plants are operated by private power producers (capacity less than 10MW). The power generated by private producers is sold to CEB at a tariff determined by CEB annually. The power generation level of these hydro plants is determined by the annual rainfall and the plant capacity.

Two different tariff values are exercised during dry (from February to April) and wet (January and May to December) seasons. The tariff rates for dry and wet seasons were Rs.11.94 per KWh and Rs.11.09 per KWh respectively in 2010.

The demand for electricity is expected to increase further with the development activities to be done in the post war scenario. Total power demand is expected to be doubled by 2018. Hence the demand for private power producers will be intact despite large scale projects such as Norochcholai and Kerawalapitiya.

Company

HPFL currently has two Mini-Hydro Plants (MHP) namely Sanquhar and Delta. Sanquhar (Sanquahr Tea Estate, Atabage) commenced operations from December 2003 with a capacity of 1.6MW and uses the water flow from the lower section of Galatha Oya.

The second MHP Delta (Delta Tea Estate, Pupuressa) commenced operations from April 2006 with a capacity of 1.6MW and uses the water flow from the upper section of the Atabage river. HPFL earns credits under the Clean Development Mechanism (CDM) scheme for preventing carbon dioxide emissions.

Both MHPs are registered with the CDM scheme and thereby earn Carbon Emission Reduction (CER) credits. The increase in revenue and net profit could be attributed to higher power generation levels obtained during the FY09/10 due to high annual rainfall and efficiency improvements carried out during the year.

Proceeds of IPO

HPFL plans to raise Rs 350 Million from the IPO. These proceeds would be utilized for the construction of two more MHPs as follows:

* Rs. 150 m to invest in construction of Thebuwana MHP (0.83MW). -Kuruwita

* Rs. 150 m to invest in construction of Stellenberg MHP (0.94 MW). - Gampola

HPFL plans to utilise the proceeds of the IPO at the commencement of construction of each project immediately after the IPO. In addition the following projects are at feasibility stage.

* Halgran Oya MHP: Phase1 (3 MW)

* Halgran Oya MHP: Phase 2 (0.6 MW)

Risks

Since hydro power generation is dependent upon rainfall, the availability of the source (rain) is unpredictable. Delaying on payments by the sole purchaser CEB, would also affect the performance of the company adversely. The tariff rates would be influenced by crude oil prices, exchange rate and inflation rate.

Valuation

We estimate an average tariff rate of Rs.11.74 per KWh in FY10/11 and a total power generation of 9,975MWh for Sanquhar and Delta. Further we forecast a gross profit margin of 75% and a net profit margin of 49% in FY10/11. Plant factor of Sanquhar was estimated at 28% in FY10/11 compared with 38% in FY09/10 since the plant was closed during the period of 29 March 2010 to 12 May 2010 due to a lightning strike. Profit margins were also reduced due to the additional cost incurred.

Power factor of Delta was estimated at 43% in FY10/11 compared with 41% in FY09/10. The plant is expected to operate at a capacity of 1.6MW in FY10/11 with the modifications done, compared with 1.2MW in FY09/10.

We estimate an EPS of Rs. 0.59 for FY10/11 (considering total shares subsequent to the IPO) with a forecasted net profit of Rs. 64 m. VPEL and VLL (which are comparable minihydro power generation companies) are trading at trailing P/E s of 22.3X and 23.5X respectively. Hence we consider a trailing P/E of 20.0X for HPFL.

Thus we estimate the intrinsic value at Rs. 12.00. According to earnings estimations for Thebuwana MHP and Stellenberg MHP the EPS would be Rs. 0.89. Hence at Rs. 12.00 the forward P/E is 13.5X. BUY.