Stocks of transformer makers are on a roll. Should you invest?

The word ‘transformer’ has three meanings today. There are Transformers, the gigantic transforming robots of the Marvel movies. This article is not about them.The second ‘transformer’ is a deep-learning model that is the basis for artificial intelligence (AI). This article is not about that either.This article is about the transformers used in electricity supply.A transformer is an electrical device that takes a given input voltage and converts it to a different output voltage. This conversion can lead to either an increase or a decrease in voltage.India is facing a huge shortage of transformers, almost how the world is facing a shortage of Nvidia’s GPU chips. Smart investors have taken full advantage of this and gained from investing in transformer manufacturing companies.The stocks of four Indian firms — BHEL, Siemens, Hitachi Energy India and GE T&D India, specialising in transformer manufacturing — have soared, capturing the attention of investors.Hitachi Energy India has been a standout performer, with its shares surging from Covid-era lows of ₹680 to recent highs of ₹14,380, representing a gain of 1,815%. Similarly, the BHEL stock has risen from just ₹20 to ₹335, a 1,715% increase. Siemens has seen a 750% surge, climbing from ₹950 to nearly ₹8,000. GE T&D India has been the most exceptional, delivering a return of more than 3,000%, rising from a mere ₹60 to ₹1,900. medium113625831Why is there a shortage?The escalating demand for high-voltage transformers is primarily driven by the expansion of renewable energy infrastructure and the need for reliable power grids. However, the production of these transformers is constrained by shortages of key components, such as cold-rolled grain-oriented (CRGO) steel and specialised insulation materials.An HVDC, or high voltage direct current transmission system, uses direct current for bulk power transmission over long distances, as opposed to the more common alternating current (AC) transmission systems.In HVDC transmission, the power is transmitted at high voltage directly (not converted to AC) to reduce transmission losses. Most HVDC projects operate at voltages between 100kV and 800kV, though some newer projects are exploring higher voltages up to 1,100-1,200kV. At present, China has the longest HVDC link in operation at 3,300km, transmitting 12,000MW of power at 1,100kV.RK Tyagi, chairman and managing director of Power Grid Corporation of India Ltd (PGCIL), acknowledged the supply challenges during an earnings call in August, highlighting the scarcity of gas-insulated switchgears (GIS), transformers and reactors.N Venu, managing director and chief executive officer of Hitachi Energy India and South Asia, echoed these concerns, pointing out the limited domestic capacity for CRGO steel production. However, he noted that some steel manufacturers are now investing in facilities to address this shortage.As energy transition gathers pace, investments in the power sector, especially in renewables and grid connections, continue to grow. However, state-owned PGCIL, the country’s largest transmission infrastructure developer, is further constrained by a mandate to source transformers domestically from suppliers that ensure at least 60% local value addition.Sagar Chopra, senior research analyst, power and renewables at Wood Machenzie, in an email query to ET Prime, says, “About a quarter of renewable projects may be exposed to delays due to procurement issues. Long lead times and shortages have impacted new project deployment, and also affect critical infrastructure that is ageing.” medium113625852The economics of a transformerThe cost of a transformer is influenced by a complex interplay of factors. Material costs, such as steel, copper and fuel oils, are primarily driven by fluctuations in commodity markets. In contrast, soft costs, including labour, logistics, profit margins and overhead expenses, are shaped by broader economic trends.Satyen Mamtora, managing director of Transformers and Rectifiers India, explains, “When you examine the Ebit margins of tank manufacturers, they are astonishingly high, often exceeding 25%. This is due to a significant shortage of tanks despite overwhelming demand. As a result, everyone is scrambling to secure tanks at any price. A tank that currently costs me ₹110 domestically is priced at ₹160. If I were to export these tanks, factoring in a 20% transportation cost to America, the price would surpass ₹350 per kilo. This presents a substantial profit opportunity.”To capitalise on this market demand, the company is planning to establish the world’s largest tank manufacturing facility for building transformers.On average, soft costs account for approximately 55% of a transformer’s total cost, while material costs constitute the remaining 45%.One significant contributor to the escalating cost of transformers has been the dramatic increase in the price of grain-oriented electrical steel (GOES). Since January 2020, GOES prices have surged by moe than 90% due to a substantial market shortage. The energy crisis that swept across Europe in 2022 further exacerbated this issue, forcing key manufacturers like ThyssenKrupp and Arnold Magnetic Technology to reduce production.Despite the prices for underlying materials easing in recent times, transformer prices have continued to escalate, with distribution and substation transformers increasing by 14% and 25%, respectively, in 2023 as suppliers pad margins due to demand outpacing supply.Are the stocks still worth a buy?The push towards renewable energy sources, including wind and solar power, is expected to further increase demand for GOES with more transformers required to transfer the energy from production sites.The government has significantly increased its investment in renewable energy, allocating a substantial ₹19,100 crore to the ministry of new and renewable energy in the 2024 Union Budget. This marks a substantial increase from the revised estimate of ₹7,080 crore. medium113625876In addition to government initiatives, private companies are also making significant investments in energy infrastructure. Gujarat Energy Transmission Corporation, for instance, has announced plans to invest nearly ₹1 lakh crore in the development of transmission infrastructure within the state over the next seven years. This trend mirrors the growth of inter-state transmission networks in the past, as more and more state transmission utilities recognise the importance of investing in robust grids.Venu of Hitachi Energy highlighted the strong demand for transformers, “We concluded the quarter with a record order backlog of ₹8,539.4 crore, the highest in our company’s history. Notable orders include a substantial HVDC project from Marinus Link in Australia. Our strategic decision to establish a new greenfield factory in Chennai has proven to be timely, as we are witnessing a surge in demand not only domestically but also in other regions,” he says.Beyond the surge in demand for new energy infrastructure, the global stock of power transformers is rapidly ageing. Many utilities are actively replacing equipment installed decades ago, particularly in regions like the US where a significant portion of transformers were manufactured during the 1950s to 1970s.While these transformers can last for decades, many are now nearing or surpassing their design life (35- to 40-year design life, but life can be extended to 70+ years if operated carefully), necessitating replacements.Around ₹44,000 crore of transmission projects are getting delayed by PGCIL, with 18 projects getting delayed by 32 months and eight projects are getting delayed by 12 months or so.Mamtora of Transformers and Rectifiers India highlighted the logistical challenges associated with the transportation of these massive transformers. Each transformer weighs between 425 and 450 tonnes, requiring specialised transportation routes that can accommodate such heavy loads. Existing infrastructure, such as bridges, may need to be reinforced or alternative routes may need to be developed to ensure safe and efficient transportation.Despite these challenges, Mamtora expressed confidence that the delayed projects would be completed by 2027. “I don’t think there will be a slowdown,” he adds.Compounding this challenge, the global pandemic disrupted supply chains, leading to extended lead times for transformers. The highly customised nature of transformers, often built to specific customer specifications, further complicates production. This customisation not only adds time to the manufacturing process but also limits the number of manufacturers capable of producing certain types of transformers, restricting supply.