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Identifying an engineering stock- Do's and don'ts - Views on News from Equitymaster
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  • Aug 16, 2003

    Identifying an engineering stock- Do's and don'ts

    If one were to consider one of the biggest beneficiaries from any country's infrastructure sector development, engineering companies have a vital role to play. As in any other sector, choices for a retail investor are high for an equity investment. However, it does that mean each stock in the sector is a BUY? In this article, we have tried to discuss the dynamics of this sector and the key aspects that one should look in, before selecting an engineering stock.

    Engineering, as a sector, has many facets. A company from this sector can be an equipment manufacturer (like transformers and boilers), execution specialist (say Bharat Heavy Electricals Limited (BHEL), Larsen & Toubro (L&T), Engineers India) or a niche player (like Thermax in environmental solutions, Voltas in electro-mechanical projects, ABB for automation technologies and so on). To define the user industries in broad terms are power utilities, industrial majors (refining, automotive and textiles), government (public investment) and retail consumers (pumps and motors). Thus, every company has a specific role to play in the industry and are looking forward to cater a specific target market. Given this backdrop, prospects of a particular company in the engineering sector have to be viewed with respect to the specific user industries. So, if the engineering sector does well, not all companies stand to benefit in equal proportion.

    When will an engineering company grow? It is highly dependent on the level of private and public sector investment in the economy. When investments in capacities and infrastructure gains momentum, more jobs are created and demand for goods in general increases. This in turn leads to higher economic growth. Historically, the growth of the engineering sector has been sensitive to economic performance (as is evident from the graph below). The industry is relatively less fragmented at higher end, as competencies required are high. It is therefore that the barriers to entry are also high. But in some cases, competition is also global in nature (like dam construction, roads, refineries and power plants).

    Let's have a look at the demand drivers for this sector

    Order Book

    An engineering company can derive revenues from domestic as well as global markets. Usually, there is something-called order book that is declared by most of the companies in its annual report. This is nothing but the quantum of projects that have been won, but are still to be executed. Therefore, order book position indicates the future growth prospects.

    Domestic market
    The power sector accounts for approximately 60% of total revenues for this sector. Therefore, growth in power capacities is very important for engineering companies. So let's have a brief look at key fundamental factors that influences power sector performance.

    Historically, politics have played a vital role in shaping the power sector as opposed to economics (profitability in easy terms). What a retail investor has to keep in mind is that power capacities will only increase when there is a political will to charge consumers for what they consume. Industrial sector pays higher tariffs while agricultural sector derives power free of cost. This is the root cause for the poor financial health of the SEBs (state electricity boards).

    SEBs are financially weak and private sector have been reluctant to invest, as they are apprehensive of receiving money for the quantity of power supplied to the SEBs. Retail investors have to keep in mind that India is power deficient (demand is more than supply). The simple way to gauge growth of a engineering company that is targeting the power sector is to understand what kind of capacity SEBs and private sector players are planning.

    It costs Rs 30-35 m to set up one MW of power capacity. If a player is planning to set up a 1,000 MW plant, then the project size could be around Rs 30 bn to Rs 35 bn. This could be assumed roughly as the potential addition to the order book. If public sector power majors are expanding capacity, then it has to be borne in mind that public sector engineering companies benefit the most (as a matter of preference).

    Industrial and Infrastructure spending

    The industrial sector contributes around 30% of the total revenues of engineering sector. The demand from this segment largely depends on GDP growth, which in turn is a function of the quantum of infrastructure spending and capacity expansion plans of corporate India.

    A lot depends on government policies. Formulation of policies favorable to industrial sector can boost the investments and expansion plans for both private and public sector companies. Talking of policies, when government increases participation of foreign companies in infrastructure development, the sector gets a fillip. Demand growth in this sector is fuelled by expenditure in core sectors such as power, railways, infrastructure development, and private sector investments and the speed at which the projects are implemented.

    The topline trends of major engineering companies since last five years have shown a high degree of correlation with the IIP (Index of Industrial Production) growth. Thus a fair idea can be taken about the sector looking at the IIP growth. Lets look at the correlation in the graph below.

    While an engineering company from India could tap global markets for contracts, there is a vast difference when it comes to competitors. Players like Bechtel and GE have muscle power and have executed projects on a global scale. This is one of the reasons increasing contribution from international markets is not easy for any company. Retail investors have to tread with caution on this front. Due to intense competition in the international arena, suppliers do not enjoy much bargaining power.

    Moreover, in order to win big contracts you need to have big balance sheet size, because only some part of entire contract money is paid up front and rest comes after installation of project. Moreover, in some cases, the engineering company buys stake in the projects during the financial closure.

    Key points to be kept in mind before investing...

    • Order book and operating margins: Order book, as we had said earlier, indicates a company's standing in a year in terms of future growth in revenues. A consistent rise in order book on a year on year basis (and not quarter on quarter) is also vital. Though order book may be huge for a company, it has to be remembered that operating margins are low in projects. In a downturn, operating margins of an engineering company comes under pressure. If a company acts as an engineering agency (i.e. buys and installs equipment), margins tend to be on the higher side.

    • Balance sheet size: One should look at the balance sheet size of the company. It will tell you whether company is capable of bagging and executing big contracts. In order to win big contracts and execute them, company needs huge working capital. In this case, past track record of projects executed could be useful (available in the balance sheet).

    • Revenue growth: Usually, an engineering company derives a large share of revenues in the third and fourth quarter. So, quarter on quarter comparisons is meaningless in this sense.

    • Valuation ratios: One of the key factors used when it comes to putting a value for an engineering company is market capitalisation to sales. Why the emphasis of assigning a value to revenues and not to earnings? The ability to grow for any engineering company is dependent on the kind of order book, which then translates into revenues. Internationally, the average of 0.4 times to 0.5 times is a benchmark. If price to earnings is used, it has to be remembered that the sector is highly dependent on the economy. So, a P/E in line with the long-term economic growth could be useful.

    Apart from what all has been said above, investor needs to look at the past record of the management, its vision and its focus on business. After all it's the management of the company who is the final decision-maker and the future of the company solely depends on the decisions taken by it.

    Click here to identify stocks from other sectors.

    Related Links for Engineering Sector: Quarterly Results NEW | Sector Analysis Report | Sector Quote | Over The Years



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