Capital goods and engineering: Early indications of bottoming of cycle

Orders are improving, cost inflation and supply chain issues are among potential headwinds

The capital goods and engineering sector is often a laggard in cyclical terms. These businesses are working capital intensive, and relatively long-gestation. Orders come in only when there’s significant corporate investment, which happens only when corporates are confident of strong future demand.

The order book for Indian engineering and capital goods firms may be due for improvement. There’s more order inflow. But there are headwinds in the form of inflation hitting raw material and finished goods costs, and also supply chain issues in vital areas such as semiconductors.

Operating margins for some companies dipped in Q3, 2021-22 but this sector could be nearing the bottom of the cycle in terms of profits. Similarly, bank credit offtake was quite low. Again, while this signals low private sector investment, it could be nearing the bottom of the cycle.  

A trend of domestic industrial automation & electrification should favour companies like ABB, Siemens and Hitachi Energy while L&T, and BEL (Bharat Electronics) are among others that could register healthy returns. The order book growth has been strong for KEC International, Thermax and Siemens with L&T and ABB seeing acceptable growth in orders.  

Emerging domestic segments such as data centres, electrical vehicle infrastructure, Metro systems, etc., are some areas registering new order flows. The key to growth would be a continuation of the government’s thrust on infra development as envisaged in the Budget and a pickup in private capex.

A quick review of several prominent firms follows. BHEL could see a positive rerating of valuation given that it’s a turnaround, moving from loss in Q2 to profit in Q3 of FY22. L&T has grown EBITDA and PAT by double-digits in sequential terms. Siemens has margin contraction QoQ. ABB has excellent revenue growth and slightly better margins QoQ. Cummins has small sequential revenue growth.

Thermax has revenue growth but PAT dropped under margin pressures. KEC International saw both revenue drop and lower margins. BEL has a big jump in revenue and margins YoY but it has seen some margin erosion QoQ. Engineers India has a poor performance YoY but it has improved QoQ in both revenue and margins. Honeywell has a similar poor performance in YoY terms but improved revenue and margins QoQ.

In terms of valuations, the current PE is high (40 plus) or very high for ABB, Honeywell, Siemens Thermax and Crompton Greaves. BEL and L&T are in the late teens and early 20s and BHEL is around PE 24. Bloomberg consensus suggests significant EPS estimate upgrades for BEL and Cummins.

BEL and Cummins have both outperformed in the last month – indeed Cummins has gained, while major indices have lost ground. Siemens has also shown counter-cyclical strength, going up 4.5 per cent while the market dropped 3.6 per cent. Crompton has underperformed in the last 12 months but has shown strength in the last 30 days. BHEL has taken a hammering – it’s down 17 per cent. Thermax has a good 12 month return but it’s down 11 per cent in the last month.

This is a sector, which is quite exposed to cyclical considerations and it may suffer as sentiment is hit by the Ukraine war. But if domestic growth holds up, valuations could start looking attractive for some corporates.