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Capital goods: Execution always the key
Oct 7, 2008

Engineering companies are largely dependent on investment trends prevailing in their respective economies. When there in an upward trend in the economy, it is likely that companies from the capital goods and engineering sector will grow at a fast rate. And when there is a slowdown, growth is most likely to take a hit (as is expected now).

As far as India is concerned, the capital goods sector has seen tremendous growth over the past few years (see adjacent chart) in line with the strong growth recorded by the broader economy. Almost all the companies from sector have seen their order books swell during this period. This has been on the back of a strong investment cycle.

To give an example, PSU power equipment major BHELís order backlog has crossed the Rs 1 trillion mark (Rs 1,000 bn) by the end of the June 2008 quarter. Infact, the company still continues to rake in large sized orders on a regular basis. Its peers like L&T and Punj Lloyd are not lagging far behind (in terms of order book growth) as well.

  • Also read - Capital goods: Raking in big orders

    Order backlog to sales

    CompanyFY02FY03FY04FY05FY06FY07FY08
    BHEL 1.6 2.0 2.6 2.9 2.5 2.9 3.9
    L&T 2.2 2.0 2.0 1.5 2.0 2.5 2.5
    Punj Lloyd - - 1.5 1.8 3.1 3.1 3.0

    Execution rate

    Company FY02 FY03 FY04 FY05 FY06 FY07 FY08
    BHEL 63% 57% 46% 47% 51% 40%
    L&T 53% 59% 61% 68% 68% 59% 59%
    Punj Lloyd* - - - 73% 52% 98% 49%
    * FY07 witnessed a high rate due to acquisitions;
    Execution rate - Latest completed yearís sales divided by previous yearís order backlog

    Companies which had an order book to sales ratio of about 1 time, now carry ratios of anywhere between 3 to 4 times. What does this imply? Either their clients have enough faith in them to execute the orders on time despite their bulging books. Or there arenít enough players in the market and as such a large number of orders are won by either a single or very few companies.

    In our analysis of capital goods companies, we have always advised investors to consider the execution risks attached to large order backlogs. We have argued that basing an investment only on the back of a companyís backlog is fraught with risks, given that orders take multiple years to convert to revenues. For instance, in case of a company like BHEL, average order execution period ranges from 24 to 48 months and sometimes going to as long as 5 years.

    Execution risks include all aspects such as delay in procuring equipments, manpower, raw material, change in order specifications from clients and cost escalations. As most of the projects have long gestation periods, it is pertinent to factor in such issues before taking an investment call on a capital goods stock.

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