Cautious on capital goods; buy L&T, Crompton, Voltas: Kotak

Lokesh Garg of Kotak Institutional Equities is cautious on capital goods due to a unstable environment existing in the sector.

In an interview to CNBC-TV18, Garg says that the sector's order inflows are likely to be weak for the next six to nine months. He adds that the investment made in various sectors need to be executed and made viable for investment to pickup.

Among the capital goods companies, Garg is positive on L&T based on the valuations as well as the diversified nature of the company. He has a target of Rs 1,600 on the stock.

"They have had decent momentum in order inflows so far in FY13 and in Q1 of FY14 as well which could remain sustainable considering that there is a very wide swath of opportunities, particularly now having added Middle East as a focus area into their business over the last two years," adds Garg.

Below is the edited transcript of Garg’s interview to CNBC-TV18.

Q: Your prime theme is that not just capex but even operational expenses is declining and that is likely to impact the sector. Can you just develop that thought for us?

A: What we are trying to say is that capex in some sense has not recovered at all. At this point of time, the trajectory actually maybe downwards. What we are essentially adding on top of that is the operational expenditure which should essentially reflect the strength of manufacturing. It is in a stagnant or a declining mode which essentially captured some numbers like bearings or abrasives which are essentially opex items and not quite capex items. Even these items seem to have entered a negative territory in the last few data points that have come out which essentially reflects the broader environment that we have been seeing. Some of these numbers have to stabilise before one starts to look for a capex recovery is what we are essentially trying to say.

Q: Your report indicates that you have pretty much split in half the amount of companies within the capital goods space. For example, Bharat Heavy Electricals (BHEL), Voltas and Crompton Greaves is on one end and Larsen and Toubro (L&T), Thermax is on another end. Can you just take us through the rationale and the key differences between these two variations that you are spotting?

A: The thought that we are trying to share with investors is that just as the broader market, even within the capital goods sector, companies are in two road buckets. The first is Crompton, Voltas and BHEL where there has been substantial earnings per share (EPS) correction and along with that, there is substantial valuation correction as well. So there,  both multiples as well as underline EPS has corrected significantly. On the other end of the spectrum is L&T, Cummins and Thermax where neither a significant EPS correction nor a significant multiple correction has happened.

This is just a reflection of the state of the market. This does not lead to any specific stock view per se. Essentially the fact that L&T, Thermax and Cummins have not corrected as much in terms of their multiples is also reflective of better management that we have seen from these companies over the last three years.

Q: Would you now have a buy on those three stocks or would you be more like hold?

A: At this point of time our overall call on capital goods in cautious because environment is still negative and has possibly still not stabilised. Within that space we are picking up names based on valuation and risk reward frameworks. The names that we are picking up for positive call at this point of time are L&T, Voltas and Crompton. Essentially we see enough safety in terms of valuations and numbers at this point of time in these companies.

Q: Would the rupee depreciation help these guys a bit? I know there are not any bids for them to compete domestically. Even then does the import competition get cut out and make life easier for them? Are they export competitive? Are they able to win orders or likely to win orders abroad?

A: We have seen some of the industrial companies scaling up export businesses meaningfully, for instance Thermax, Crompton. Maybe some of the smaller industrial names have been scaling up export businesses as domestic business seems to have become more sedate over the last two to three years.

However, this takes time because in each incremental country that one makes their presence in, one has to set up a service network, some kind of an installation base. So, it takes time.

We would expect that over a period of time these companies would actually scale up export businesses. Companies which are likely to do that strongly are essentially companies like Thermax, Crompton and Cummins in our view. Larsen is a project company. It is also scaling up business abroad, but I will not call that export. That is mostly project execution abroad.

Q: In terms of a longer-term outlook how would you be placed in terms of further project inflows? You have highlighted the risk of elections which has been highlighted by a lot of experts in the past couple of days as well. In terms of these particular companies what sort of risk do you think they will run in terms of uncertainty or project inflows etc.?

A: I think order inflows could continue to remain weak not just in near-term which is next 6 to 9 months, but also a little longer than that. The sense that we are essentially trying to share is that in lots of sectors wherein investments have been made, some of those investments are either not running or are not viable today. That sort of viability has to first get established, particularly in sectors like power for instance. Only post that could we start to see some investment pick up for some of these companies.

So, on an individual basis maybe there will be a few opportunities that these companies would get, for instance Thermax got a large one recently. But on a sector wide basis order inflow opportunities for some of these set of companies continue to remain quite weak and may actually remain so for a while.

Q: Can you give us what is your EPS forecast and price target for L&T? What are you expecting in terms of numbers this quarter from L&T?

A: We have a positive call on L&T at this point of time. This is primarily based on valuations as well as a very diversified nature of this company. Our price target or a fair value is about Rs 1,600. The stock is trading at Rs 1,400, so there is little bit of an upside there.

I think they have had decent momentum in order inflows so far in FY13 and in Q1 of FY14 as well which could remain sustainable considering that there is a very wide swath of opportunities, particularly now having added Middle East as a focus area into their business over the last two years.

We are atleast a little bit positive on L&T. In terms of numbers expectations of this quarter we are expecting 13-14 percent revenue growth. Last year was very weak in terms of margins which came in at only about 9 percent and we would expect slightly better margins at 9.5 percent this quarter. We are looking at a profit after tax (PAT) number in the vicinity of something like Rs 890 crore or so for this quarter in L&T.