• JULY 10, 2013

Do recent order inflows in Capital Goods give hope?

The Indian Capital goods sector has been under pressure for more than two years. Many factors can be attributed to slow pace of growth of this sector. These include lack of policy reforms, lack of investment in power, steel and oil and gas sectors. Power, which is the major contributor to order book of capital goods companies, has been clouded with coal supply, land acquisition and environment clearance issues. Naturally, the capital goods index has underperformed BSE Sensex. In FY11, FY12 and FY13; BSE-Sensex delivered annual returns at 9.9%, -10.4% and 7.8% respectively while capital goods index delivered negative annual returns at -7.3%, -24.9% and -11.6% respectively.

What role do order inflows have to play?

Decline in order inflow is the first sign of trouble for any capital goods company. Order inflows are often regarded as the key growth driver for the capital goods stocks. Order inflows are generally a mirror to the company's business strength. For instance, even if the order book of a company is growing but if its order inflows are not growing more than sales or are not in tandem with sales growth, chances are that sooner or later, order book and sales will also start to decline. Unfortunately, order inflows for majority of the capital goods companies have either remained subdued or volatile over the years.

Order inflows of major capital goods companies have been volatile
Inflow in Rs bn4QFY133QFY132QFY131QFY134QFY123QFY12
BGR Energy22151937017
KEC Intl172340201825
Jyoti Structures141598 5
Source: Company, Press releases

In capital goods sector, few companies make announcements for some of the orders as they are received. This information is given on their company websites and on bse. This helps us gauge the order inflow situation regularly even before the quarterly/yearly results are declared. A look at announced order inflow of these companies gives us an estimate of how the actual total order inflow scenario is expected to pan out for these firms.

What do recent order inflows say?

Looking at the chart below, one can observe that Larsen and Toubro (L&T) has bagged few substantial orders. Earlier L&T's total announced to received order inflow ratio was 60% on an average. However, over the last two quarters; mere 25-35% of its actual inflows have been announced. Considering that, 1QFY14 could well be a really good quarter for the company as L&T has already managed an order inflow of Rs 212 bn. Also, in recent times, the engineering sector has witnessed some traction in big ticket orders particularly in Hydrocarbon and Dedicated Freight Corridor (DFC) space. For instance, L&T has received an order of Rs 67 bn from Dedicated Freight Corridor Corporation of India Ltd. (DFCCIL). This order has been won under a consortium of L&T with Sojitz Corp., Japan.

Source: Company, press releases

This is an EPC order which constitutes construction of 626 km of a double track corridor from Rewari in Haryana to Iqbalgarh in Gujarat, via Rajasthan. Apart from L&T, Jyoti Structures, Punj Lloyd and Thermax shall also have better order inflows. Thermax has recently won an order of Rs 17 bn from a petrochemical company. The project includes design, manufacturing and commissioning of 9 CBFC high pressure boilers. The execution period of the project is 25-29 months. BHEL, on the other hand, has not announced any order recently.

Tight liquidity and high cost of funds discourage industry players and developers to expand capacity; even if there is a need for one. As a result, all the equipment manufacturers have to compete for a pie of small number of orders floated in the market. Although, one comfort could be that many established companies are exploring international markets to overcome the dry spell of domestic orders. They currently have an advantage of the depreciating rupee also. However, in international markets like Middle East and Africa, companies from China, Europe and America are also vying for orders; thus making the competitive landscape even harder.

Therefore, looking at the current scenario, we do not see any major recovery in order inflows. Also, ordering activity is likely to slow down in the near term. This is because, at the time of elections; corporate refrain from awarding new orders. This may go on for at least couple of quarters after election as well. Hence, overall, barring few major order wins by L&T and Thermax, order inflow scenario is expected to remain weak for a few more quarters.

What should investors do?

While a decline in order inflows may be an indication of temporary slowdown in the capital goods sector, it is not a very good reason to sell all stocks in the sector. On the contrary investors must remember that some engineering companies do have a very healthy order back log which indicates good revenue visibility. And it is only a matter of few quarters before they start accruing more orders on their books. Hence the attractive valuations during the times of such pessimism could offer few good long term buying opportunities.

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