Capital goods` margins to remain under pressure in Q4: MOST

Motilal Oswal has come with its quarterly earning estimates on capital goods sector for March 2012. The research firm, is Neutral on the sector and expects re-rating once there is visibility in government and private capex and has preferred L&T, Cummins India and Havells India from the sector.

High capital cost holding back investment; IIP declining: The Capital Goods Index continues to register negative growth and also remained very volatile. During YTDFY12 till January 2012, the index was down 3% YoY, while it fell by 16% over 3QFY12. On the positive side, the pace of decline moderated in January with the index declining 1.5% YoY. However, it continues to remain highly volatile. High inflation and interest rates have almost rendered several projects unviable. Increased working capital costs and lack of liquidity are challenges for capex upturn in the near term.

Execution on track, but intake growth lackluster: In 3QFY12, the capital goods sector's revenue grew 12% YoY. In 4QFY12, we expect revenue to grow 14% YoY driven by healthy order backlog with BTB of 2.7x TTM revenue. Ordering activity remains sluggish although the current order book is sufficient to fuel growth in FY12, and to a larger great extent in FY13. However, we are concerned about visibility beyond FY13. During 9MFY12, the sector's aggregate order intake declined 12% YoY (v/s 19% YoY decline in 3QFY12).

Aggregate EBITDA margin for 4QFY12 estimated at 15.9% (down 134bp YoY): For 4QFY12, we estimate aggregate EBITDA margin at 15.9%, down 134bp YoY. We expect margins to remain under pressure due to rising inflation and hardening commodity prices. Raw material prices have risen by 25-27% since the start of FY12. Steel prices increased 3-4% YoY in 4QFY12.

Deteriorating visibility and concerns on orders justifies lower valuations: Capital goods companies under our coverage trade at 16x FY12E earnings (30% discount to its longterm average of 22.7x). The sector P/E, which is trading at a 13% premium to the broader BSE Sensex P/E (v/s an average 33% of premium over the last 5 years) has significantly eroded during the last one year due to growing concerns about slowdown in fresh order inflows. Despite attractive valuations, the sector is facing the dual risk of sluggish revenues on depleting orders and margin compression on account of high interest rates and slowing demand. We are Neutral on the sector and expect re-rating once there is visibility in government and private capex. Within the sector, our preferred picks are L&T, Cummins India and Havells India.

Company	Sales			Net profit
	Mar.12	% YoY	% QoQ	Mar.12	% YoY	% QoQ
ABB	20,820	15.9	-4	784	31.7	22.3
BGR Energy	11,195	-23.4	39.3	551	-43.9	0.6
BHEL	193,671	8.1	83.6	30,907	10.5	116
Crompton Greaves	31,993	10	5.7	1,876	-35.2	143.2
Cummins India	10,969	4.5	9.7	1,449	0.7	2.8
Havells India	10,526	25.2	17.5	983	42.1	24.6
Larsen & Toubro	188,857	22.8	34.9	14,342	-6.1	27.2
Siemens	32,215	3.3	33.3	2,575	-7.3	264.6
Thermax	17,627	-0.5	38.9	1,245	-1.6	30.4

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