X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Identifying an engineering stock- Do's and don'ts - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • 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.

    Profile
    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.

    Exports
    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

     

     

    Equitymaster requests your view! Post a comment on "Identifying an engineering stock- Do's and don'ts". Click here!

      
     

    More Views on News

    BHEL: Margins Dip into the Negative (Quarterly Results Update - Detailed)

    Aug 14, 2017

    The company also saw order inflows of Rs 18 billion during the quarter, which was a massive 41% YoY lower than the previous year's quarter.

    Cummins Ltd: Domestic Revenues the Saving Grace (Quarterly Results Update - Detailed)

    Aug 14, 2017

    The domestic economy continues to grow largely in areas which are positively impacted through continuing government investments in infrastructure.

    ABB: Large Orders Remain Muted (Quarterly Results Update - Detailed)

    Aug 2, 2017

    Decisions on government initiatives and private investments were stalled in anticipation of upcoming tax restructure.

    L&T: Amidst a Challenging Business Environment (Quarterly Results Update - Detailed)

    Aug 1, 2017

    Bank credit to industry remained muted and investment momentum was driven mostly by public sector spending.

    L&T: Private Sector Capex Remains in a Tizzy (Quarterly Results Update - Detailed)

    Jul 24, 2017

    Vast majority of private players remain more concerned with debt payback rather than starting new projects.

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

    Aug 10, 2017

    Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE CAPITAL GOODS


    Aug 18, 2017 (Close)

    S&P BSE CAPITAL GOODS 5-YR ANALYSIS

    COMPARE COMPANY

    MARKET STATS