Capital goods index has outperformed the broader index by ~5% over the last three
months. Government off-late has been making lot of positive noises which hasn’t
been backed by concrete action. RBI’s ability to act has been hindered by
government inaction on the fiscal front and high inflation, while government
perceives rate cut as a way to boost growth. Recent downgrade of GDP estimate for
FY13 and risk of rating downgrade has added to the uncertainty. So India Inc.
continues to live with an uncertain outlook albeit with a hope of revival for the time
being (as it has been for last several quarters). We might be closing in but it’s still
tough to call the bottom yet.
Order flow shows growth YoY after four quarters of de‐growth; Commentary
still uncertain: Order flow for the quarter for our coverage universe was up 28%
YoY to Rs357bn (excl. L&T and BHEL, order flow is up 7% YoY). Order flows have
shown growth in the current quarter after showing de-growth YoY for the
previous four quarters. While commentary on T&D order and short-cycle order
continued to be positive, commentary on infrastructure projects and industrial
recovery continues to be weak. The order book for the sector was flat YoY to
Rs3.5trn with B2B ratio of 2.3xTTM sales (down from peak of 2.92x in Q2FY11).
High interest, policy inaction, land and environment clearance issues and tight
liquidity were cited as primary reasons for uncertain macro environment.
Increasing focus on export market (mainly MENA region) to counter domestic
slowdown continued to be visible. CMIE data on new project announcement
continues to show a declining trend. Increase in projects shelved also point to a
weak outlook in the near term. Strong ordering from Power Grid supported
order flow for many T&D companies. However, with peaking ordering cycle,
companies will have to look at other areas to support incremental growth.
Margin pressure continues to persist: EBITDA for the sector was up 9.6% YoY to
Rs34bn. Margins for the sector came down by 67bps YoY to 10.5%. Slower pace
of order over the last few quarters (leading to higher competition) is clearly
showing up in the margins, apart from increased raw material and weak rupee.
Most companies acknowledged the increasing competitive intensity in both
domestic and international markets. Slowing demand has made cost passthrough
difficult, putting pressure on margins.
Interest cost continues to drag earnings: Interest cost for the sector was up
34% YoY. Rise in interest expense was across the board. Apart from increased
borrowing cost, the major culprit was the elongated working capital cycle (lower
advances due to lower order flow and higher debtor days due to tight liquidity
situation). PAT growth was at 9.3%.
Our top pick in the sector are Voltas, KEC International and Power Grid.
Voltas is trading at 11.5x FY14E earnings. We believe that the worst might be
behind us, given that the large part of provision on the Sidra project has already
been accounted for. Write-back from the Sidra project could provide positive
surprises. The outlook might be slightly muted in the near term on order flow.
Voltas has increased its reach in terms of geography in the international markets
and business segments in the domestic market which should help order flow
once the cycle turns. We believe that a lot of pessimism related to order flow is
in the price and hence, downside seems to be limited.
KEC is trading at 5.5x FY14E earnings. The company’s strong order book,
continuing growth in order pipeline and ability to win orders in the current
environment gives comfort on revenue visibility. Improved balance sheet gives
additional comfort. We expect the stock to deliver earnings CAGR of 20% over
FY12-14E.
Power Grid is trading at 1.6x FY14E book value. The company sounded
confident of achieving its implied guidance for capitalization for FY13
(~Rs200bn). It also tried to soothe investor’s nerves on dilution by assuring that
it can avoid dilution (by tweaking D:E ratio requirement for 1-2 years). We expect
the stock to deliver earnings CAGR of 16.2% over FY12- 17E.
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