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India Equity Research Reports, IPO and Stock News
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1) What are the major cost items for this business?
Across the Capital Goods Sector, raw-material expenses are the major cost item
(70-80% of revenue). If we were to break down the raw-material costs of the
project companies in this sector, subcontracting costs and bought-out items would
account for the majority of raw-material costs. Other operating cost items include
employee expenses (5-6% of revenue) and SG&A (around 10% of revenue).
2) What has been the trend in the price of these items? Has the price change been
accelerating or decelerating?
The impact of rising raw-materials prices (mostly steel and copper) was felt partly
in 3Q FY11. However, we believe it will become more apparent in 4Q FY11 and
1Q FY12, as increases in prices of raw materials (particularly metals) were not
reflected fully in corporate earnings announced recently, given that companies
were able to mitigate this with low-cost inventory.
4) In prior periods of accelerating inflation, how have sector valuations changed?
During the previous commodity bull run in 2005-08, the sector underwent a major
rerating. PERs of companies such as BHEL and L&T expanded from 9-10x earlier
to 20x. This was due mainly to the buoyant domestic macroeconomy. During this
period, order books expanded at a CAGR of 40%, as orders from sectors such as
infrastructure, oil and gas, and power made a significant contribution. Also, limited
competition helped margins to expand.
5) What has been the trend in selling prices? To what extent can higher costs be
passed on?
We believe increasing raw-material prices would be a double whammy for the
product companies (ie, companies that sell capital goods on a product basis and do
not take up turnkey/EPC jobs), as ASPs are already under pressure due to
competition. Hence, we believe they may only be able to pass on costs if the
industry becomes less competitive. As far as project companies are concerned,
those with contracts already on the order book and with pass-through clauses may
not be affected as much as those with a greater proportion of fixed-price contracts.
Companies that we believe may be affected negatively on this count include KEC
International, as the company derives about 50% of its revenue from exports based
on fixed-price contracts.
6) If cost increases can be passed on, is there a lag? If yes, how long does that lag
tend to be?
Companies enjoy pass-through clauses for certain projects. For instance L&T
maintains that about 70% of its current order book of Rs1,149bn have pass-through
clauses. However, increases in costs may not be passed on immediately, and there
is usually a lag of about 1-2 quarters. Also, the entire increase in costs may not be
passed on, as beyond a certain point the client may also ask the contractor to bear
part of the rise. In the case of product companies, we have witnessed their inability
to pass on costs due to competitive pressure over the past eight quarters. It remains
to be seen that whether these companies can raise prices if raw-material costs
continue to increase. We do not believe they will be able to do so.
7) Does cost inflation cause supply disruptions along the production chain as
producers adapt their processes or cut output in the face of weaker margins?
We do not foresee such a scenario affecting the sector, as a well-diversified vendor
base, along with intense competition from Chinese and Korean companies, ensure
regular supplies of products/raw materials and critical components. Hence, despite
cost pressure, we do not envisage any supply disruptions for the sector.
8) What is the outlook for share prices in the sector, bearing in mind cost
pressures and the potential for PER or PBR compression?
We attribute the share-price declines for capital-goods companies in India since
November 2010 to multiple reasons, with cost pressure being one of the lesser
concerns. We see the primary reason as a lack of government and private sector
capex, which may result in execution delays for project companies and a loss of
revenue for businesses with short cycles. Second, we believe the power ancillary
companies have been de-rated for two main reasons: 1) the poor financial health of
the state power-distribution companies, and 2) concerns in the market about
overcapacity in the power-generation sector. Last, the near-term issue of inflation
and its impact on raw-material costs has also played a role in the sector’s de-rating.
However, looking ahead to 2012, we expect corporate and government spending to
pick up by the second half of the year, as we expect issues relating to liquidity and
high interest rates to have been addressed by then. With regard to the slowdown of
capex in the power sector, we believe that concerns in the market about the health
of the state electricity boards are genuine, and need to be addressed as a high
priority. We would expect L&T to be the primary beneficiary in the event of a
pick-up in capex.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
1) What are the major cost items for this business?
Across the Capital Goods Sector, raw-material expenses are the major cost item
(70-80% of revenue). If we were to break down the raw-material costs of the
project companies in this sector, subcontracting costs and bought-out items would
account for the majority of raw-material costs. Other operating cost items include
employee expenses (5-6% of revenue) and SG&A (around 10% of revenue).
2) What has been the trend in the price of these items? Has the price change been
accelerating or decelerating?
The impact of rising raw-materials prices (mostly steel and copper) was felt partly
in 3Q FY11. However, we believe it will become more apparent in 4Q FY11 and
1Q FY12, as increases in prices of raw materials (particularly metals) were not
reflected fully in corporate earnings announced recently, given that companies
were able to mitigate this with low-cost inventory.
4) In prior periods of accelerating inflation, how have sector valuations changed?
During the previous commodity bull run in 2005-08, the sector underwent a major
rerating. PERs of companies such as BHEL and L&T expanded from 9-10x earlier
to 20x. This was due mainly to the buoyant domestic macroeconomy. During this
period, order books expanded at a CAGR of 40%, as orders from sectors such as
infrastructure, oil and gas, and power made a significant contribution. Also, limited
competition helped margins to expand.
5) What has been the trend in selling prices? To what extent can higher costs be
passed on?
We believe increasing raw-material prices would be a double whammy for the
product companies (ie, companies that sell capital goods on a product basis and do
not take up turnkey/EPC jobs), as ASPs are already under pressure due to
competition. Hence, we believe they may only be able to pass on costs if the
industry becomes less competitive. As far as project companies are concerned,
those with contracts already on the order book and with pass-through clauses may
not be affected as much as those with a greater proportion of fixed-price contracts.
Companies that we believe may be affected negatively on this count include KEC
International, as the company derives about 50% of its revenue from exports based
on fixed-price contracts.
6) If cost increases can be passed on, is there a lag? If yes, how long does that lag
tend to be?
Companies enjoy pass-through clauses for certain projects. For instance L&T
maintains that about 70% of its current order book of Rs1,149bn have pass-through
clauses. However, increases in costs may not be passed on immediately, and there
is usually a lag of about 1-2 quarters. Also, the entire increase in costs may not be
passed on, as beyond a certain point the client may also ask the contractor to bear
part of the rise. In the case of product companies, we have witnessed their inability
to pass on costs due to competitive pressure over the past eight quarters. It remains
to be seen that whether these companies can raise prices if raw-material costs
continue to increase. We do not believe they will be able to do so.
7) Does cost inflation cause supply disruptions along the production chain as
producers adapt their processes or cut output in the face of weaker margins?
We do not foresee such a scenario affecting the sector, as a well-diversified vendor
base, along with intense competition from Chinese and Korean companies, ensure
regular supplies of products/raw materials and critical components. Hence, despite
cost pressure, we do not envisage any supply disruptions for the sector.
8) What is the outlook for share prices in the sector, bearing in mind cost
pressures and the potential for PER or PBR compression?
We attribute the share-price declines for capital-goods companies in India since
November 2010 to multiple reasons, with cost pressure being one of the lesser
concerns. We see the primary reason as a lack of government and private sector
capex, which may result in execution delays for project companies and a loss of
revenue for businesses with short cycles. Second, we believe the power ancillary
companies have been de-rated for two main reasons: 1) the poor financial health of
the state power-distribution companies, and 2) concerns in the market about
overcapacity in the power-generation sector. Last, the near-term issue of inflation
and its impact on raw-material costs has also played a role in the sector’s de-rating.
However, looking ahead to 2012, we expect corporate and government spending to
pick up by the second half of the year, as we expect issues relating to liquidity and
high interest rates to have been addressed by then. With regard to the slowdown of
capex in the power sector, we believe that concerns in the market about the health
of the state electricity boards are genuine, and need to be addressed as a high
priority. We would expect L&T to be the primary beneficiary in the event of a
pick-up in capex.
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