This is the second part of the Market Leader Series, in which I discuss companies that lead their respective sectors. The first part, discussing Polycab, can be accessed here.
In this article, we discuss IEX, a company with stellar financials — ROCE >25%, 5-year FCF CAGR at 45%, nil debt, and very strong profit margins. IEX also enjoys monopoly in its sector. There are, however, risks. Pls do study them closely.
What is IEX?
Indian Energy Exchange is the first and the largest energy exchange in India. It allows for trading of electricity (for physical delivery), just as NSE or BSE allow for trading in stocks.
To understand the dynamics of IEX, however, it may help to understand some basics of the electricity market.
The electricity trade cycle
As you may know, here’s how the electricity trade cycle operates:
The electricity generation companies (popularly called gencos for generation companies), which include the likes of NTPC Ltd, Tata Power Company, Adani Power, JSW Energy, Adani Green Energy, Torrent Power, and so forth, sell electricity to electricity distribution companies (popularly called discoms), which are more regional in nature.
These distribution companies then distribute electricity to you and me.
Examples of distribution companies include Madhya Gujarat Vij Company Ltd (MGVCL), Assam Power Distribution Company Ltd., Maharashtra State Electricity Distribution Company Ltd., and so forth.
In between gencos and discoms, there’s what we call “transmission” of electricity from power generation companies to distribution companies through a transmission network
Electricity Market in India
In India electricity has traditionally been traded in two markets. One, long term markets which allow for trading of electricity for periods extending to as much as 25 years. Two, short term markets for a period extending to an average of 1 year.
(1) Long term market:
A bulk of electricity, as much as 89% of India’s capacity, is currently traded in the long-term market through what we call “power purchase agreements” or PPAs.
These PPAs are commercial agreements between the generator of electricity, say NTPC, and the distributor of electricity, say MGVCL for long term purchase of electricity. What’s more, these agreements set a “fixed price” for purchase and sale of electricity.
Why would both parties sign long term agreements, and that too at fixed prices, you may wonder!
In simple terms, it’s because setting up a power generation plant is very expensive and requires huge capital whereas the revenue generation timeline (or what we call the gestation period) is very long.
Before investing in setting up a power plant, the investors may want to ensure that it is financially viable to set up a plant. Long term agreements locking in a fixed price for electricity ensures that the costs of investment are recovered.
Besides, the buyers of electricity or discoms also know in advance what price they must pay to buy electricity over the course of the agreement.
But these long term PPAs had their challenges, which precipitated trading in the short-term market.
These challenges included, for instance, the fact that hourly consumption over the long term without forecasting errors was difficult to predict, leading to shortages of power in one region while surplus power was available in another region.
Many power plants also saw their generation costs rise over the years, so much so that the electricity price discovered on IEX was cheaper than their breakeven prices.
(2) Short term market
Only 11% of India’s electricity capacity is traded in the short-term market, primarily because a bulk of trade is locked into long-term PPAs.
Short term market primarily comprises three types of trades.
One, those done on exchanges such as IEX and Power Exchange of India (PXIL). Almost 6 % of India’s electricity is traded on these exchanges
Two, those executed through bilateral deals – which are similar to over-the-counter trading (outside of exchanges) of stocks between two parties. Only 3% is traded through these deals.
And three, DSM or deviation settlement mechanism (not much relevant to our discussion for now) which comprises a meagre 2% of electricity trade.
Enter IEX, a virtual monopoly in energy exchange
So as you may notice, IEX operates in the short-term electricity market which as a whole comprises about 11% of India’s traded capacity as of March 2021.
What particularly stands out is that, within this short-term market, as much as half (or 6%) is traded on exchanges. Compare this to developed countries, where about 30-80% of electricity is traded on exchanges.
This, in my view, poses a massive potential for India’s exchanges in future as the per capita (meaning per person) demand for electricity grows with broader economic growth.
India’s electricity statistics and how IEX may be uniquely placed to benefit:
Talking of India’s per capita electricity consumption, let’s discuss some relevant statistics:
Higher expected per capita consumption of electricity
As of last year, India’s per capita consumption of electricity was 1181 units. By 2025, this is expected to reach 1616 units, an increase of about 37%. This is faster than the previous two decades during which the per capita consumption of electricity had only doubled.
This potential increase in electricity consumption will have a direct, positive impact on the trading volumes in exchanges, primarily IEX.
Note that IEX is a virtual monopoly in energy exchanges with almost 92% market share. The second exchange is Power Exchange of India or PXIL which commands the remaining share.
Besides the growth in per capita consumption, another factor that has worked in favour of IEX is the low prices discovered on its platform.
Higher electricity generation (supply) but lower demand equals low electricity prices: A key positive for IEX
Remember, since IEX is a marketplace the electricity market prices are “discovered” through the interaction of buyers and sellers in the market and the fundamental laws of demand and supply. In other words, if demand is higher than supply, then the prices increase. Conversely, if the supply is higher than demand, then the price reduces.
The low price of electricity on IEX platform is a result of high supply compared to demand.
Consider this: India’s total installed power capacity currently stands at about 370 GW while peak demand (or the highest demand at a particular time) stood at 184 GW.
Furthermore, in 2020 India generated 1383 billion units of electricity while it consumed 1271 billion units. This is to say that India produces more electricity than it consumes – it suffers from a surplus.
This keeps “discovered” prices in the exchange as low at Rs 2.64 per unit (on a weighted average basis). Compare this to the weighted average prices on the bilateral deals, which are higher at Rs 3.67 in FY21.
To know the difference between KW and billion units, study this link.
The low prices help discoms, who have been reeling under financial woes for a long time, to procure their short-term power requirements from the exchange and save costs.
Short-term market, where IEX is present, is especially favorable to discoms or state electricity distribution utilities that have to manage the seasonal variation in demand for electricity.
What do we mean by seasonal variation in demand?
Consider states such as, for instance, Himachal Pradesh or Jammu and Kashmir, or Uttarakhand which have access to hydroelectric power and therefore tend to run power surplus during summer. They can sell this surplus power to states such as Punjab or Haryana which normally run power deficit in summer.
The conventional fixed-rate, long term power purchase agreements in these cases become expensive for discoms as they have to pay “fixed rates” to gencos even though the demand for electricity during a particular season may be low.
Exchanges such as IEX help these buyers and sellers plug their seasonal variation in power requirements through trading on their platform.
Market segments allowed on IEX platform
IEX platform allows trading in six major segments.
The DAM or day ahead market allows for trading electricity – in 15-minute time blocks – that would be delivered the next day.
This means, for instance, that if today is 25th May 2021, then MGCVL, which is a discom, can buy electricity from Tata Power, which is a genco. But this electricity trade is for 15 minutes on the next day, say, from 12 pm to 12:15 pm. Of course, MGVCL can purchase electricity even for one hour, but in 15-minute blocks.
Similarly, IEX also provides trading in the term-ahead market or TAM which allows for delivery for up to 11 days.
Then there’s also the Real-Time Market or RTM which allows for electricity to be delivered within 1 hour of purchase.
Besides trading in the thermal energy, IEX also allows trading in the Green Term Ahead Market, Renewable Energy Certificates, and Energy Saving Certificates. If you wish to read what each of these mean you may wish to explore this link:
Even though IEX operates in the power sector, it is primarily an information technology (IT) services company.
To understand this, take a look at IEX’s income statement line items as a % of revenues below:
As you may notice, the company’s business model is such that it only has about two major costs, out of which employee benefits expense is the most significant.
This is obvious considering the fact that for an online exchange, the efficiency and security of their IT systems is central to success.
To operate and maintain the electronic trading platform, including servers, IEX must spend heavily to hire and retain talent including computer engineers, data analysts, website designers and more – much like any other IT services company.
In that sense, IEX is very much an IT company and therefore commands a valuation similar to other IT companies.
As you may notice, the employee benefit expense during FY21 was about 12% of its revenues. This is likely to be a result of annual increments, hiring of additional manpower to meet business requirements for strengthening of IT team, creating talent pool, product development, and so forth.
The second major expense for IEX is “other expense”. What would this include? Take a look at this table from FY20 annual report:
As you may notice, the most significant of these are related to technology upgradation and maintenance (again, this reaffirms IEX’s position as an IT company), rent, business promotion, legal and professional fees, travelling, and CSR.
IEX has been a major beneficiary of “operating leverage”.
What is operating leverage? As I discuss in the case study of Intellect Design here, most companies face two costs. One is “variable costs” which increase in proportion to sales. Higher the sales, higher the variable costs – think of raw material expenses, for instance.
The other is “fixed costs”. These are costs that reduce (on a per unit basis) when the sales increase. For instance, say, salaries expense. This is cost that the company must ideally pay irrespective of good times or bad, isn’t it?
But during good times when the sales are high, the company essentially earns higher margins because the salaries do not increase proportionally – it is fixed (at least in the medium term).
This benefit of higher margins owing to greater sales but fixed costs remaining same is called the benefit of “operating leverage”.
Since the only major cost for IEX is salaries, any increase in revenue directly flows to net profit margin. As seen below, the net profit margin for IEX in FY2021 was a stupendous 54%.
This is because salaries – though high – do not increase in proportion to the growth in revenues. Even the spending on technology upgradation is not proportional.
The resultant high net margins also mean extraordinary return on capital employed, as you may notice below.
Robust free cash flow generation
IEX is also generating stellar cash flows every year. In fact its compounded annual growth in free cash flows (this is operating cash flows minus capital expenditures) over previous five years has been as high as 49%. See below
And finally, this growth is on back of zero long term debt
What’s more, since IEX’s capital intensity is low – meaning it does not need to invest heavily in fixed assets every year – it distributes free cash flows to shareholders. See below:
In FY21 for instance, it paid Rs 74 crore worth of dividends against spending only about Rs 20 crore on purchasing fixed assets. In FY20, it also bought back shares worth Rs 69 crores, besides paying out dividends worth Rs 74 crore.
The question is, will the extraordinary growth in free cash flows continue?
I believe yes, at least for the next five years – this may be a direct result of zero debt and continuation of operating leverage benefits discussed earlier.
In the post-COVID era, India’s economic recovery may heavily boost the demand for electricity and therefore also trading volumes on IEX. The government’s push for 100% electrification through the Saubhagya Scheme, Smart Metering, Integrated Power Development Scheme (IPDS), Deendayal Upadhyay Gram Jyoti Yojana, and more is only going to boost this demand.
Three Major Risks for IEX
1. India’s economic growth — Since IEX derives a significant majority of its revenue from transaction fees and annual subscription fees, the success of its business depends on the ability to maintain and increase the number of participants and volume of electricity contracts traded on its exchange, any blow to India’s economic growth potential – and therefore the demand and supply for electricity – could damage IEX’s revenues going forward.
2. IT system limitation or failures – IEX depends on the performance and continuing availability of technology and software that underpins its electronic trading platform. It relies on both third-party and in-house tech specialists, including computer engineers, systems, and quality analysts, database admins and website designers to maintain their online platform.
Heavy trading on their online platform during peak trading times or times of unusual market volatility may cause their systems to operate slowly or even fail for certain periods.
To understand why this could be a real threat, remember how NSE systems outage recently (23rd March 2021) led to turmoil on the Street: https://www.livemint.com/market/stock-market-news/glitch-disrupts-nse-trading-for-4-hours-in-longest-such-outage-11614213355286.html
3. Highly regulated industry – IEX operates in a highly regulated industry and may be subject to fines and enforcement proceedings if they fail to comply with regulatory obligations. There is also a risk of regulations aimed at reducing their fees or margins on transactions in future. If this happens, it may significantly threaten IEX’s revenue.
Where will future growth come from?
1. As mentioned, IEX’s future growth is likely to come from higher trading volumes as a result of economic recovery post-COVID.
2. It’s also likely to come from expansion in new markets (cross border electricity trade), particularly in neighboring countries such as Bhutan, Bangladesh, Nepal, and Sri Lanka.
3. Besides, IEX signed a licensing deal with MCX to launch electricity derivatives on the latter.
4. These, and new segment such as the Green Term Ahead Market (which allows for trading in renewable energy, deliverable for up to 11 days) could bring in more participants to the platform thereby strengthening liquidity and therefore alsos network effects.
5. Another factor that could potentially increase trading volumes on IEX is the Centre’s directions that enable discoms to exit long term power purchase agreements with old central utilities-run stations once their 25 year contracts expire.
As per ET, this could free up about 20 gigawatt of power to be traded freely. A significant portion of this could move to the short term market, especially exchanges.
6. Obviously, IEX may also benefit from good volumes on Indian Gas Exchange (IGX) in future, which is an arm of the former. The use of natural gas is likely to rise over medium term in the country. The government has committed to reduce carbon emissions under the Paris Climate Agreement. Under this, the government plans to increase the share of natural gas in the total energy basket from current 6% to 15% by 2030.
A Look at IEX’s chart
As you may notice below, the stock has been moving within a channel. For those who are new to this, a channel is the area between two lines, with the upper line acting as resistance and the bottom line acting as support.
The stock opened gap down a couple of days ago on news that Dalmia Power sold about 4.5% stake in IEX (likely for its own funding needs). But as you may notice, the channel support stayed strong and the stock seems to be bouncing off of it.
Unless we see some semblance of recovery in the economy (from the second wave), the stock’s upside movement may likely be gradual from here.
IEX chart @hvinvesting.com
Please note that none of my posts, either on hvinvesting.com or anywhere on social media, should be construed as a financial advice or investment recommendation. Kindly conduct your own due diligence or consult a SEBI registered investment advisor.