Capital goods stocks: What next?

Mon, 24 Jan Pre-Open

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After two consecutive weeks of severe underperformance, Indian markets were back in the reckoning last week. While the overall gains for the Sensex were not so great in absolute terms, these were still much better than what the other key global markets clocked. The Sensex closed 0.8% up in a week when others like China and Brazil were down over 2.5%.

Among Indian stocks, those from the engineering and capital goods sector emerged as the key gainers during the week. This was largely due to a set of good numbers announced by leading engineering companies - BHEL and L&T - for the quarter ended December 2010.

Power generation equipment major BHEL, for instance, reported sales and profit growth of 25% and 30% YoY respectively. This was brought by a strong performance from its 'power' division where sales grew by 28% YoY. What is more, the company recorded an improvement in its operating margins led by a lower than expected rise in raw material costs. The company has benefited from high operating leverage given its scale of operations and a general recovery in the demand environment. Further, given its huge order backlog, the company also has a good growth visibility. What however worries us is the execution track record that has been weaker than what is expected from a mammoth like BHEL. The company has been accused to delay equipment deliveries for whatever reasons. The power ministry has in fact sometimes pointed fingers at BHEL's execution as one of the reasons why India continues to lag behind in power capacity expansion.

Anyways, talking about L&T, the company also recorded a decent performance for the quarter. While its sales grew by 40% YoY during 3QFY11, net profits were up 11% YoY. As against BHEL, L&T faced some pressure on its operating margins on the back of higher raw material costs. The company however continues to do well in its core engineering business. This was seen from a 42% YoY growth in sales from this business during the quarter.

Some other leading engineering companies like Crompton Greaves, Engineers India and Cummins are slated to announce their December 2010 quarter results over the coming few days. Looking at the results of companies like BHEL and L&T, it seems that the recovery has finally taken ground for India's engineering companies. The worrying part however is the rise in commodity prices over the past few months. The impact of the same is already showing on the margins of engineering companies. And the impact is only going to intensify over the next few months and quarters.

As far as valuations of engineering stocks are concerned, these seem to be already factoring a good medium term growth in earnings. As such, there are greater chances of a negative surprise for investors in these stocks. Just watch out and be cautious!