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Capital Opportunities

Despite headwinds, strong growth in the power sector augurs well for capital goods manufacturers…

The capital goods sector is currently the weak link that is pulling down IIP (index of industrial production) growth. Recent numbers show that capital investment is declining. The capital goods segment of IIP declined 18 per cent y-o-y in January. The markets too reflect the pessimism prevailing within the capital goods industry. The BSE Capital Goods Index is down 4.78 per cent over the last one year while the BSE Sensex is up 7.9 per cent over the same period.

On the upside, the sector has a number of things going in its favour. Humongous capacity expansion planned in the 11th and 12th five-year plans, a huge captive power market, huge balance of plant (BoP) demand, and investments in transmission networks augur well for capital goods companies.

On the flip side, very few new projects have been announced in recent times. Hardening of interest rates over the last two quarters has also negatively affected investment prospects. NTPC’s 11x660 MW boiler tender has got delayed and is now expected only in Q1FY12. Power Grid Corporation, the country’s largest capital goods spender, in the country has so far been slow in tendering new orders.

Notwithstanding the headwinds, the capital goods sector offers immense opportunities to both companies and investors over the long term. Here are some of the key drivers:
Capacity additions in the power sector: In the 11th five-year plan, so far 31 GW of capacity has been added, taking India’s total installed capacity to 169 GW. Delays due to reasons such as difficulties in land acquisition and obtaining environment clearance, inadequate coal linkages, and shortfall in supply of equipment have plagued the sector.
In spite of these speed-breakers, an additional 19 GW is expected to be added in the one year that is left in the 11th five-year plan, taking total additions to 50 GW. Around 90 GW is expected to be added in the 12th five-year plan, taking total capacity to 293 GW by FY17. This huge investment demand is expected to throw up opportunities galore for players in the capital goods segment, especially for power-equipment manufacturers.
Robust captive power market: Power-hungry industries like steel, cement, chemicals have been at the forefront of captive power generation in India. From a miniscule 1.5 GW in 1970-71 this segment had grown to 25 GW capacity by 2007-08. What is expected to keep the captive market strong over the next couple of years is the severe power shortage that these industries face. Their power-deficient situation is unlikely to change anytime soon.
Huge BoP demand: BoP constitutes a considerable 44 per cent of the total cost of building a power plant. Going by the generation capacity that is to be added in the 12th five-year plan, the BoP space could see an annual demand of Rs20,000-30,000 crore over the next couple of years. BoP players like BGR Energy, L&T, BHEL, Tecpro Systems and McNally Bharat stand to gain from this opportunity.
Network improvements in power sector: Not only is India’s transmission and distribution (T&D) network inadequate, the obsolete technology deployed therein causes huge T&D losses to power companies. In a bid to bring down these losses, the 11th five-year plan envisages an expenditure of Rs1,39,500 crore. An estimated Rs1,90,000 crore could be spent on curtailing T&D losses during the 12th five-year plan.
Power Grid Corporation, India’s biggest transmission utility, aims to spend Rs55,000 crore during the 11th five-year plan. Its investment is expected to double to Rs1,00,000 crore during the 12th five-year plan.

That the Indian capital goods manufacturers will enjoy a number of opportunities is well known. What is not so well known is the speed-breakers in its growth path, such as order inflows that are not showing signs of picking up, increasing competitive intensity, and rising input costs.
No significant jump in orders: The sector has not shown a substantial increase in demand in the last couple of quarters. Major orders have been few and far between. Orders from Power Grid Corporation are down 22 per cent year-on-year for the period between April 2010 and February 2011. The sub-sectors affected most by the slowdown include rural electrification, sub-stations, and transformers.
Industry leader L&T too has not been immune. L&T is expected to miss its order inflow guidance as a result of lower inflows of new orders. Rising inflation and interest costs and stricter credit norms after the financial collapse of 2008 are factors that are hindering capital expenditure.
According to Misal Singh of Religare Institutional Research, “Industrial capex-led orders could moderate as companies may have deferred their plans for capacity addition owing to the high cost of financing.”
Another concern is where the economy is headed. Even the slightest whiff of a slowdown could result in industries deferring their capital-expenditure plans.
High competitive intensity: Of the Rs420 crore orders in the transformer market (April 2010-February 2011), 27 per cent went to Korean player Hyosung. Of the Rs1,330 crore substation orders (over the same period) around 4 per cent again went to Hyosung. These awards reflect the changes that the sector is witnessing. A greater number of Chinese and Korean players are now vying for a larger piece of the Indian capital goods market.
Then there are the Indian MNCs — ABB, Siemens and Areva, among others — that have captured 50 per cent of the sub-station market (up from 38 per cent only a year back). To understand how competitive the industry has become, consider this: industry behemoth L&T has not got a single order from Power Grid Corporation in the whole of FY11.
Overcapacity in some areas: Increased number of participants in some sub-sectors of the capital goods sector is now manifesting itself in capacities that outstrip demand. In the BTG (boilers, turbines and generators) space, for instance, while total capacity is expected to rise to around 40 GW by the end of the 13th five-year plan, annual demand is a few notches lower at around 20-25 GW. BHEL is expected to battle it out against Chinese equipment manufacturers in this space.
Where are the margins? As if increased competition was not enough, commodity prices have also risen significantly. Stiffer lending norms and higher interest rates are together expected to pare the margins that capital good companies enjoyed between 2004 and 2007.
In the capital goods space, one company that looks good is Cummins India, whose returns ratios are high and whose margins are steady. Another is Voltas which, according to Misal Singh of Religare, offers an attractive entry point for the long-term investor at current valuations. BHEL too is looking good. Despite all odds, the company achieved its target orders for FY11 — a feat that not many players can boast of.