What you will learn
-Why debt is becoming a hindrance to OPG Power
-True cash flow is LOWER than reported.
-For OPG to realize shareholders value it must recapitalize their capital structure towards equity.
OPG Power operates and develops power generation assets in India and currently has 750 MW in operation principally under the group captive model.
When it was listed in the AIM Market (Junior market in the UK) back in May 2008, it had 20 MW of generating capacity.
Most of the 750 MW power generation relates to the coal-fired thermal plant, but there is a renewable division with 62 MW being commissioned.
Over the next three years, OPG will increase solar capacity to 300MW.
STRATEGY and OBJECTIVES
OPG has short to medium-term objectives and like of focus on the following: –
1). Maximising the performance of our existing assets; – after long-period of expansion, it’s time to consolidate and enhance their assets by focusing on stable cash flow generation*.
2). Looking for ways to reduce the cost of capital; High-interest costs of £37.7m on total borrowings of £326m. With operating profit of £54m, it sucked profits that would have gone to reducing debt*.
3). Be responsible towards key stakeholders.
* italics are my thoughts and reasoning behind their objectives.
INDIA: Potential Energy Needs
India has one of the lowest energy consumption countries per capita. In 2014-15, India saw each person consumed 1,010 Kilowatt-hour vs. China’s 4,000 Kwh. Developed nations average around 15,000 Kwh.
OPG POWER’s Interim
There is money to be made in India’s energy infrastructure. But, who is profiting from this boom depends upon the make-up of their capital structure.
For OPG, it is clearly a debt-driven and the debtholders received a high percentage of interest each year (more than 10% of total debt outstanding).
Meanwhile, the equity holders are struck was a market equity valuation of £60m, despite the balance sheet having over £200m in net assets.
As for the interims, OPG saw operating profit fell to £16m, down from £36m last year, due to lower power generation to 717MW from 750MW and higher coal import prices.
According to the Australian Thermal coal, prices rose from $50 per ton to $100 in 18 months, a five-year high.
It helps to raise costs of sales to £86m from £69m. Interim’s gross margin fell to 24% vs. last year’s 38%.
OPG’s operating margin fell to 12% vs. last year’s 34%, and the company made a net loss of £7.2m.
Six reasons why the market low balling OPG Valuation?
First, rising net borrowing to fund its energy capacity appears unsustainable. That has risen from net cash of £11m to net debt of £310.6m, a rate faster than sales.
Second, rising net interest costs have skyrocketed to £37.2m from £15m. That is an equivalent of 17% to turnover and affected pre-tax profit as this fall from £28.6m to £17.5m. The adverse effect is mitigated when it received a tax credit of £5.6m.
Third, the nature of their business. Being in the power generation business means you have to produce to get paid. For OPG, it has to wait 140 days for credit sales to turn into cash.
Worse, the company has I.D. receivables of £43.7m due for over 180 days.
This put a lot of constraints on working capital.
Fourth, Cash Flow. Normally, I would look at operating cash flow and be satisfied with the numbers.
With a mountains load of debt and tons of interest to pay, it needs to include interest paid in operating section, not financing section.
When you see finance costs of £19.9m gets added back to the operating section, then interest paid must get deduct on the operating section to reflect accurate net cash flow.
Otherwise, it gets overstated.
Instead of £24m, we deduct interest paid of £15.4m to get £8.6m, this is lower than last year £20.4m.
On an annual basis, net cash flow showed £56.1m excludes £38.8m of interest paid. Therefore, the real net cash flow is £17.3m.
With £12m required to maintain capacity each year, it is hard to see OPG can ever reduce debt without the help of recapitalizing their business with equity fundraising.
Fifth, Investors are worried about more borrowing. For the company to achieve 300MW by 2020, it needs to invest heavily and this requires a lot of borrowing.
Estimating how much it would cost is hard because of the completion of the projects.
However. they did make a £45m investment in their 62MW solar project and promised it would be ready by 2017, that being pushed back to 2018 and would no doubt result in extra costs.
Extrapolating the above calculations, I would say OPG needs a minimum of £172m of investment to bring 238MW of solar capacity to operation by 2020.
It needs to generate £57m in net cash flow per year (and after interest paid) to finance without resorting to extra borrowing.
Six, being an Indian or Asian company. First, investors need to accept that transparency and truth of these numbers could be questionable.
Also, the bad memories of Chinese companies with ridiculously low valuation, along with buckets load of cash added to this stigma of false reporting.
Looking at OPG’s accounts, I say it is quite transparent.
A Unique Investing Opportunity
The market is valuing this business close to four times PER, but for good reasons.
If you look at it in terms of enterprise value, then the EV/EBIT multiple is close to 15-20 times.
Poor half-year profitability will push EBIT LOWER for 2018.
Final Thoughts: OPG Ventures
This Indian company isn’t in a unique position to reduce £30m to £40m of debt each year.
And that’s why the share price is down another 21% today to 18 pence per share.
I can’t see OPG reducing debt if capex of around £12m is needed to maintain existing assets, it needs to high-interest costs and high imports of coal.
It took out a lot of interesting features that makes OPG a viable investment opportunity for shareholders.
With a market capitalization of £60m and Enterprise Value of £360m, I see the share price falling further.
Re-capitalizing debt for Equity
An alternative is to swap debt for equity (aka re-capitalization), so investors would have clout in the business.
Here’s lies the problem:
Given the market equity is £60m vs. total borrowing of £300m. A stark contrast of differences.
Let’s say OPG wants to reduce debt reduction by 50% or £150m. It would require an issuance of 900m new shares at current share price.
The enlarged share capital of 1,255m shares gives it a market capitalization of £225.9m.
N.B.: For a company like OPG it needs a big discount to current share price to attract big investors. Therefore, the enlarged share capital would be even greater and the share price more diluted.
Assuming OPG manages to make £30m operating profit, it still needs to finance £19m of interest costs and pay tax.
Net profit would be no more than £9m or 24 times PER.
Unless costs of coal imports fall, OPG will struggle to make a profit.
The recommendation is to avoid the shares until it recapitalizes their debt. Otherwise, you would be paying a high price for nothing.
This share price has collapsed from over £1 to 18 pence, I expect it to hit below 10 pence for the next 12 months.
CALL TO ACTION
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The above analysis is based on my opinion and nobody else. It does not constitute professional investment advice. Data is correct on at the time of availability. I don’t hold the company’s shares unless stated.