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Engineering: King in good times! - Views on News from Equitymaster
 
 
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  • Dec 30, 2005

    Engineering: King in good times!

    Introduction
    Investors in engineering stocks could not have wished for a better year than 2005, which saw stocks from across the sector breach into stratospheric territories. Against Sensex gains of 44% the BSE capital goods index rose by a whopping 92% during the year. While companies recorded strong order book positions, margins also improved, though marginally, on the back of cuttings on staff costs and decline in global commodity prices. The year marked intense competition for orders and talent, the latter leading to increased attrition levels across the sector.

    What was different in 2005 as compared to 2004?
    Not much, really! While 2004 marked the beginning of good times for the engineering sector, 2005 marked the continuation of the same. Despite increased competition, companies across the sector benefited from the upturn in capex cycle. Growth was in abundance for engineering companies serving across the spectrum of industries – power, infrastructure, hydrocarbons and defense, among others.

    Power sector, once again, was the biggest contributor to the burgeoning order books of the engineering sector. Apart from power generation, large-scale investments were also seen in the power transmission and distribution (T&D) networks and equipments, with companies like ABB (61% revenues from power) and BHEL (73%) being among the biggest beneficiaries.

    Construction and infrastructure was another key area of operation for major Indian engineering companies. L&T, for example, garnered 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. Another segment that witnessed increased engineering activities was energy exploration and production (E&P), where investments were fueled by high global crude prices.

    The years 2005 also saw increased forays by Indian engineering companies into the global territories, especially the Southeast Asian and Middle East regions, which are seeing a boom in construction led activities.

    The sector outperformer: ABB
    Transmission and distribution equipment major, ABB, stole the limelight in 2005 with the stock more than doubling over December 2004. Continued strength in the capex cycle, whereby the Indian power transmission and distribution (T&D) and industrial sectors are witnessing increased investments, has helped the company post a string of robust performances over the past few quarters. At the end of 9mCY05, the company’s order backlog stood at Rs 20.8 bn, which is almost 90% of its CY04 revenues. We believe that acceleration of the reforms process, corporatisation of SEBs, the Electricity Act of 2003, the ongoing APRDP (Accelerated Power Reforms & Development Program), focus on reduction of transmission and distribution (T&D) losses, the adoption of new IT based technologies and the development of the national transmission grid, continue to offer good growth prospects for ABB going forward. The company is also playing an increasing role in the parent, ABB Group's regional and global operations and is currently recognised as one of key growth engines globally.

    Engineering: Key gainers in 2005
      23-Dec-04 23-Dec-05 % Change
    Bharat Earth Movers 348 1,001 187.7%
    Siemens 1,315 3,630 176.1%
    Crompton Greaves 284 757 166.6%
    Wartsila India 187 461 146.6%
    Engineers India 334 685 105.1%
    ABB 987 1,988 101.4%
    BHEL 732 1,397 90.8%
    L&T 975 1,732 77.7%
    Atlas Copco 733 1,252 70.7%
    Thermax 544 915 68.3%

    What to expect in 2006?
    We expect continuance of the robust growth for engineering companies in 2006 as well. Power sector is likely to contribute maximum to this growth. 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.

    Also, in the latest 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, we believe that 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% to 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.

    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 the potential 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 in 2006 has to be with utmost caution and from a long-term perspective.

    To read our thoughts on year 2005 and our view for 2006, click here - Reflections 2005.

     

     

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