Goldman Sachs Equity Research- Initiate on 3 cap goods stocks

Please Share:: India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��

India: Capital Goods

Goldman Sachs Equity Research
Initiate on 3 cap goods stocks; high cash generation and recovering growth, but expensive


Industrial activity is the key growth driver
We initiate coverage on three capital goods
companies with strong exposure to India’s
improving industrial and infrastructure capex
investments. Order inflows across the power,
infrastructure, and manufacturing segments grew
about 70% yoy in 1HFY11, signalling strong growth
prospects for the capital goods companies as these
projects move into the implementation phase.

High cash generation – a key differentiator
Cash generation and capital returns for these
companies have been consistently high, unlike the
infrastructure and construction companies. Thus,
these companies are well funded and the risk of
further equity dilution is low, in our view.

Sharp run-up in valuations prices in positives
However, valuations for these companies have
expanded significantly in 2010 – 12-m fwd P/E is
up 18% ytd on an average pricing in most of the
improvement in business fundamentals. While
Cummins has returned the best stock
performance, Bharat (BHEL) has underperformed.

Initiate with Sell (on CL) on Voltas…
We forecast Voltas’ revenues to grow at 11%
CAGR over FY10-12 vs. 22% over FY08-10, and
ROE to decline to 28% in FY12 from 40% in FY10,
on the back of muted order inflow in the project
segment over FY11-FY12. Given a decreasing
growth and return profile, we believe a premium
valuation for the stock is not justified, and the
stock can only maintain current multiples if there
are strong order inflows in the next few quarters.

…and Neutral on Thermax and Cummins
The strong improvement in business
fundamentals for Thermax (larger size orders
improving revenue visibility) and Cummins
(strong growth in exports segments) is priced into
current valuations, in our view. Our target prices
imply limited upside from current levels – hence
we initiate with a Neutral rating on both stocks.

Risks
1) Rise in interest rates; 2) delays in capex
investments across industrial and infrastructure
segments; and 3) volatile raw material costs.



Initiating on three high cash generating equipment companies; Voltas on Sell (CL)
We initiate coverage on three capital goods companies with strong exposure to India’s improving industrial and infrastructure capex
investments as well as beneficiary in any pick up in industrial activity overseas.
Cash generation and capital returns for these companies have consistently been high. However, multiples have expanded
significantly in 2010 – 12-month forward P/E is up 18% ytd on an average (after expanding 100% in 2009), pricing in most of the
improvement in business fundamentals.
Voltas (VOLT.BO, Sell): Continued weak order inflows would hamper growth, valuations capped, Sell (on CL)
 Muted order inflow seen in FY2010 and 1HFY11 are likely to continue for the next few quarters as construction activity in the
Middle East does not appear to be picking up and competition in the Mechanical, Electrical and Plumbing segment has
intensified.
 As a result, we expect the MEP segment (which contributed 65% of revenue in FY10) to grow 2% yoy in FY11 and 11% in FY12
amid slow order inflow.
 Slowing growth and returns for the company do not justify premium valuations, in our view. Hence, we value the stock
based on its 5-year historical median P/E multiple of 15X, giving us a 12-month target price of Rs201, implying 12% downside
from current levels. Hence, we initiate coverage on Voltas with a Sell rating and add it to the regional Conviction List.
Thermax (THMX.BO, Neutral): Improved order book provides revenue visibility; Boiler-Turbine-Generator (BTG) expansion
should drive growth but likely at lower margins; Neutral on valuation
 The strong traction in order inflows over the last five quarters – driven by industrial capex – has improved revenue visibility, and
we expect an EPS CAGR of 35% over FY10-12, higher than the 31% in FY05-10.
 Recovery in industrial capex across the various industrial segments, upcoming orders in the supercritical power equipment
space, and emerging opportunities in the water treatment and air pollution control space are key drivers for the stock, in our
view.
 However, the stock has risen sharply ytd – up 37% vs. the BSE Sensex (up 10%) – and now factors in this improving growth
visibility, in our view – we value the stock at a 10% premium to 5-yr historical P/E multiple of 20.8X implying a 8% upside, and
hence our Neutral rating on the stock.
Cummins India (CUMM.BO, Neutral): Recovery in export markets, continued domestic market growth; premium valuations
reflect a strong medium-term business outlook
 Ongoing power shortages are driving demand for back-up power; recovery in the export market for engines and generators,
along with capacity expansion at the Phaltan-megasite, are key drivers for the stock, in our view.
 Margins for the company have improved by 530 bp since FY08, driven by capacity expansion and efficiency improvement
initiatives, and are expected to stay at current levels, in our view.
 Cummins India currently trades at a 12-month forward P/E of 20.5X – a 28% premium to its 5-yr average 12-m fwd P/E
of 16X. We believe the premium already reflects likely strong earnings over the next six quarters. Hence, our Neutral rating.


Improving industrial activity is a key growth driver for capital goods companies....
New order inflows for construction companies, especially from power and infrastructure segments, continue to grow; a pick-up has
been seen recently in manufacturing orders as well. After consecutive quarters of negative yoy growth in new orders since June
2009, 1QFY11 saw an 89% yoy growth in new orders in the manufacturing space. The share of manufacturing sector orders
increased to 39% in 2QFY11 (see Exhibit 6) – the highest share in the past four years.
Increase in construction activity across the infrastructure, power and manufacturing segments is a key demand driver for the capital
goods companies. The yoy growth in projects under implementation has also been strong, with the power segment recording 63%
yoy growth in the value of projects under implementation in Q2FY11. We expect the manufacturing projects under implementation
to pick up in 2HFY11, as the announced orders in the segment move into implementation mode. In addition, as execution across
various infrastructure projects picks up pace, post the monsoon season, we also expect a strong rebound in the value of
infrastructure projects under implementation.


…however, valuations have run up over 2010, pricing in most of the positives...
Within the Capital Goods space, Cummins India and Thermax have delivered the best stock price performance over the last 12
months – mirroring the improving business fundamentals that the two companies have reported over the last three to four quarters.
Bharat Heavy Electricals (BHEL.BO) (refer “Upgrade BHEL post underperformance; structural concerns remain” published on 14
Dec’10) has underperformed the most over the last 12 months on increasing competition and concerns about loss of market share.


EV/GCI – CROCI/WACC analysis and Global comps sheet
On a cash return analysis, based on FY10 returns, BHEL appeared expensive at the beginning of the year relative to Cummins and
Voltas trading at reasonable valuation. However, BHEL has de-rated in the last nine months and Cummins and Voltas have re-rated
significantly and now appear fairly valued based on returns for FY11E.
Based on our estimates, as Voltas returns decline into FY2012 to 30% from 36% in FY10 , the stock appears expensive relative to the
peer group and relative to its own history and hence our Sell rating (on Conviction List). We expect Thermax and Cummins to
increase their cash returns over the same period.
Though Thermax also trades above the sector average for FY12E, the stock has historically also traded at a premium and supports
our Neutral rating.
Cummins, which trades close to the sector average, is also rated Neutral based on FY12E returns.