Engineering & Capital Goods - Darkest before dawn; monthly update :: Edelweiss PDF link

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Monthly Highlights: What’s inside?

·       Q4FY12 earnings preview

·       Company visit / management discussion and channel checks

·       Key highlights/ news for the companies/ sector

·       Key macro trends

Economy impact: Uptick on the anvil

Momentum seen in January 2012 extended to February and March as well, with decent rebound in PMI. Also, IIP and exports data improved over November 2011 till January 2012, indicating an uptick in overall investments. With rate cut round the corner, liquidity is expected to ease and hence trim overall cost of funds, thus improve the outlook. Current interaction with most industrial players viz., EPC players in power and non-power space indicate declining profitability and cash flow issues.

Industrial pulse: Headwinds persist

Visibility and profitability concern persist; rate cut and policy initiative holds the key

Overall project awards remained subdued (barring power T&D, roads etc.) as sustained hindrances like fuel and land availability, environment clearances, high cost of funds remain. Our channel checks suggest continued deferment of project closure by clients in the power BTG, metals, and hydrocarbons. Also, railway (DFC, Metro) projects have not seen any major activity wrt project milestones in recent past, barring a few (Delhi Metro-III).

With an expected interest rate cut in the next few months, we believe industrial capex is likely to see an uptick. Also, key steps from government’s side wrt issues like fuel availability (gas and coal availability), land availability and environmental clearances could provide further fillip in the overall industrial investment cycle.

Institutional ownership, valuations at historic lows; EPS cut cycle bottoming out

Institutional shareholding in Capital Goods companies is at a 6 year low at 31% (peak at ~35%), owing to macro concerns, visibility and profitability issues. MSCI Industrials premia to MSCI India currently is nil which is significantly below historical average premia of 22% (FY03-FY12). Also, we believe with more than 16% earnings cut by consensus for capital goods companies over the last 12 months, earnings’ cut cycle could be bottoming out, given an expected uptick in overall industrial investments.

Outlook: Prefer Crompton, L&T and Bajaj Electricals

We continue to prefer diversified players like Crompton Greaves, L&T and Bajaj Electricals. We reaffirm our belief in their resilient business models which provide excellent opportunity in the overall uptick in the industrial capex. Our outlook for power generation equipment companies remains subdued owing to larger issues over capacity, fuel availability, high cost of funds, clearance issues etc.

Engineering & Capital Goods - Darkest before dawn; monthly update

Regards,