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Capital goods: Outperformer! - Views on News from Equitymaster
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  • May 31, 2005

    Capital goods: Outperformer!

    As the Indian stocks markets try and come to terms with uncertainties regarding the monsoons, movement of global commodity prices, the US interest rates and Foreign Institutional Investors (FIIs) inflows, there is one sector that has withstood the pressure and has shown a remarkable performance. It is the capital goods sector and the buoyancy is well indicated by the movement of the BSE capital goods index, which has outperformed the other key sectoral indices (see chart below).

    The buoyancy is, however, not without reason. Let us look at the key reasons why engineering stocks are having a gala time on the bourses.

    Deregulation benefits in the power sector: Power sector contributes the largest to the engineering companies' revenues. For instance, ABB and BHEL derive 60% and 69% of their revenues from supplying equipments to the power sector. And with the government clearing the blueprint for adding 100,000 MW in the tenth (2002-07) and eleventh (2007-12) five-year plans, the potential seems high for the engineering majors. This is because, apart from the investment of Rs 4,000 bn (or Rs 40 m per MW) in generation capacity buildup, an equivalent amount is likely to be spent in the transmission and distribution space as well. Investors however, need to practice caution on this account, as we have been 'consistent' in missing our targets of generation capacity additions in the past. For instance, while China, with a capacity of 380,000 MW adds around 30,000-40,000 MW per annum, the Indian power sector's average is just around 3,500-4,000 MW!

    Government's increased focus on infrastructure development: Infrastructure is another key area of operation for major Indian engineering companies. L&T, for example, garners around 35% of its sales from infrastructure activities like engineering, design and construction of industrial projects and social & physical projects like housing, hospitals, IT parks, expressways, bridges, ports, and water & effluent treatment projects. In the recent budget, the government had outlined an investment of Rs 100 bn (US$ 2.3 bn), through a special purpose vehicle, to finance infrastructure development in the country. While this is a step in the right direction, the corpus of investment outlined is not enough to match the growing needs of a developing country like India. In order to sustain a growth of 6%-7% in the long-term, we need to raise infrastructure spending to around 10% of GDP, or US$ 50 bn per year! If this were to happen, investors in engineering stocks will have more reasons to cheer.

    High oil exploration and production activities: The high global crude prices on account of growing demand has led to increased activities in the exploration and development space. This has helped the engineering companies in this space. More importantly, this segment of the engineering business has relatively higher margins than infrastructure owing to more complex engineering tasks involved. Increasing contribution from this segment will, thus, help engineering companies improve margins that have been under pressure from high global commodity prices and cutthroat competition.

    So, what lies ahead?

    While the above factors enthuse us to be buoyant on the Indian engineering and power companies, the same is not without its share of concerns. These include global slowdown, uncertainty about global commodity prices (inputs for companies), intensifying competition with new global entrants, and above all, the interference of politics in economics that has slowed down progress in the past. Another factor for investors to consider is the fact that valuations of these majors are already factoring in a lot of their future potential. So any investment in this sector has to be a long gestation one.



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