Capital goods yet to dawn: Prabhudas Lilladher

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Capital goods yet to dawn: Prabhudas Lilladher

Prabhudas Lilladher has come out with its report on Capital goods update. According to the research firm benefit of softening raw material cost might be negated by the weakening rupee.

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Prabhudas Lilladher has come out with its report on Capital goods update. According to the research firm benefit of softening raw material cost might be negated by the weakening rupee.

Capital goods index has underperformed the broader index by 7% over the last 1 month. The sector is stuck with "Hope" of recovery on one end and reality of deteriorating macro variables on the other. Though RBI has indicated pause in rate hikes in the recent policy statement, looming risk of government missing fiscal deficit target, leading to large borrowing programme in H2FY12, could keep rate high risking crowing out of private investment. Lack of reforms on land, fuel and environment side, together with high interest rate, continues to delay recovery in investment cycle. We believe, in this uncertain environment, companies with strong balance sheet, cash flow and strong management pedigree will stand out. Hence, we remain positive on Cummins (KKC) and Thermax (TMX).

Order flow weak: Weakness in macro environment was clearly visible in the order inflow number for the sector. Order inflow for the sector was down 10% YoY to Rs394bn. Though the commentary on outlook for most industries was subdued in the near term, outlook for power was particularly negative, with no respite in sight for issues like fuel, discom health, land, environment etc. CMIE data shows significant slowdown in new project announcement. Increase in projects shelved, also point to a weak outlook in the near term. The only positive commentary on order flow was from Power Grid, where we saw increase in pace of order flow and outlook also remains buoyant.

Sales - A mixed bag: Sales for the quarter was up 16.8% YoY to Rs337bn, though was ahead of our estimate of Rs322bn (12% growth). Though the growth for large companies was held up (BHEL and L&T), smaller companies missed estimate. The major reason for the misses were extended monsoon and delay from client side in contracting companies and high interest leading to slower demand in industrial and consumer durable companies.

Margin pressure: EBITDA for the sector was up 6% YoY to Rs39.3bn. Margins came down by 119bps YoY to 11.6%. 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 wage cost. We believe benefit of softening raw material cost might be negated by the weakening rupee.

Interest cost balloons: Interest cost for the sector was up 23% YoY. Rise in interest expense was across the board. Apart from increased borrowing cost, the major culprit was elongated working capital cycle due to higher debtor days and accumulation of inventory build-up. PAT recorded slowest ever growth of 2.6% (Adj. for BHEL , it would have been de-growth of 12%).

KKC is currently trading at 14.6x FY13E earnings. Though there might be some near-term pain, we believe the company is on track to double its turnover in the next five years. With investment in capacity and technology leadership, the company will be able to capitalize once the market bounces back. Strong balance sheet and cash flow will continue to support valuations.

TMX is currently trading at 12.4x FY13E earnings. It has been able to grow base business even in this difficult environment, we believe orders could surprise on upside once cycle improves. It has also worked towards building new business and acquiring technologies (Solar, Chemical, Power, Air pollution etc) which makes them future ready. We believe valuation is attractive and strong balance sheet and management quality provides additional comfort.

Order Book-inflow weakens
Weakness in macro environment was clearly visible in the order inflow number for the sector. Order inflow for the sector was down 10% YoY to 394bn. Though the commentary on outlook for most industry was subdued in the near term, outlook for power was particularly negative, with no respite in sight for issues like fuel linkages, DISCOMS health, land acquisition, environment issues etc. CMIE data shows significant slowdown in new project announcement. Increase in projects shelved, also point to a weak outlook in the near term. The only positive commentary on order flow was from Power Grid, where we saw increase in pace of order flow and outlook also remains buoyant.

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To read the full report click on the attachment