At CESC, the loss-making retail business is finally coming back to life. Support from its integrated power business which is on a roll will make sure that the show will continue and there is more upside

LONG-TERM investors can consider buying the CESC stock at current levels. Considering the projected operational turnaround in its retail business and support from its strong power business, there could be a potential upside for investors.

BUSINESSES:

CESC, the largest company of the RPG Group, is engaged in the business of power generation, transmission and distribution. It has four operational power plants with a total capacity of 1,225 mw and two projects under construction - Chandrapur and Haldia with 600 MW capacity each - expected to be commissioned in FY13 and FY14. The company's transmission and distribution network covers 16,500 km.

CESC also owns Spencer's, a multi-format retailer with stores across the country. It also has a 100% subsidiary, CESC Properties, which has three acres in a prime location of Kolkata and is now building a premium shopping mall there.

FINANCIALS:

CESC has a very strong cash flow - 870 crore in FY10 from its power business. Profit from the power business in FY10 was 433 crore, but the consolidated net profit was only 156 crore due to losses in the retail business. As a result, the return on net worth is low at 5.4%.

In FY10, net sales of the company were 4,200 crore, of which 3,456 crore was contributed by the power and retail business - Rs 965 crore. The power business has an operating margin of 27%, but the consolidated operating margin is 15% due to operating losses in the retail business.

CESC will incur a combined capital expenditure of 5,000 crore over the next three years. The cost of building the Chandrapur and Haldia plants would be 6,200 crore at a debt-to-equity ratio of 3:1. At the end of March 2010, its debt was 4,862 crore with a debt-equity ratio of 1.2, which is not very high in the power industry.

INVESTMENT RATIONALE:

The lossmaking retail business has shown an operational improvement over the last few quarters. The company is increasing sales and pruning costs by lowering rent-to-sales and employee cost-to-sales ratios, which are very high compared to its peers. The management expects losses to be trimmed to 150 crore in FY11 from 350 crore in FY10 and a turnaround by FY14.

CESC's integrated power business provides a strong support to its retail business. For the generation business, its own coal mines cover half the fuel requirement, which is quite high when compared to its peers. Lower transmission losses and sales to the financially sound West Bengal State Electricity Board makes its operations healthier.

VALUATION:

Since CESC is into multiple businesses, it would be appropriate to adopt the sum of the parts valuation method. We reckon that the CESC stock could be pegged at 400 valuing its power business at Rs 380 per

share and retail business at 20 per share. The price-to-sales ratio for Pantaloon is 0.9. Considering its smaller scale and losses, we believe a lower price-to-sales ratio of 0.3 is reasonable for CESC's retail business. This works out to a value of Rs 20 per share.

Tata Power, which has a similar business model, trades at a price-to-earning multiple (P/E) of 13. We believe CESC's power business should be valued at a smaller P/E of 10, which means 380 per share. At the current market price of 308, the stock is trading at a 24% discount to its fair value.