Sharekhan Investor's Eye

Sharekhan Investor's Eye
Sharekhan Special
[July 08, 2008] Sharekhan
www.sharekhan.com

Summary of Contents
SHAREKHAN SPECIAL

Q1FY2009 Capital Goods earnings preview

a.. The underperformance of the capital goods sector with respect to the broader market continued in Q1FY2009. The sector underperformed because of increasing concerns over the execution capability, the pressure on the margins and the relative slowdown in the order inflow of the capital goods companies against the backdrop of a tightening monetary policy.
b.. The key challenge facing the capital goods companies is to execute the existing orders on time. The main bottleneck remains the shortage of critical components due to the inadequate manufacturing capacity of the vendors. For instance, Bharat Heavy Electricals Ltd (BHEL) had faced a shortage of components like casting and forging in the last quarter of the previous fiscal. This had led to a mere 4% growth in its revenues in that quarter. Not only that, the capital goods sector is also witnessing an acute shortage of skilled manpower.
c.. An unprecedented rise in the prices of the key inputs like copper and steel has taken many industry watchers by surprise. Not all the capital goods companies under our coverage have all their orders covered by price variation clauses. Consequently, the operating profit margin of these companies is expected to face pressure on account of the increasing prices of their key inputs. Especially since these companies are unlikely to pass on the price increase completely to their customers.
d.. So far the order inflow has remained strong in the sector. However, in future the hardening interest rates may slow down the order inflow for the capital goods companies, especially those that derive the majority of their revenues from the corporate capital expenditure exercises. But on the brighter side, we would like to highlight here that except a few, the companies under our coverage are sitting on huge order backlogs that impart visibility to their future earnings.
e.. We believe that the concerns relating to the sector may have been overdone and maintain our optimistic outlook on the sector for mainly two reasons. One, the majority of the companies in this sector are sitting on order books that are at record levels and hence impart strong visibility to their earnings. Two, the capital goods companies are making increasing efforts to shift from fixed cost contracts to variable price contracts. They have already started booking new orders with a price variation clause which should protect their margins going forward.
f.. For the quarter ended June 30, 2008, we expect Sharekhan's capital goods universe to report a top line growth of 23.4% and a bottom line growth of 22.3%. Our preferred buys in the sector are Larsen & Toubro, BHEL, Crompton Greaves and Sanghvi Movers.