Capital Goods: Not out of the woods yet

Analysts are of the opinion that performance in Q2 will not be very different from that in Q1

The stocks of capital goods companies have underperformed in the second quarter of the current financial year (Q2FY14) with the BSE Capital Goods index losing 15.4%, as compared to the Sensex which was down a marginal 0.1%.
 
Most stocks from this space have slipped in the range of 2-37% in the September 2013 quarter with frontline counters like Larsen & Toubro (L&T) and Bhel skidding 16% and 21%, respectively.
 
The slide in these counters comes amid slowdown in the Indian economy as investments across the various sectors have almost come to a halt. Tight liquidity and high cost of funds have kept a leash on the capex plans of most companies. Order inflows remain lacklustre amid an uncertain macro environment while project execution remains muted due to a declining order book and softer off take of domestic products business.

 

“Despite all the hue and cry about reform announcement, structural reforms surrounding power companies continue to weigh on the companies. Other concern is the rapid decrease in the order back log for companies like BHEL and many others,” says an analyst from a local brokerage tracking this space.
 
However, the July IIP numbers took the Street by surprise. The 2.6% industrial output growth in July was largely attributed to capital goods that constitutes nearly 9% of Index of Industrial Production (IIP), which grew a massive two year high of 15.6% against contraction of almost 6% a year back. The rise was fuelled by the electrical machinery segment that grew by 83.6%. This segment has a weight of 1.98% on IIP.

 
“Industrial production growth for July surprised on the upside, increasing by 2.6% y-o-y versus an expectation of a decline. However, the increase was led by a spurt in the volatile capital good production, we believe, may not sustain at these high levels,” points out Chetan Ahya, Asia – Pacific Economist at Morgan Stanley.
 
Outlook
 
Given the developments and the current state of the economy, analysts are of the opinion that Q2 will not be very different from that in Q1.
 
Amit Patel, sector analyst at Angel Broking is of the opinion that even there have been some positive announcements; it is still an unknown fact as to when all these will be implemented. He maintains a cautious stand as the revenue visibility is very low.

 
“In light of execution slowdown, weakening working capital cycle (recent legal action against customer overdues to the extent of Rs 170,000 crore) and limited opportunities (except in UMPPs), we expect a period of negative operating leverage and reducing margins. Reiterate ‘sell’ with a price target of Rs 120/share based on 10x FY15E EPS,” suggest Prakash Gaurav Goel, Vivek Sharma and Hardik Shah of ICICI Securities in a recent report.
 
Kishor Ostwal, CMD of CNI Research, however, sees a silver-lining in amid all this gloom. “The picture is not as bad as it is made out to be. General Elections can be a game changer for some of the stocks from this space and I expect bounce-back in stocks like L&T and BHEL,” he points out.

“L&T is better placed than its peers to weather the economic slowdown due to its wide range of businesses, superior track record and a strong overseas presence. Though the order inflows are on track to sustain a decent growth in the revenues, but the company is facing pressure on the margin,” states a Sharekhan report.
 
Saurabh Mehta, an analyst with Daiwa Capital Markets maintains Buy rating on L&T with an SOTP-based six-month target price of Rs 1,150. “L&T has a strong order backlog which should enable solid execution, and as we forecast revenue growth of 13% p.a. and PAT growth of 9.5% p.a. over FY13-16, backed by a 2.7x book-to-bill ratio,” he says.