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Capital Opportunity

With valuations turning attractive & opportunities multiplying, this is a good time to bet on the capital goods sector…

The Indian capital goods space had a dream run in the last decade. The BSE Capital goods index gained over 700 per cent between 2004 and 2007. Times have changed though. One of the sectors most severely hit by the 2008 recession, it has yet to come out of the dumps. The BSE Capital goods index, which peaked in November 2007, is still 33 per cent lower than the levels achieved in those heady days. What caused investors to lose faith in the sector was a virtual standstill in capital investment by industry. Incremental orders dried up fast. Successive earnings downgrades have been the norm ever since.
However, things have started looking up for the sector now. The pace of order intake has started rising, albeit at a slow pace. The massive infrastructure investments planned for the 12th five-year plan augur well for the sector. Regulatory changes taking place currently are also expected to favour domestic companies. Even earnings seem set to rise from the current low levels.
Given the battering that these stocks have received in the post-recession period, many are now trading at attractive valuations. Many of them offer attractive investment opportunities provided you have an investment horizon of at least three years.

Opportunities
Expanding order book. As happened with several other sectors, the global recession of 2008 saw the Indian capital goods sector screech to a virtual halt. As Indian industry postponed capital expansion, incremental order growth for the capital goods sector dwindled to 6 per cent in FY09 and plunged even lower to 3 per cent in FY10. On cue, revenue growth declined to 15 per cent and 6 per cent respectively in those two years.
Things started getting better in FY11. Order intake jumped 15 per cent (compared to only 3 per cent in FY10) while revenues rose 15 per cent (6 per cent in FY10). Order book for the sector was up 17 per cent in FY11. The momentum is expected to sustain as spending during the 12th Plan (FY13-17) gathers pace. Growth in international demand and other non Power Grid orders are expected to pitch in to help grow the sector’s order backlog by around 12 per cent in FY12 and 18 per cent in FY13.
Opportunities in the 12th Plan. The 12th Plan will see transmission capex of around Rs 2,40,000 crore which is expected to start flowing in by the end of FY12 and beginning of FY13 before peaking in FY14. This will mean order growth in the transmission segment will be up around 40 per cent (y-o-y) in FY13 and 35 per cent in FY14.
The state of Power Grid orders. Power Grid, the country’s largest buyer of power equipment, has started giving out more orders. Orders amounted to Rs 13,000 crore in the last quarter of FY11, which is high compared to Rs 6,610 crore worth of orders in the last quarter of FY10. However, orders in the current financial year (FY12) could be affected as the PSU undergoes changes at the helm.
Pace of execution to pick up. The book to bill ratio (order book to trailing 12-month sales) for companies in the sector stood at an average of 1.33x. The last few quarters saw lower order execution because clients were delaying pick-up of orders. Analysts tracking the sector say the emphasis will now be more on order execution than on incremental order intake. Capacity expansion (by capital goods companies) over the last couple of years and improving order deliveries by clients is expected to help the sector post 18 per cent annualised growth in revenue over the next two years.
Industry regulations to benefit domestic companies. India already had a large number of players in the capital goods space. With the entry of Chinese players competition has intensified. Competition is expected to remain intense even in future. However, certain regulatory changes promise to shift the balance in favour of domestic players.
A change in regulations in the transformer segment that requires foreign companies to set up manufacturing facilities in India within three years of acquiring an order is expected to benefit domestic players as it will prevent the Chinese from dumping their transformers into the Indian market.
Furthermore, domestic companies are near to another qualifier that requires them to have operational experience of two years for supplying the entire order for 765kV transformers. If they fulfil this criterion, they stand to gain from cost rationalisation, which will in turn enable them to compete better against foreign rivals.
Established players preferred now. In the transmission segment, a recent trend favours large established majors over smaller new entrants. Over the last couple of years, many new entrants won contracts by bidding aggressively and then later not delivering as per the contracted terms. These lowest-cost bidders are now being overlooked in favour of established majors who can deliver. Kalpataru and KEC are two recent examples of companies that have won transmission EPC (engineering, procurement and construction) orders despite not being the lowest-cost bidders.
Margins to remain stable, earnings to pick up. Buoyed by capacity expansion over the last couple of years, capital goods companies are expected to see improved volume growth in future. That should counterbalance the growing competitive pressures within the industry and raw-material cost inflation, say industry analysts. Despite rising raw material costs, margins have largely held up — falling by only 25 basis points in FY11. Most companies in the sector have guided for near similar or improved margins in FY12. The sector should achieve near 12 per cent margin in the current year — the same as it reported in FY11.

Threats and weaknesses
Slower-than-expected incremental order growth. Order book to bill ratio for the sector stood at an average of 1.33 for FY11. Compared to a ratio of 1.26x for FY10, the current number shows that business sentiment has yet to take off significantly. Take the case of Bharat Heavy Electricals Ltd (BHEL). The company’s order book has remained stagnant at around `60,000 crore per annum over the last three years (FY09-FY11). The usual suspect — increasing domestic and international competition — is responsible for this situation. BHEL’s book to bill ratio currently stands at 1.5x compared to 2x historically.
Other macro headwinds. Industrial capex has yet to show the buoyancy that it did in the FY05-FY07 period. Uncertain global economic outlook, especially in US and Europe, has put the brakes on incremental capex by local industry. According to industry sources, corporate India registered a capex growth of only 10 per cent in FY11. That situation is not expected to change dramatically in the current fiscal year.
Most of the growth in orders that has come in so far and which is expected in the next couple of quarters will come primarily from public sector entities like Power Grid and state PSUs.
Other concerns that have affected the industry’s prospects include high interest rates, shortage of coal, and difficulties in land acquisition.
Anaemic order flows from PSUs. Although the government has plans to undertake massive capital investment during the 12th Plan, there are some concerns regarding how fast actual execution on the ground will be. State Electricity Boards (SEBs) reeling under financial losses and coal shortages could delay planned capacity expansion. These financial and fuel-related concerns have led some analysts to estimate that not all of the `2,40,000 crore worth of orders expected from the transmission segment will come through. The actual execution on the ground may be closer to 70 per cent of the targeted levels.

Valuation
The BSE Capital Goods index has declined around 11 per cent over the last one year — a reflection of market sentiments. The sector now trades at 23 times its FY11 earnings.
As a result of lower expectations, many companies in the sector now trade at a significant discount to their historical earnings multiples (see table below).
Among those that trade at low price-earnings to growth (PEG) ratios (PEG calculated using five-year EPS growth), you have Jyothi Structures at 0.23 and BHEL at 0.57.
Since the sector is trading at much lower levels than those seen prior to the recession, and the opportunities are only growing in size, it appears that all the negatives have been priced in. However, keep in mind that any upward revision in earnings multiples, and consequently share prices, will happen gradually over the next two years. Since valuations are attractive, one may take a position in this space but with a long-term horizon of not less than three years.