Are capital goods stocks really cheap?

Last Updated: Fri, Dec 28, 2012 04:07 hrs

Shares of capital goods companies are available for a song currently, as valuations crash. If one looks at the price/earnings multiples, then stocks like Bharat Heavy Electricals Ltd (BHEL), BGR Energy and Thermax might seem attractive but analysts say this would be akin to catching a falling knife. There could be further downside left in these stocks, as the worst is clearly not over.

The order inflow outlook for FY13 remains challenging and the second half of the year has not seen any uptick. In the first half, order inflows contracted by 57 per cent compared to the previous year. The third quarter has seen new orders of Rs 7,900 crore, which is a 91 per cent year-on-year fall. In the years preceding this slowdown, private sector ordering comprised 60 per cent of total order inflows of most capital goods companies. However, share of private sector is down to 30 per cent this financial year, indicating a sharp deceleration in ordering. Though the government is ordering, these projects are yet to get land and forest clearances. As a result, no benefit will flow into the companies in FY13. Espirito Santo's analysts say: "Issues surrounding improving domestic fuel supply, price pooling for imported coal and signing of FSAs continue to be an overhang." Most power projects in the country are stalled either due to fuel availability or environmental and land clearances. The power sector is a major consumer of capital goods. Currently, 58 per cent of power projects are stalled due to fuel linkages and 31 per cent are stalled due to land and environmental issues.

Undoubtedly, the government's reforms push has raised hopes, but with no new power projects being announced, ordering is expected to remain weak. Goldman Sachs says: "With continuing concern on no new power capacity being announced by the private sector, NTPC's capex plan over the medium term also may not be sufficient to boost ordering – many orders for capacity to be set up till FY20 have already been placed."

The revenues of leading capital goods companies are decelerating. According to IIFL Institutional Equities, consolidated revenue growth of the engineering and construction sector is consistently falling as execution of ongoing projects falters. With power sector customers delaying payments for long-gestation projects, capital goods companies like BHEL are going easy on order execution to conserve cash. Given the current logjam, the working capital cycle would continue to deteriorate, further impairing earnings, margins and return ratios, explains Espirito Santo. If order cancellations become a reality, then a further de-rating could happen.

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