IEX India – analysis of a highly profitable monopoly business

This article was originally published in Moneylife Magazine
Link to the IEX India article on Moneylife Magazine
The editors of Moneylife have been kind to also let me host an edited version of the article on my blog.

 

Would you like to own a monopoly platform business which makes 80% operating margins and which will not be disrupted by technological innovation?
Read on to know more about this business and exactly why its current or future competitors will not be able to make a dent in its market share

Which business are we talking about?
IEX India – it is the stock exchange of the electricity sector.
It is a monopoly business which is very profitable with operating margins of 80%+.

Why do we need to have a different exchange just for the electricity sector?

  • Once electricity is bought by the customer, it needs to be transmitted by the generator over long distances to finally reach the end consumer. Unlike stocks, this is a physical process, not a digital one.
  • Thus, even though electricity is electronically bought and sold on the Indian Energy Exchange (IEX), the physical delivery needs an elaborate physical mechanism.
  • Transmission of electricity is facilitated by the Central Transmission Utility (CTU) and allocation is governed by elaborate procedures issued by the National Load Despatch Centre (NLDC). The entire electricity sector is regulated by Central Electricity Regulatory Commission and jurisdiction solely lies with CERC. Indian Energy Exchange (IEX) also facilitates the physical delivery of electricity in coordination with NLDC.
  • Thus, other established exchanges in India like BSE, NSE, MCX, NCDEX etc will find it very cumbersome to get this mechanism implemented. Also, talent required to set-up, scale-up and operate an electricity exchange is completely different from the current businesses of the existing exchanges. Plus, IEX is already a monopoly for the last 11 years with 97% share in the traded volume.

 What competition does IEX India face right now?
The exchange business is a monopolistic business. Once the buyers and sellers come to prefer a particular platform, they tend to stick to it. This phenomenon is observed across markets and geographies.

There are two other power exchanges established in India

  1. Power Exchange of India Ltd (PXIL)
    http://powerexindia.com/
    PXIL is promoted by National Stock Exchange (NSE) – the largest stock exchange in India, NCDEX, Tata Power, PFC, GMR Energy, Gujarat Urja Vikas Nigam Ltd. Etc.
    Inspite of starting operations in 2009, PXIL only has a market share of 3% in the overall electricity traded on power exchanges in India and is a loss-making entity. High pedigree (NSE) and experience in power sector (Tata Power, GMR etc.) of the promoters has not been able to change this for the last 9+ years
  1. National Power Exchange Ltd (NPEX)
    https://pfcindia.com/Home/VS/8
    NPEX is promoted by PFC (Power Finance Corporation), NTPC, NHPC & TCS (largest software company in India). Inspite of stalwarts establishing this exchange in 2009 itself, the company has not even started operations till date. The main reason for this is that the exchange business is a monopolistic business and there is no room for a 2nd/3rd player.

We did spend a lot of screen time to understand that it is extremely unlikely that a competitor will take away business from IEX India. This was important to understand the robustness of the business that IEX India is.

 Threat of disruption?
A scenario where people will not consume electricity seems unimaginable at this moment. All the pleasures of modern technology viz. washing machines, computers, mobile phones, mass manufacturing etc. require electricity.
Irrespective of whatever “app” is created by a future “start-up”, physical delivery of electricity will require transmission lines and hence the business of transacting electricity will have to go through coordination with NLDC and the regulatory process.
We can very well remove any doubt about the possibility of disruption from our minds.

Show me the money – How do the financials shape up?

  2013 2014 2015 2016 2017 2018 2019
Revenues (Rs Cr) 138 174 176 200 232 256 293
Profits (Rs Cr) 66 92 90 100 114 132 165

Sales Growth (5 yrs) = 11%
Profit Growth (5 yrs) = 13%
Average 5-year Return on Equity (ROE) = 46%

What is the catch?
There must be some problem with the company.
Of course, no investment can be perfect and the catch with IEX India is that growth is limited. Electricity demand typically increases at approximately 70% of the GDP growth and thus the Indian electricity demand will increase by about 5% every year assuming an average GDP growth of 7% for the future.
Average growth in electricity consumption in India in the last 11 years is 6%.
Electricity Demand - India

IEX India may not turn out to be a fast-growing company.

 Valuations of IEX India
Stock Price (27.09.2019) = Rs 121
Market Cap = Rs 3,638 Cr
PE Ratio = 23
Trailing Return on Equity (ROE) = 50%

However, the business does not have the ability to grow by re-investing its profits. Growth in sales is largely determined by factors external to the company.
The decision to invest in this company boils down to

“Should we pay a PE ratio of 23 times to a highly profitable monopoly business which may not grow by more than 5% in the long-run?”

Valuations (say PE ratios) are largely determined by two factors

  • Earnings Predictability
  • Earnings Growth

Though earnings quality and predictability are very high for IEX, the earnings growth is mediocre.
A lot of famous and respected fund managers have paid higher to own this business

Shareholding - IEX

Mohnish Pabrai (author of the Dhando Investor), Guy Spier (of “Education of a Value Investor” fame) have bought this stock at higher valuations. In fact, Akash Prakash of Amansa Holdings has also recently bought the stock.

 

However, my take is – you and I invest in stocks to make outsized returns.
Why will we take the risks of investing in stocks to make a 10% CAGR returns?
Investing even in a great business like IEX at a PE ratio of 23 when growth prospects of the company are around 5% will not yield outstanding results.
The return expectation of institutional investors like Pabrai, Guy Spier or Akash Prakash managing foreign funds could be much lower than Indian investors (afterall interest rates in most of the developed world are 0%)

But there are some green shoots which could turn the stock into a screaming buy. Several regulatory measures have been proposed which have the potential of exponentially increasing the volume of electricity traded on the power exchanges.

Potential Upside

  1. Introduction of Real-Time market in India
    These regulations have already been proposed by CERC (Central Electricity Regulatory Commission) and are in advanced stage of implementation
    http://www.cercind.gov.in/Draft_reg.html
    This may result in a spurt in trading volumes on the exchanges (anywhere between 10% to 30%)
  2. Introduction of Electricity Derivatives
    The annual report of IEX India mentions that there might be government decision soon on introduction of electricity futures trading in India.
    Futures extract from Annual Report
    If long-term electricity contracts are introduced on the stock exchanges, the market for bilateral traders will shift to power exchanges (ie IEX). This modification in regulation could lead to a 50% to 70% jump in volumes on the power exchanges within a period of 12 months.
  3. Government has made it compulsory to use the LC (letter of credit) mechanism for purchase of power under long-term contracts. This means DISCOMs will have to pay upfront. Buying through the exchanges would become cheaper and preferable
    This may result in more volumes being traded on the power exchanges in the short-term.
  1. Reduction in trading margin of electricity traders.
    It is proposed to curtail the trading margin of electricity traders to 1 pa/unit from the current 4 to 7 p/unit if the trader does not provide payment guarantee mechanism (letter of credit) to the seller of electricity. If this rule is implemented, there is high probability of volumes shifting to the power exchanges.
    This could result in a 10% to 30% increase in trading volumes in power exchanges.
  1. Budget speech mentioned intention of the government to remove cross subsidy surcharge on open access consumer.
    This reform has been talked about for the last 2 decades and is next to impossible to implement because it will take away all the profitable industrial/commercial consumers away from the DISCOM to the open market (Power Exchanges).
    If this reform is actually introduced (will have to be done by each state). We can rule out this possibility in our calculations of the decision to buy into the stock of IEX India.
  1. Electric vehicle charging infrastructure
    Whenever, electric vehicles become mainstream in India, the need for charging infrastructure will dramatically increase. It will be like petrol pumps for vehicle charging. Most of these charging stations may end up buying electricity from the power exchanges and hence volumes would substantially increase.
    Also, in April 2018, the government has clarified that electric charging infrastructure does not amount to “electricity sale” and thus under the Electricity Act 2003, would not require a license – thus there are no regulatory hurdles to establishing charging infrastructure. However, electric vehicle disruption is still several years (5 or more?) away.
  1. Separation of wire and content business – Electricity Act Amendment 2014
    If the Parliament does pass this proposed legislation, the business of electricity distribution will be thrown open to several players and most of these players will end-up buying significant quantum of their electricity demand on the power exchanges.
    This will be a revolutionary step, but is very difficult to implement. The Amendment bill was first introduced in parliament in 2014. The bill was referred to the Parliamentary standing committee. After making suggested changes, the bill was re-introduced in Parliament in 2018. So, this in sum and substance, this is a very complicated reform and the probability of it getting implemented at all is very bleak

The direction that reforms in the power sector are moving towards will result in a massive surge in the volume of electricity traded on the power exchanges (ie IEX). All odds are in favour of trading volumes increasing on the power exchanges in the long-run.
However, reforms in the power sector happen at their own very slow pace.
The reforms implemented in 2003 resulted in massive changes in the power sector.
The share of private sector in the installed capacity for generation of electricity moved from 11% in Jan-2006 to 46% as of July-2019
Share of Installed Capacity 2006-2019

If reforms in serial no. 2, 4, 5, 7 get implemented, it will trigger a huge surge in the trading volumes on IEX India. Our job as an analyst is to be prepared to take advantage of the opportunities that the markets present us.

I will be a buyer in the stock as soon as any one of the above reforms (2,4,5,7) are announced.

Disclaimer:

Do not consider this article as a recommendation to buy or sell a stock. This article is an illustration of the kind of analysis that goes into fundamental research and equity investing.

Please seek advice from your investment advisor before making any investment decisions. The author (@amey153) is a SEBI registered Investment Advisor.

 

If you want to seek investment advice click here and someone from my team will get in touch with you within 48 hours.

 

Note: I have by purpose tried to keep detailed explanations of the technical intricacies of the electricity sector to the minimum otherwise the jargon becomes too over-whelming for the general reader. You need to just understand just one thing about the business of IEX India – it is the “stock exchange” for the power sector.

 

 

 

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