The capital goods sector is one of the strongest components of the Indian growth story and has traditionally led in a recovery in the economy.
Major Companies we like here are BHEL, L&T, Suzlon, ABB & Siemens.
The sector's fortunes are directly related to the activity that takes place in its end-user industries—power, telecommunication, construction and turnkey projects. Considering the increased activity that has taken place and is slated to take place in these sectors over the next few years, capital goods is on a long-term uptrend.
Stocks from this sector had caught investor fancy during the last three years. The sector became overweight in most portfolios and was trading well beyond its fair valuation in 2007. The last three quarters have seen prices correct significantly, by as much as 40-70 per cent, from their peaks. While the BSE Sensex has shed 28 per cent of its value till date, from its highest close of 20,873 on 8 January 2008, the BSE Capital Goods Index shed over 38 per cent during this
period from its highest close of 20,214.92. Inflation and resultant increase in interest rates coupled with higher input prices have impacted the sector's performance. To discuss this sector's future, Outlook Money brings in expert analysis.
MARKET FRONTRUNNER
SANDIP SABHARWAL EXECUTIVE DIRECTOR AND CIO (EQUITY), JM FINANCIAL AMC
Current outlook. Over the next few quarters the outlook is extremely positive and we expect the sector to outperform the broader markets. With commodity prices cooling off, the input cost pressures are likely to reduce. Companies are sitting on strong order book positions. The past few months saw concerns due to rising prices of inputs like steel, copper and cement, but given the growth outlook of the West as well as of Japan, commodity prices have started falling and are likely to remain soft over the next two years. Reducing inflationary pressures will also ultimately lead to lower interest rates over the next few quarters. This will lead to a further uptrend in capital formation and help in order book growth. This will allow them to sustain their growth rates over the medium term.
Key challenges. The current controversies on land acquisition as well as increasing litigation from companies that do not win government sponsored projects are key execution challenges on the domestic front. The other major risk is from high interest rates; a prolonged high interest regime can impact capital formation negatively. Emerging opportunities. Increased focus on domestic infrastructure and overseas opportunities in the Middle East and Africa are some emerging
opportunities. Funds of mineral-rich states in Africa and the petro- dollars from oil-rich Gulf nations are being used for infrastructure development in these countries. This offers a significant opportunity to Indian EPC (engineering, procurement and construction) companies.
RIGHT ORDERS
DEEPAK JASANI HEAD (RETAIL RESEARCH), HDFC SECURITIES
Performance. Despite concerns, first quarter results for these
companies reflect an expected revenue growth on the back of order
backlog and a pick up in execution. Margin erosion was limited due to
material cost management initiatives and gradual shift towards price
escalation clauses. There is continued order inflow. A positive
trigger is the Rs 28 lakh crore capex being implemented, as of March
2008, led by sectors such as metals, cement, power and construction.
Order backlogs in most companies is two-and-a-half to six times FY08
revenues, giving visibility on future revenue. The waiver from the
Nuclear Suppliers Group (NSG) could, in the long term, improve
visibility for power equipment suppliers.
Concerns. The sector grew by 5.6 per cent in June, up from 3.4 per
cent in May 2008. But it has grown just 5.6 per cent in the first
quarter of FY09, against over 15 per cent in the last three years.
Execution concerns in power generation could delay capacities, which
could affect power transmission and distribution. Higher interest
rates have impacted corporate capex with less critical projects likely
to be shelved. Rising fiscal deficit and impending general elections
could impact government's capex.
Valuation. The sector beat the Sensex in each of the upward movements
in the last three years, though the level has shrunk as of early
September 2008. Currently, stocks look fairly valued, especially in a
market where risk aversion and volatility could lead to shifts to low
beta portfolios (low-volatility portfolios). An announcement of
general elections could result in expectations of improved visibility
and a re-rating of the sector.
COST CONCERNS
B. BHATTACHARYA ASSOCIATE DIRECTOR, BUSI-NESS PERFORMANCE SERV., KPMG
ADVISORY SERVICES
Outlook. Besides strong current order books, some structural factors
are likely to aid the sector's continued growth. First, for companies
serving the power and construction infrastructure sectors, planned
growth in end-use sector investments has continued so far despite
delays in project closures due to rise in interest rates and a
slowdown in real estate activity. A key question for these companies
would be future levels of interest rates, and the consequences on
project viability of their customers.
Second, growth in machinery sector depends on new orders from core and
manufacturing sectors. Several of these sectors are on a sustained
capacity expansion due to high present capacity utilisation, demand
potential and high prices of several output products.
Third, many companies are emerging as players in the global market
(particularly in Middle East and emerging markets) with competitive
labour rates, reasonably strong engineering skills and quality, and
increasing acceptance of outsourced Indian design and R&D capability.
Concerns. On the margins front, concerns around cost inflation do
remain, though leading companies seem to have handled these reason-
ably over the past few quarters. Measures adopted include passing on
raw material cost hike to customers through contract clauses, managing
inven-tory and improving labour productivity. However, increasing
competition from Western and Asian MNCs investing in India, and lack
of world-class technology and R&D capability of some Indian
incumbents, is concerning.
THE OLM TAKE
Higher interest rate, which could lead to a slowdown in fresh orders,
is a concern, but revenue visibility from order backlogs offers
potential over the next few quarters. During the first quarter of the
fiscal, companies in the capital goods sector were able to maintain
their margins due to price escalation clauses and better utilisation
of resources. Lowering commodity prices could ease pressure on
margins. Higher interest rates could mean a slowdown, but long-term
plans remain intact on the back of expectations from the end-users.
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