Energy sector’s meteoric rise raises valuation concerns; HSBC Securities predicts post-summer correction

Energy stocks have performed remarkably well in recent sessions on Dalal Street, with many of them achieving new milestones and contributing to a significant increase in their market capitalisation.

The BSE Power Index, a key gauge of the health of energy stocks, has surged 100% in the past year, with 10 of its 13 constituents posting multiple gains.

The rise in energy stocks was primarily due to a power shortage, exacerbated by a weak monsoon that boosted agricultural demand and air conditioning use despite inadequate hydroelectric support. This increased demand pushed up energy prices, sparked discussions about expanding the sector’s production capacity and boosted stock valuations.

The one-sided rally in stock prices began in July 2023 and was triggered by the power shortage from July to October 2023, attributed to the weakest monsoon in 122 years.

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In response to rising electricity consumption, the government has announced plans to add 80 GW of thermal capacity by 2032 and increase annual renewable energy auctions to more than 50 GW, up from about 18 GW in fiscal 2024, further boosting energy stocks.

However, global brokerage firm HSBC Securities predicts stock valuations will fall after the summer due to capacity expansion, effective management, La Nina phenomenon and high base effect.

The brokerage notes that the increase in electricity demand in FY2022 and FY2023 was due to lower COVID-19 base, while the increase in demand in FY2024 was due to severe rainfall shortfall from July to September 2023.

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If monsoons continue as predicted by the IMD and La Nina continues, HSBC predicts much lower deficits and a drastic drop in electricity demand between July and October 2024.

Since September 2023, 4.1 GW of thermal capacity and 14.9 GW of renewable energy (RE) capacity have been added to meet demand. HSBC believes there will be another significant capacity addition of around 10 GW of thermal capacity and 25 GW of RE capacity in fiscal 2025. This is likely to cool the valuation premium attributed to capacity shortages, it said.

Moreover, despite strong demand in fiscal years 2022-2024, the 5- and 6-year average annual growth in electricity demand was 5.1% compared to fiscal years 2019-2024 and 2018-2024, reflecting a much lower contribution from industrial activities to energy demand.

Positive but calibrated

While brokers remain bullish on the long-term potential of the Indian power sector, they advise a more measured view. According to brokers, generating capacity in India will come on stream, but it will be based on the ability of state-owned distribution companies (discoms) to pay. Increased electrification is expected to boost power demand, but the adoption of more efficient power equipment will help manage this growth.

The increased focus on renewable energy (RE) will increase the number of RE plants, reducing demand pressure on distribution companies but also negatively impacting their finances. The brokerage notes that RE installations combined with batteries will accelerate thanks to favorable economics, driven by lower module and battery prices.

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It further notes that the expiration of the Interstate Transmission System (ISTS) waiver, the adoption of battery storage, and the promotion of decentralization programs will democratize transmission and reduce the burden on the ISTS.

Finally, the brokerage believes that India will reform its power sector, but given the involvement of states and a smaller majority in the central government, the reforms will only happen gradually.

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Lower your ratings

The brokerage downgraded a number of stocks, saying investors had overestimated the companies’ growth trajectory.

The brokerage house lowered the rating of Powergrid Corporation from “Hold” to “Reduce” and set the target price at ₹270, down 18% from current levels. Similarly, NTPC has been downgraded from ‘Buy’ to ‘Hold’, with a target price of ₹355, which is a decrease of 2.1%.

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Moreover, the brokerage house has maintained a ‘Reduce’ rating on Tata Power and BHEL shares, setting target prices at ₹300 and ₹72, respectively. This suggests a 31.6% decline for Tata Power and a significant 75.6% decline for BHEL.

Disclaimer: The views and recommendations in this article are those of the individual analysts. They do not reflect the views of Mint. We recommend that investors consult certified experts before making any investment decisions.