Capex plans an early sign of capital goods sector's return to normality

The strong stock price momentum is now backed by improving fundamentals

One of the key indicators of corporate investment is a pick-up in the capital goods sector. Capital goods gain when there is capacity expansion, which is usually a signal of better demand. The capital goods segment has an encouraging performance in the Q2, 2021-22 and more broadly in the H1, 2021-22. While the two-year CAGR for the sector is still negative, there are signs that it is reverting to normality.

A study by Motilal Oswal Securities of eight large capital goods companies shows year-on-year (YoY) revenue growth aggregated to 15 per cent over Q2, 2020-21 and it was flat when the two-year CAGR was taken. This was the third quarter in a row, where double digit revenue growth was registered YoY and that is after four successive quarters of revenue contractions.

Although the spurt in Q1, 2021-22 of 37 per cent revenue growth can be attributed to a low base due to the crash in Q1, 2020-21, the final quarter of 2020-21 (Q4, 2020-21) and Q2 2021-22 are both encouraging.

The flat CAGR suggests activity is ramping back to pre-Covid levels (note these are nominal numbers. Adjusted for inflation, revenue would be lower than in 2019-20). L&T saw 12 per cent revenue growth YoY with flat two-year CAGR, while BHEL has a negative two-year CAGR and losses at the bottomline. Short-cycle businesses such as ABB and Cummins India reported better growth. KEC International also beat expectations.

However, higher commodity costs hit margins, alongside supply chain disruptions, especially in supply of chips. The aggregated Gross Profit growth was at 13 per cent YoY – lower than the topline growth. Aggregate adjusted PAT was also well above estimates, at 92 per cent YoY growth, with the only disappointment being BHEL.

Aggregate operating profit was up 40 per cent YoY, aided by strong growth across L&T, ABB and Cummins India. In L&T, growth was led by the infrastructure segment. Lower interest costs contributed to bottomlines, while higher operating leverage contributed to rising EBITDA. Operating leverage measures the likely contribution to profits from any revenue increase – the higher the fixed costs in relation to variable costs, the higher the operating leverage.

Order books seem to be recovering with order inflows up 64 per cent YoY and flat on a two-year CAGR. The low base effect contributed to the YoY improvement. Compared to the pre-covid period of H1, 2019-20, orders were at 80 per cent levels. Excluding L&T, order inflows increased 99 per cent YoY, indicating broader demand. There was a revival in orders across diverse segments such as Mining, Cement, Specialty Chemicals, Oil and Gas and the international Transmission and Distribution market. L&T is seeing 20 per cent increase in the infrastructure order pipeline.

The key challenges ahead will lie in managing working capital and liquidity, given the escalation in commodity prices. Banks are still cautious, and commodity price rises are hurting margins, although low interest rates have eased the financial environment. Given a rising pace of infrastructure tenders, the capital goods performance should remain robust across Engineering and Construction, Electrical Goods, etc.  

The 21-stock BSE Capital Goods Index has risen 103 per cent in the past year, comfortably beating the broad Sensex/ Nifty. In calendar 2021, it has risen 53 per cent while it is up 7.4 per cent in the last month. The strong price momentum is now backed by improving fundamentals.