28 June 2011

Capital Goods (Mkt cap: US$63bn) Underwhelming growth, increasing competition:: IIFL

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The Capital Goods sector’s ROE improved sharply in the first half of
the analysis period (FY04-07), helped by expansion in EBITDA
margins and higher asset turns—but since then, it has seen a gradual
but steady decline. The decline was despite further expansion in
EBITDA margins and was driven by lower asset turnover. A large part
of the decline in asset turns was contributed by L&T, which invested
heavily in the long-gestation infrastructure business. Suzlon
contributed to a further diminution of ROEs from FY08 onwards, as its
consolidated profitability eroded following two acquisitions in Europe.
EBITDA margin of the Capital Goods sector has ranged from 10.2%
in FY10 to 13.7% in FY11, with a peak of 14.1% in FY07. While
margins dropped drastically for Suzlon (24.3% in FY06 to 5.7% in
FY11) and have started to stagnate for other companies, BHEL has
driven recent buoyancy in overall EBITDA margins for the sector.
After decadal recalibration of salaries in FY09-10, BHEL is benefiting
from operating leverage. During the previous peak, BHEL’s margins
were depressed, as the company had raised salaries in those years.
During FY11, BHEL also benefited from the large low-cost inventory
which drove 210bps YoY expansion in gross margins.


Excluding BHEL and Suzlon, EBITDA margin for the sector improved
from 11.3% in FY07 to 13.1% in FY10, but dipped to 12.6% in FY11,
as order inflows slowed down and competition intensified. Competitive
intensity for power generation and T&D equipment has increased
significantly owing to large supply addition (both capacity expansion
and entry of new domestic and foreign players). Going forward, lower
margins in new orders would start to impinge on margins. All
companies except ABB were able to maintain or improve margins till
FY10, mainly by cutting costs. Post the dip in margins in FY09 due to
commodity prices, companies have undertaken better risk mitigation
measures by focusing more on price variation clauses in contracts.
Suzlon is a showcase of how business acquisitions done at
inopportune times and over-leveraging can impair a quality business
franchise. Through FY04-07, Suzlon’s operating matrix was perhaps
one of the best when compared to its global peers (Vestas, Gamesa,
etc), when it was focusing only on manufacturing of wind turbines
from India (known for its low manufacturing costs). In FY07, it
acquired Hansen and later in FY08/09, part of RE Power, largely
through debt. But both these entities had manufacturing locations in
Europe (high cost base), and this led to a fall in blended operating
profit margins. The financial crisis of 2008-09 put a break on
renewable-energy capex, and this clubbed with product quality
issues at Suzlon led to a sharp fall in the order book. Through FY09-
11, sustained pressure on margins, together with depleting order
flows led to losses.
Excluding L&T and Suzlon, asset turns in the sector trended up till
FY07, but subsequently, they have remained stable. BHEL witnessed
peak capacity utilisation in FY07-08, but thereafter it has made
steady investments to increase capacity. EBITDA margin expansion
over FY08-12 has not resulted in higher ROEs, as strong cash
generation has resulted in a decline in leverage ratios.
Going forward, we expect ROEs to decline as pressure on margins
due to higher competitive intensity starts to become evident (with
execution of new projects ramping up). Slower growth in order
inflow would also result in higher working capital intensity as growth
in customer advances slows down. Combined with an increase in
investments for the infra business (L&T) and equity commitments for
generation SPVs (BHEL), asset turns for the sector would continue to
witness a steady decline.



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