Sunny days are here again

With investors staying away due to low demand, leveraged balance sheets and policy issues in user industries such as power, the capital goods sector has been a severe underperformer. So much so that its weight in the Sensex dropped to 4.8%, the lowest in a decade. Moreover, the sector is currently trading at 2.5x (price to book value), which is a 42% discount to its 10-year average of 4.3%.

However, the pall of gloom is likely to lift, with L&T igniting hopes of a revival. During its March quarter result, L&T guided for a 15% growth in order intake this fiscal, a 50 basis points improvement in margin and 12-15% growth in revenues. Post the announcement, the BSE Capital Goods index has gained 15%, outpacing the Sensex’s 6% return in the period. 

The order pipeline is also providing some respite. For instance, the aggregate order book of top 10 sector companies grew 7% year-on-year in the March quarter. As against the 18% decline in Q1FY16 and 31% decline in Q2FY16, order flows grew 6% in Q3FY16. Further, CMIE data suggests that there was a 12% hike in new investment announcements in the quarter. 

Stalled projects too have started moving. From Rs.1 lakh crore in December 2014, such projects have dropped to Rs.40,000 crore. This is reflecting in sales growth, which has started to stabilise after a gap of almost three years. The order book to sales ratio (an indication of the work in hand compared to annual revenue) has shot up from 2.4x in Q4FY14 to 3.1x in Q4FY15 and 3.3x at the end of Q4FY16, signaling good future demand. 

While segments such as power generation and industrial capex are yet to show revival in orders, sectors such as power, railways, defence, oil and gas, water and transportation has seen good uptick. Companies such as KEC International, Kalpataru Power, Bharat Electronics, ABB, Siemens, Crompton Greaves, VaTech Wabag, L&T among others thus have been able to grab opportunities. 

Besides, the Ebitda margin for the top 10 companies has improved, rising to 11% in Q4FY16. It had nosedived from 12% in Q4FY15 to 1.3% in Q3FY16. 

The bottom-up analysis also suggests that the impact of lower commodity prices, reduction in interest costs and economies of scale should start to reflect in the companies’ profitability, helping margin recovery. To put things in perspective, Motilal Oswal expects its cluster of 15 capital goods companies to report 70% earnings growth in FY17 and 15% growth in FY18. Similarly, broking house Axis Capital expects its clutch of 13 companies to grow earnings by an average of 34% in FY17 and 28% in FY18. 

Adding to the possibilities, as per government estimates, capital good companies are operating at 60-70% of their capacity. So, additional operating leverage due to higher capacity utilisation and margin expansion will mean that the era of capped returns might just start to fade.