Is the capital goods sector on the recovery path as inflation eases?

Revenue growth estimates have moderated post Q2 but the bottom may be close

Can the capital goods sector finally move into a meaningful upcycle as inflation eases and global supply chains adjust to the disruptions caused by the past three years? After the July-September quarter (Q2) results, analysts are suggesting that electrical capital goods businesses like Siemens, ABB India, Thermax, GE T&D, Hitachi Energy, Bluestar, and Voltas will see an 11 per cent revenue CAGR over the next three years, rather than 16 per cent anticipated after Q1 (April-June quarter) results.

This is based on a Q2 slowdown in order inflows. However, this can also be the bottom of the cycle or close to the bottom, with revenue growth momentum rising in the future. In terms of earnings upgrades, many of these companies have seen positive upgrades, even though order inflows have slowed. 

One interesting data trend is that capex has been flat or witnessed low-growth for much of the past 10 years. This is an unusually long period of revenue stagnation. This has led to extremely high valuations for various stocks. If there is an acceleration in growth rates, there can be a period when valuations fall, even as share prices move up.
 

It is interesting to compare Siemens and ABB. Siemens has seen Ebitda grow by around 20 per cent over the past 12 months, while ABB’s Ebitda has grown by around 55 per cent. The underperformance in Siemens’ Ebitda growth versus ABB’s Ebitda growth is reflected in their stock performance – the Siemens stock, with gains of 87 per cent in the past three years, has underperformed ABB, which has moved up 136 per cent. ABB has invested more as well and it can have faster future revenue growth and gross margin. ABB is also exporting more to meet the demands of its global parent.

Over the past three years, Siemens’ capex has been less than 50 per cent of depreciation levels and this is a multi-year low in terms of the absolute amount spent by Siemens. The FY22 capex for Siemens at Rs 160 crore was still low versus the Rs 310-crore depreciation expense.

The period of capex moderation for Siemens started in 2018-19. While Siemens has a higher Ebitda margin, ABB is catching up. ABB has improved its Ebitda margin by roughly 300 basis points (bps), in the last five years, while Siemens has seen a 150-bp improvement. However, ABB has a far higher payout to the parent, around 6.8 per cent of revenues, than Siemens, where the payout is at 3.6 per cent.

Both companies look to have healthy prospects, with Siemens order inflows up by 15.7 per cent year-on-year (YoY) to Rs 3,560 crore with higher activity in renewables, warehousing, and data centres. The target valuation for Siemens is Rs 3,100-3,150, according to some analysts, versus a current price of Rs 2,775. However, Siemens missed Street’s revenue and PAT estimates and it has lost ground over the past month. ABB met revenue estimates and beat the PAT estimates and has seen a small positive return in the same period.