Edelweiss, Engineering and Capital Goods - macro headwinds spoil the show

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While Q3FY11 was largely in line with execution and profitability soaring 22% and 17% Y-o-Y, respectively, macro headwinds like rising interest rates, environmental issues, among others, led to an overall slowdown in order intake momentum in power, roads, and infra space, dampening execution outlook. The sector is facing issues like delayed financial closures in a large number of projects, which in turn has led to an extended ordering activity.

n  Q3FY11 execution in line, but outlook bleak

The sector posted stable execution in Q3FY11 with a decent 22% Y-o-Y growth, led by large value executions by Larsen and Toubro (LT), Thermax, BGR Energy (BGR), and Siemens. However, the entire T&D pack with domestic focus reported muted revenue growth owing to an overall slowdown in pick up from utilities. Given the current slow down and macro headwinds we are concerned about execution going ahead.

n  Rising input cost dents sector margins

Barring BHEL, which continues to report rising operating margins owing to lower opex and inventory cost benefits, the sector largely posted a sharp 140bps Y-o-Y dip in core EBIDTA margins owing to rising steel, copper, and aluminium prices over the past one year.

n  Strong disappointment in order intake; sector OB flattish sequentially

With orders worth INR 332 bn, order inflow during Q3FY11 declined 22% Y-o-Y and 9% Q-o-Q. The slowdown was largely due to deferred ordering activity across power, roads and Oil & Gas  as a large number of developers face funding and clearance issues. While order backlog, at INR 3,115 bn, improved 19% Y-o-Y, Q-o-Q growth was flat at 1%. Our interaction with various market players suggests there are chances of the overall slowdown continuing for the next two-three quarters, at least from the private sector.

n  Outlook and valuations: Macro concerns cloud sector outlook

We remain cautious on the overall execution pick up in the sector over the next few quarters owing to macro headwinds like environment clearances and rising interest rates scenario, coupled with tender award deferments, which has led to overall slowdown in the engineering and capital goods space.

While there are no major project cancellations, utilities and clients have become skeptical and are witnessing slow down in financial closures of projects, given the rising interest cost scenario. This coupled with rising input cost pressure has led to a strong PE de rating with capital goods valuations down 29% versus 17.5% decline in the benchmark Sensex over the past three months. While stocks have corrected majorly in the past few months, there could be further down side even from current valuations if the overall slowdown continues for the next two-three quarters, triggering downward revision in FY12 earnings.