Capital goods manufacturers are caught between a rock and a very hard place. On the one hand, order flows have dried up, and on the other, prohibitive interest rates are delaying execution of existing orders. High interest rates are eating into the earnings of companies, more so the medium-sized ones. Number-crunching done by IIFL’s analysts shows that interest costs as a percentage of operating profit were at 87 per cent for mid-cap contractors in Q2 FY13, compared to 61 per cent a year earlier. If costs spike by another 100 basis points, these companies will start making losses. This possibly explains the sharp slowdown in order execution seen across the board. Be it the big boys or the smaller contractors, high cost of funding has skewed the math of most projects.
In recent times, however, the market has shown a lot of interest in the capital goods sector on hopes of a possible revival. Over the last three months, the Sensex has returned 3.7 per cent, while the BSE Capital Goods index has returned 6.1 per cent. The tide may take a little longer to turn. Barring some traction in the metro rail projects and the construction space, fresh contracting in the engineering and construction space remains weak. Consolidated revenue growth of the sector is falling consistently as most players, even the large ones, are going slow on existing orders for fear of non-payment or order cancellation. Also, those banking on overseas markets are not likely to benefit as demand remains soft even in those markets.
While the going seems rather rocky for mid-cap players, the large companies are holding on to margins and some even to revenue growth, as these are longer gestation projects that they had bagged earlier. Larsen and Toubro (L&T) has maintained margins primarily because nearly 55 per cent of FY13’s revenues would come from orders won in H2FY11. It’s the same story for Bharat Heavy Electricals Ltd.
New project announcements have gone back to 2004 levels, according to the Centre for Monitoring Indian Economy. The only segments where the order flow is looking promising are the short-cycle orders and transmission and distribution orders. The number of projects shelved has also come down in the second quarter of FY13 from the highs it touched in the corresponding quarter last year. L&T has surprised the Street by reporting a 30 per cent year-on-year growth in order flows, driven by infrastructure segments. Thermax has also managed to put up a strong performance in this environment, says Prabhudas Lilladher. Though recovery is expected to be slow, analysts expect the second half to be relatively better.