Engineering & Capital Goods Delusional optimism to reality :Emkay,

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Engineering & Capital Goods

Delusional optimism to reality

Sinking feeling that scenario is worsening; current environment remains non-conducive for asset creation

¡        High inflation, high BPLR, high commodity prices, indecisiveness, procedural delays, unwillingness, etc appear to be all-pervasive, omnipresent

¡        These factors have surprisingly taken centre-stage for a fairly long duration of time – about 4-5 quarters...

¡        …Resulting in drying out of order announcements, slowdown in execution and decision-making coming to a grinding halt

¡        In a nutshell, catalysts are nowhere in sight, with concerns or risks dominating both capital (Corporate) and financial investments (Investors)

Revisiting our assumptions for FY12E and FY13E earnings forecasts

¡        Have revised order inflow growth assumptions to -3% and +8% (Ex-BHEL) for FY12E and FY13E respectively

¡        Revised order backlog growth to 5% for FY12E and 6% in FY13E

¡        Marginally revised the execution run-rate of order backlog owing to operational and financial challenges

¡        Cut growth in product business to 7% in FY13E, assuming investment spend at 1X GDP growth

¡        Case specific increase in interest rate by 1-2% for FY12E

Ex-BHEL, cutting earnings forecasts by -6% and -11% for FY12E and FY13E

¡        Revenues revised by -3% and -7% for FY12E and FY13E respectively. Highest cuts in Voltas, Blue Star, Mcnally Bharat and TRF

¡        Cut operating margins by 20 bps & 50 bps to 12.8% & 13.0% for FY12E & FY13E. Highest cut - Cummins (-110 bps), Blue Star (-100 bps), Greaves Cotton (-110 bps)

¡        Earnings forecasts revised by -6% and -11% for FY12E and FY13E. Highest cut in Cummins, Voltas, Blue Star, Greaves Cotton and TRF for FY12-13E period

Revisiting valuation methodology- Valuing the ECG sector at 15-year average PER

¡        Earnings CAGR dropping to 7% in FY11-13E period versus 12% in FY09-11 and 42% in FY04-08 period. ROCE to soften from peak of 24% in FY08 to 16.6% in FY13E (Ex-BHEL)

¡        No strong catalysts at play with higher probability of gradual recovery (spanning atleast 3-4 quarters) against immediate recovery.

¡        Erstwhile target valuations were based on average PER of FY04-08 investment cycles. With no strong catalysts in place, FY04-08 valuations remain out of sight

¡        Valuing sector at 15-year average PER with best case upside potential of 15-16%

Change in ratings –Prefer L&T, Thermax, Voltas and Greaves Cotton

¡        Despite all gloom, only silver lining remains healthy ROCE and relatively strong balance sheets

¡        Downgraded L&T, Thermax and Mcnally Bharat by a notch from BUY to ACCUMULATE

¡        Downgraded Cummins and Elecon Engineering by two notches from BUY to HOLD

¡        Prefer companies, where risk or ambiguity is lowest with strong return ratios and valuations being closer to 15-year average PER

¡        Prefer L&T, Thermax, Voltas and Greaves Cotton. Top Avoids- BHEL, Cummins and Blue Star

	Previous Rating	Revised Rating	Previous Target Price	Revised Target Price	CMP	Upside/ Downside
BHEL	Hold	Hold	430	376	326	15.2%
L&T	Buy	Accumulate	1936	1603	1380	16.2%
Cummins	Buy	Hold	687	388	403	-3.6%
Thermax	Buy	Accumulate	735	495	430	15.0%
Voltas	Accumulate	Accumulate	165	121	104	17.0%
Blue Star	Hold	Hold	280	196	221	-11.2%
Punj Lloyd	Hold	Hold	76	63	55	14.6%
Greaves Cotton	Buy	Buy	124	103	90	15.0%
TRF	Hold	Hold	390	282	335	-15.8%
McNally Bharat	Buy	Accumulate	201	147	128	15.2%
Elecon Engineering	Buy	Hold	101	61	71	-13.6%