Capital goods expensive now, rally on poll hopes: Experts

The capital goods sector rallied 8 percent in the week gone by, but Sanju Verma, Group CEO, Violet Arch Capital, feels the rally was overdone. Companies like Voltas are now hugely expensive, she says. She explains: "Order book to sales for most capital goods companies has always been pretty healthy, anywhere between 2.5-3 times revenues. But the working capital cycle is still under tremendous strain."

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Also, the Q2 numbers show that the results have been polarised within a given sector between stocks, she says. She believes that for sometime more it will continue to be a stock pickers market.
She continues to remain bullish on stocks IT like Tech Mahindra. It has reported a compounded quarterly growth rate (CQGR) revenue 4.6 percent in dollar terms in the last six quarters, which is excellent. She is also positive on the metals space.
Manish Sonthalia, Motilal Oswal AMC, on the other hand believes the entire premise of the capital goods rally is hope and sentiment change. Markets are trying to read a change in the investment cycle post the incorporation of a new government and most people are by and large expecting that there will be a change of guard at the Center. He says the company would take a call on whether it wants to increase its exposure to the capital good space or not after December 8.
At the moment, the company is sticking to midcaps that are already a part of its portfolio. It is continuing to buy Eicher Motors even at current prices. One of our stocks which was lagging behind was Voltas, it has started moving up. He is basically betting on quality names, with unlevered balance sheets, good managements, growth visibility of at least 15-18 percent over the next two-three years. Below is the verbatim transcript of Sanju Verma & Manish Sonthalia’s views: Capital good rally Sanju Verma: The rally in capital goods has been overdone for instance, example: Voltas, which has had a brilliant rally. But I would be very wary of trying to accumulate the stock at current levels of Rs 111 because it is ridiculously expensive at around 11.5 times EV to EBITDA and a price to earnings of somewhere between 14-15 times.
September quarter numbers were excellent with net profit growth coming in at more than 40 percent year on year, but the point is some of these structural problems for the capital goods space will continue to remain. Voltas really got legs on the rally when there was an announcement a couple of weeks back that it had announced acquisition of overseas orders to the tune of Rs 1,000 crore from some of the Middle Easter markets. But what people fail to understand and realize is that the rally will sustain going forward only if the order book inflow translates into execution. Even today a large part of the international order book with respect to Voltas is low end low margins, back-ended and the execution cycle is very slow. So its obvious what is happening in the larger capital goods space - be it Larsen and Toubro (L&T), Bharat Heavy Electricals (BHEL) or Voltas.
It is one thing to acquire orders, have a good order inflow and it is another thing to execute them. Order book to sales for most capital goods companies has always been pretty healthy at anywhere between 2.5-3 times revenues. But the working capital cycle is still under tremendous strain; for instance look at BHEL, we have seen so many brokerage reports from competition saying this is a buy. Why would you want to buy a company like BHEL which has Rs 20,000 crore plus in terms of receivables and Rs 8,000 crore of debt on its books and the cash is increasingly deteriorating from Rs 6,000 crore a year back to less than Rs 4,000 crore now.
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Our markets have always been very bottom-up irrespective of what the Gross domestic product (GDP) numbers come in at. The fact of the matter is that for some time more this will continue to be a stock pickers market. Even if you look at the Q2 numbers, results have been polarised within a given sector between stocks. So while you had an ITC within the FMCG space, which disappointed and how with net sales growth number of just 8.8 percent, the lowest in the last so many quarters.
You had a Britannia which outdid the most optimistic analysts expectations, but the fact of the matter is that not only did the company notch up a 100 percent plus growth in profits, but also a 30 percent plus growth in return on equity and return on capital over the next two years. It is perhaps one of the few FMCG names that will continue to notch an 18 percent CAGR growth in revenues over the next two years and anywhere between a 30-35 percent CAGR growth in profits. Britannia still has steam to go up all the way to Rs 1050 odd taking a pause.
So, the results have clearly said one thing very clearly that going forward it is not going to be a top down call, it is not going to be a sector call either, it will be very much within sectors you will have to do homework and you will have to do a bit of teeth grinding before you go and take the plunge.
For instance the Power Grid FPO, I may not be a great optimist on the sector, but if you look at the FPO, if you are somebody who is risk averse then the best thing is to either avoid or buy December Put Option because when you buy a put Option there is certainty of a positive payoff and you can buy a Put Option by just paying a premium of Rs 3-4 a share to the current stock price which has been hovering in the Rs 94-95 levels. But if you are somebody who is risk prone then buy the call Options, sell the December Futures and invest in the FPO and there is a good chance that you might make 6-7 percent in just one month. So the strategy has to be tweaked based on the risk appetite and whether the horizon is immediate one-two months or do you care for more but over the medium to long term. Metal watch
Chinese demand is not gung ho and it will take a while before that materially translates into better Aluminium prices on the LME. Aluminium prices have actually fallen even further to USD 1745 but for September quarter it was already at a four year low of USD 1780 which was 7 percent lower than last year’s USD 1910. So there has been a secular decline and it doesn’t look like it is going to stop in a rush.
Now the reason why I am positive on metals is because I believe that you cannot look at Hindalco just standalone. True these standalone numbers - Indian operations will continue to disappoint for a while but the reason why we are bullish on Hindalco Industries is the fact that people simply seem to have forgotten that Novelis is a large part of their business and Novelis results were excellent despite aluminium prices being soft. Novelis threw up free cash to the tune of USD 178 million and EBITDA to the tune of USD 228 million. And I think the fact that Novelis after many quarters has turned free cash flow positive, I think that dwarfs a lot of other negatives with respect to Hindalco standalone domestic operations.
The other key is going forward the international operations will continue to throw positive surprises because while the North American market, which is a large part of the global demand for Novelis, continue to be sluggish, Novelis has really ratcheted up its act in South America. It is expanding automotive finishing capacities globally, its share of value added businesses is increasing. So I won't be surprised if over the next three-four quarters you see the company doing an EBITDA per tonne of something like USD 350-360/tonnes which is what they did a year back.
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Coming to Jindal Steel and Power Limited (JSPL), this is a slightly riskier bet because the government a couple of weeks back deallocated 11 coal blocks and some of those obviously belong to JSPL. But the reason I am positive on this company is that despite the fact that here is a company which has net debt to EBITDA of 1.1 times, is that a reason to be alarmed, yes, but that is not a reason to panic. More so here is a company which every quarter throws up free cash profits of something like Rs 1000 crore and I would give them a lot of marks for their strategy which is on the right track.
It was a brilliant move to acquire 52 percent in Gujarat NRE Coke with 650 million tonnes of coal reserves. Gujarat NRE Coke just produces 1.5 million tonnes and JSPL has said over the next three-four years they will ramp up production to 5-6 million tonnes. I also believe that while FY14 profit numbers for JSPL will be pretty much pedestrian in the region of Rs 3200-3300 crore which is flattish over FY13, FY15 will be a game changer. I wouldn’t be surprised if on the positive side they do something like Rs 4400-4500 crore and on the conservative side they do something like Rs 3800 crore, which means they could easily do 34 percent in terms of profitability growth over FY14 and conservatively speaking they will at least do 18-19 percent.
I wouldn't really read too much into the fact that their Chhattisgarh coal blocks are under the scanner because that in any case does not account for more than Rs 15-16 per share. But the reason I said this is a risky bet is because this stock has seen a lot of volatility if compare from last year to now. All in the price Manish Sonthalia: I think most of the negatives are there in the price of all the capital good companies, you know everything about the deteriorating working capital cycle, the Index of Industrial Production (IIP) numbers are showing decrease in capital goods even on a lower base etc but everything is there is the price. So the short point is markets are trying to read a change in the investment cycle post the incorporation of a new government and people are by and large expecting that there will be a change of guard at the Center that is the entire premise on which the capital goods space is moving up, hope and sentiment improvement.
I think a confirmation of this from my end whether we want to increase the exposure on the capital goods space would only be known may be after December 8 if you have a better election results. Then there could be definitely a phase of moving into some of the investment related themes. But as of now I am just giving it a pass as far as the capital goods space is concerned, they have rallied but we are just not increasing exposure to capital goods space and the infrastructure space or the real estate space just yet.
One of our stocks which was lagging behind was Voltas, but it has definitely started moving up. Reverse gear
I am not a great fan of the tyre industry because it is a play on rubber prices so stocks like MRF, JK Tyre, all these names have seen a very big cyclical move from when the rubber prices started correcting. So on a structural basis one auto ancillary that we like is Bosch. Even though environment is very tough the commercial vehicle segment is down some 30 percent but even then they have been able to grow their top line by 5 percent and due to the non automotive side of business doing well and they have been able to maintain profits somewhat given the tough environment. So on structural basis we like Bosch in the auto space.
On the OEM side, Maruti Suzuki looks good, yen depreciation is helping things, margins are going to be better than what people are thinking. Tata Motors again a China play expecting somewhere like 4.70 lakh JLR volumes in FY15. So these are the top favourite rural themes. Hero MotoCorp that is one of our old favorites, we continue to like that as well.