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Capital Goods
Capital Goods Index - Lagging behind
The current quarter saw narrowing of premium valuations in
the capital goods (CG) sector vis-à-vis the Sensex. While majority
of the sector specific indices reported positive growth, the CG
index ended 3QFY2011 down 3.6% and underperformed the
Sensex by 5.8%. Valuation consistently drifted during the first
two months of the quarter under review before marginally
recovering during December 2010. The quarter also witnessed
high volatility in the reported numbers for the Index of Industrial
Production (IIP) and CG production. Despite underperforming
the broad-based Sensex for a major portion of the quarter,
valuations of front-line stocks in the CG index continue to trade
at a premium to the Sensex.
On a stock specific basis, Areva T&D was the top performer
gaining ~11.8% in absolute terms and outperformed the Sensex
by ~9.6%. Despite the price erosion of 10-15% in the T&D
segment, Areva managed to register 40% yoy revenue growth
and 425bp expansion in EBDITA margins to 12.7% during the
September 2010 quarter. Being the market leader in the high
voltage transmission, the company is expected to gain from the
expected release of T&D orders post the successful FPO of
PGCIL. In contrast, ABB was the major loser during the quarter.
The scrip lost ~-13% in absolute terms and underperformed
the Sensex by ~15.2%. Declining revenue and margin
contraction on account of the exit cost of RE Projects continued
to weigh on the stock.
Macro indicators showing strength
The IIP numbers for October 2010 came in at a decent 10.8%
as compared to 6.9% and 4.4% for the previous two months,
respectively. The manufacturing sector, which contributes ~80%
to the IIP, reported double-digit growth of 11.3%, almost double
than the 4.6% clocked during the previous month. The rebound
in IIP was mainly driven by the consumer durables and CG
production, which reported growth of 31% and 22% yoy,
respectively. Along with the strong 8.9% GDP growth reported
for the first half of the current fiscal, we expect the investment
cycle to pick up in the near term as robust corporate profit and
favourable financing conditions fuel investments.
..but benefits not percolating down to CG industry
The Indian CG sector continues to be negatively impacted by
the increasing quantum of imports, especially from China. We
believe that the administered currency regime, cheaper finance
and the favourable duty structure under which the Chinese
companies operate have enabled them to flood the Indian
markets with cheaper equipment. Segments worst affected by
the import deluge have been the construction equipment,
machine tools, turbines and transformers. The domestic power
equipment manufacturers such as BHEL and L&T have been
losing bulk of the orders to their Chinese counterparts. Notable
orders placed during the current quarter include the Lanco
Infratech order for supply of 16 sets of 660MW power equipment
to Harbin Power for ~`6,800cr, Abhijeet Projects for supply of
10 sets of 660MW supercritical units to Dongfang Electric for
~USD 2.5bn (~`11,500cr) and the Reliance Power order to
Shanghai Electric for the supply of coal-fired power generators
worth USD 8.3bn (~`38,000cr). The above orders were placed
when the domestic power equipment industry was in the midst
of expanding capacities to meet the growing demand. Besides,
the power transmission and distribution (T&D) segment has also
seen serious competition from the Chinese and Korean majors.
Key Developments
ABB
Major order inflow for ABB during the quarter included the USD
40mn contract from PMC Project (I) Private Limited to supply
765 kilovolt (kV) and 400kV substations for the Maharashtra
Eastern Grid Power Transmission Company. ABB also won an
order worth USD 32mn from PGCIL to construct two transmission
substations, to be located in the cities of Gwalior and Indore in
Madhya Pradesh. In the metals space, ABB was awarded orders
worth USD 23mn to provide integrated automation systems and
related services to modernise the plate mill at the Rourkela Steel
plant in India.
Crompton Greaves (CGL)
CGL announced that it has developed high range 1,200KV
capacitive voltage transformer (CVT), becoming the first
company in the world to develop such a high range power
product. The company recently delivered its first 1,200KV
product to the ultra high voltage (UHV) station of PGCIL at
Bina, Madhya Pradesh.
BHEL
BHEL and GE India Industrial Private Limited (GEIIPL), a whollyowned
subsidiary of GE, USA joined hands to co-operate on
water treatment equipment. Orders worth `3,700cr were
received from the Karnataka Power Corporation (KPCL) for
setting up a 700MW coal-fired thermal unit with supercritical
parameters.
BGR Energy
During 3QFY2011, the BGR stock displayed extreme volatility
on the back of the ongoing CBI investigations into the LIC
Housing scam, which had named BGR Energy as one of the
implicated companies. At the analyst conference call hosted by
the company thereafter, management clarified its position and
strongly refuted the allegations. The company was also awarded
a BoP contract worth `2,168cr for the 2 x 660MW supercritical
thermal power project of Thermal Powertech Corporation.
KEC International
KEC bagged orders totaling to `1,018cr across the transmission,
railways and cables segments. In transmission, the company
bagged three orders for construction of 765kV transmission
lines totaling `540cr. These orders were received from the
Rajasthan Rajya Vidyut Prasaran Nigam (`313cr), PGCIL (`130)
and Eskom, South Africa (`97). In addition to above, KEC's
wholly-owned subsidiary, SAE Towers, secured `246cr supply
orders in the Americas.
Jyoti Structures
Jyoti Structures announced plans to set up base in the US for
making lattice steel towers. The company is likely to invest ~USD
12mn (~`55cr), which would be fully funded through internal
accruals.
Thermax
Thermax acquired Danstoker A/S, a leading European boiler
manufacturer and its German subsidiary, Omnical Kessel at a
valuation of Euro 29.5mn. Danstoker has strong presence in
biomass-based boilers and waste heat recovery systems for a
wide range of industries. The acquisition will enable Thermax
to leverage the ongoing renewable energy movement of Europe
aimed at generating 20% of its overall energy generation from
renewables.
3QFY2011 expectations
We expect the companies in our universe to post cumulative
top-line growth of 41% on a yoy basis on the back of improving
order executions and favourable base effect. Companies like
BGR Energy and Thermax are expected to report strong
top-line growth of 90% and 50% yoy, respectively. Jyoti Structures
and KEC are expected to maintain a steady top-line growth of
20% and 25% yoy, respectively. In the T&D segment, we expect
ABB to report strong growth of 17%, while Areva and Crompton
Greaves are expected to show a growth of 1.5% and 7.5%,
respectively.
On the operating front, we expect our universe companies to
report flat margins at ~14.8%. ABB is likely to report a pick-up
in margins from the current quarter and post strong OPM of
10.7%, while Areva is expected to report OPM of 12.7%. We
expect BHEL to report 360bp dip in OPM to 18%, while BGR is
expected to maintain its OPM at 11%.
The expected top-line growth of 41% yoy coupled with flattish
margins would result in 41% yoy growth in net profit. BGR Energy
and ABB are expected to report strong profitability growth a
low base, while companies like KEC and Jyoti Structures are
likely to maintain steady growth.
Outlook
The revival in the IIP numbers during the past few quarters signals
strong recovery of the Indian economy in general and that of
the capital goods industry in particular. Almost all the companies
in our CG universe are highly dependent on the generation,
and T&D segments of the power sector.
The generation segment has attracted increasing domestic
competition in addition to the Chinese imports. In transmission,
companies like ABB and Areva T&D have consistently lost ground
to lower priced imports from China and Korea. However, with
the government mandating domestic manufacturing to be a
pre-requisite to bid for NTPC and PGCIL tenders, we expect the
flow of imports to temporarily slow down thereby benefitting
the domestic companies. Foreign companies can still enter into
joint ventures (JV's) with the local manufacturers and supply
equipment manufactured at the Indian facilities. However, similar
restrictions do not apply to the private sector projects, which
can place direct orders with the foreign companies. Post the
recent spate of equipment orders placed with the Chinese
companies, we expect other private sector power projects to
follow suit.
KEC and Jyoti Structures are expected to benefit from the capex
plans of PGCIL and other state utilities. With increasing number
of power projects likely to be commissioned over the next couple
of years, we expect the work orders for setting up transmission
facilities to be released over the next 6-8 months, especially by
PGCIL as the recent FPO proceeds are likely to be utilised for
setting up transmission assets.
On the valuation front, we believe that most of the CG
companies in our universe are presently trading at premium
valuations offering meagre upside from current levels. In such
a scenario, we prefer a stock-specific approach. Crompton
Greaves, KEC, Jyoti Structures, Blue Star and Lakshmi Machine
Works figure among our preferred picks.
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