Can the capital gains continue?

The growth story in capital goods sectors remains intact but the breathtaking run in the past couple of years makes stocks vulnerable to disappointments

A major thrust on improvement in the country's infrastructure ranging from basics like roads and railways to the development of ports, has meant boom-time for the capital goods sector.

Add to this the urgent need to fulfill energy requirements, especially in the power sector, and the various capacity expansions planned to sustain a high level of economic growth, the message is loud and clear: the big machine makers will continue to be the most sought after companies for the next couple of years, at least.

The question haunting investors however is whether the growth rates of the past year are sustainable. And even if they do, can this translate into share price gains? The worry is not unjustified. The capital goods index has outpaced the broader BSE Sensex by a significant margin during this rally.

Since January 2004, the BSE Capital Goods index has gained 202 per cent while the Sensex has gone up 71 per cent.

More importantly, key stocks seem to be counting on growth rates of over 30 per cent in the coming years as reflected in their trailing 12-month price-earnings multiples "� Larsen & Toubro (37.08x), Bharat Heavy Electricals Ltd (32.21x), Siemens (53.79x) and ABB (46.99x). Based on FY07 estimates, too, stock are valued at over 20x earnings. 
 

FINANCIALS
	ABB	Siemens	Larsen & Toubro	BHEL
Sales (Dece 2005)	2963.05	3111.58	14430.97	13234.56
Sales (Dec 2004)	2263.83	1998.54	12380.45	9498.33
% change	30.89	55.69	16.56	39.34
Net profit (Dec 2005)	218.69	272.40	840.79	1395.85
Net profit (Dec 2004)	154.32	166.19	936.33	854.31
% change	41.71	63.91	-10.20	63.39
Operating profit (Dec 2005)	369.27	449.57	1362.61	2495.57
Operating profit (Dec 2004)	262.02	288.22	1353.37	1604.21
% change	40.93	55.98	0.68	55.56
Operating margins (Dec 2005)	12.46	14.45	9.44	18.86
Operating margins (Dec 2004)	11.57	14.42	10.93	16.89
Net margin (Dece 2005)	7.38	8.75	5.83	10.55
Net margin (Dece 2004)	6.82	8.32	7.56	8.99
Train 12-Month EPS	51.60	82.20	62.35	57.03
Current price	2425.00	4421.00	2312.00	1837.00
TTM P/E	46.99	53.79	37.08	32.21
FY07 P/E	22.04	21.05	30.42	21.11

According to Arvind Jain of Fortis Securities, "Stock prices seem to be discounting the earnings of 2008." That means counting on too many chickens.

Further, with a larger revenue base, it will be all the more difficult for companies to sustain growth rates. As one analyst with a domestic broking firm puts it: "Considering that the pace of growth will taper-off, especially after a couple of years, investors are paying a higher price for lower returns going forward."

Put simply, analysts have no quarrel with the overall buoyancy in the economy but they feel that the performance of capital goods companies on the bourses can't be sustained.

This is despite the fact that during the last quarter all the capital-goods majors sprung positive surprises. BHEL posted spectacular numbers with the topline growing 45 per cent and bottomline surging by 78 per cent.

Its orderbook at the end of the third quarter stood at Rs 33,800 crore, up 6.6 per cent compared to the same quarter last year. BHEL is now sitting on an orderbook that is more than two and a half times the cumulative sales recorded in the last four quarters.

Similarly, ABB posted a 33 per cent growth in sales and bottom-line and a slight improvement in margins. Its orderbook swelled by 49 per cent. Siemens also stunned analysts by clocking a 56 per cent growth in it's bottomline on the back of strong growth in its top-line.

Its new order intake stood at Rs 4,162 crore compared with Rs 817 crore in the previous year. Even the biggest of them all "� Larsen & Toubro "� posted an 11 per cent growth in topline. Interestingly, its recorded a 108 per cent growth (Rs 7897 crore) in order bookings in the third quarter. But the big question is how long can this last?

Currently, most industries are operating at peak capacities which means that an expansion will be necessary sooner rather than later. For instance, last fiscal the steel industries had a utilisation rate of 91 per cent while cement was operating at over 80 per cent utilisation.

Similarly, the mid-stream and downstream oil companies have also been operating at peak capacities. Last year, refining margins all over the world remained firm due to capacity constraints.

Thanks to a burgeoning economy, sectors like steel, cement, petroleum refining and power are on a expansion spree. Over the next couple of years, a total outlay of Rs 1,150 billion is planned in mega projects, according to industry estimates. 
 

MEGA PROJECTS
Total outlay in mega projects which are likely to come up within the next two years (Rs billion)
Dharma Port	20
Dubai Alumina Plant	135
Tata Steel greenfield expansion	300
Posco greenfield project	150
Reliance refinery	200
IOC Paradeep	83
ONGC Barmer	79
HPCL Batinda	120
BPCL Bina	63
Total	1150

Private sector behemoth Reliance Industries has announced a Rs 200 billion refinery plan. The state-owned oil companies, too, announced capacity expansions in refining sector to cater to the increasing domestic and export demand.

According to the Economic Survey, the capex by the Indian corporate sector is expected to more than double over the next five years. To be precise, compared to a capital expenditure of Rs 1265 billion between FY99-05, the capex for FY06-10 is projected to be Rs 2627 billion. 
 

CAPEX PLANS Capex in key industrial segments (Rs billion)
(Rs crore)	FY99-05	FY06-10
Steel	100	318
Aluminium	20	319
Paper	41	118
Cement	60	93
Petrochemicals	20	175
Textiles	26	148
Oil and Gas	998	1456
Automobiles	181	245
Total	1265	2627
Source: Motilal Oswal

The climb is already visible. In fiscal 2003, capex as a proportion of the GDP hovered around 15 per cent. In fiscal 2005, it was already nearing 25 per cent.

Obviously, a buoyant economy will help in keeping the party alive. The macro fundamentals seems to be pretty much intact. Last week, the Central Statistical Organisation forecast the economy would grow 8.1 per cent in 2005-06, up from 7.5 per cent last year but below the 8.5 per cent of 2003-04.

Currently, the manufacturing and services sectors are leading the way as a 2.3 per cent pick-up in agricultural output this fiscal year has spurred demand. Manufacturing is pegged to grow 9.4 per cent in 2005-06, up from 8.1 per cent last year.

A Confederation of Indian Industry-ASCON survey of manufacturing for the first nine months of 2005-06 reported that of the 139 sectors covered, output in 71 grew over 10 per cent. Of the 78 sectors reporting sales, 47 grew over 10 per cent.

It is not just the expansions planned for commodities. In the power sector again, the planning commission feels that a capacity addition target of the order of 41,110 MW should be achievable during the tenth plan period.

The infrastructure spend is also seeing a dramatic rise. Infrastructure spending during FY01-04 was Rs 3,955 billion. By fiscal 2007, the figure is likely to be Rs 8,340 billion. 
 

INFRASTRUCTURE SPEND Trend In Infrastructure Spending (Rs billion)
(Rs crore)	FY01-04	FY04-07E
Roads	626	817
Power	738	2957
Oil & Gas	380	660
Airports	58	107
Ports	39	158
Irrigation	532	1266
Railways	405	474
Urban Infrastructure	517	1189
Telecom	660	712
Total	3955	8340
Source: Economic Survey, Crisil

Even beyond the next year, growth isn't not going to vanish. Experts believe that the Indian economy has just reached a tipping point and there are still enormous opportunities.

Havings said that, there are also risks that capital goods companies face. Any delay in implementing these projects is a major spot of bother as they could hamper the earnings of these companies severely.

Says Sameer Ranade, analyst at Pioneer Intermediaries, "A single project getting delayed will not hamper the earnings to an greater extent but if the delays spirals to a few projects it may prove the valuations entirely wrong."

Raw material prices is another cause for worry. During the last financial year higher input cost ate into profit margins. In the past two quarters however, commodity prices, especially steel prices, have eased which has triggered an uptick in margins.

The domestic hot roll steel prices declined from Rs 35,000 per tonne in June 05 to nearly Rs 21,000 per tonne currently. "The steel prices will stay lower for at least the following two quarters and that should help margins," says Ranade.

In a nutshell, analyst bet that there may not be any serious disappointment from the companies in the medium-term given that the capex cycle is still miles away from peaking.

But stock market performance may be subdued since stock prices have already run substantially and look vulnerable to disappointments as expectations are high.

Interview with Y M Deostahlee, CFO, Larsen &Toubro

On sector outlook
The overall outlook for the capital goods sector is encouraging for the next 10 years. The growth will be driven by key sectors like the hydro-carbon sector where upstream and mid-stream oil companies are making big investments. ONGC has undertaken massive expansion and modernisation particularly in deep sea exploration.

Further in the commodities segment various companies have massive capex plans. The total capex is worth $180 billion. This apart, the thrust on development of ports and airports apart from roads and railways will also aid growth. All this augurs well for the capital goods sector.

Incidentally, Larsen & Toubro bagged a contract from the Oil & Natural Gas Corporation recently.

L&T, along with Korea's leading ship building, offshore construction and engineering company, Samsung Heavy Industries, has bagged a Rs 2,117 crore order from ONGC for the Vasai East development project. This is to be completed in a little over two years. As consortium partner, L&T will execute jobs worth around Rs 776 crore.

On major challenges
For Larsen & Toubro there are two major challenges. The first is risk management. This pertains more to business risk rather than the financial risk.

This includes everything related to carrying out business especially the project related risk, the contract and the sub-contract risk etc. The other critical aspect is that the business requires highly talented and skilled manpower. Pooling and sustaining key talent will be major task for the company going forward.

On macro fundamentals
Most of the macro fundamentals are in place. Inflation has been under control. Though the interest rate are on the uptick. The key factor is that rates had bottomed down and are reversing now. But it is still quite low compared to the past years. Thus, rates moving higher will be not be the key concern.

Sensex 10,000

The rise of the Sensex to the level of 10,000 has been faster than most people expected. Confident of the India story and tempted by superior returns, Foreign Institutional Investors bought stocks worth a staggering $10.7 bn last year, pushing the market to new heights.

The confidence doesn't seem to have been shaken yet : though inflows in January were a trifle subdued at $ 705 mn compared with December's $2.1 bn, they've picked up in February which has already seen inflows of $687 mn. 
  

FII FLOWS
	FII Inflow (Rs cr)
1999	6096
2000	6640
2001	12819
2002	3575
2003	30792
2004	38413
2005	47603
2006	6333

At 10,100, the India market now trades at nearly 17 times estimated FY07 earnings making it one of the most expensive in the region and in the world. This, in an current environment which is characterised by slowing earnings growth of Indian companies, rising interest rates and a high current account deficit. Why then would foreign investors be willing to wager their money in India?

The answer lies in the continuing strong fundamentals of the Indian economy. India is tipped be among the fastest growing and most resilient economies in the region with the GDP growing at 6.5-7 per cent for the next three years. Foreign direct investments are expected to pick up providing much-needed supply of capital and boosting the investment rate.

The farm economy is expected to well boosting rural income. The competitive edge whether in manufacturing through auto ancillaries or services through software remain intact while the outsourcing story only gets better.

Extremely favourable demographics, changing lifestyles and increasing purchasing power are expected to keep demand buoyant. And while reforms may not progress at the expected pace, given elections in some states, no regressive measures are anticipated on the policy front either.

All this makes for an attractive investment destination where earnings growth for companies should sustain at around 15 per cent. Infrastructure, outsourcing and consumption are the three themes that investors would be looking to play in the months ahead.

While some of the re-rating may have happened, especially with companies that have a larger market capitalisation, there is a whole universe of smaller companies waiting to be re-rated and FIIs have shown that they are not shy when it comes to investing in mid-caps.

While there is little doubt that it is buying by FIIs that has propelled the Sensex to this level, 2006 could well turn out to be the year of the Indian investor.

After being net sellers in 2004, local mutual funds were net buyers to the tune of Rs 13, 305 crore in 2005.

Given the trend in inflows, the number could be significantly higher in 2006, providing good support to the market. 2006 has started on a extremely bullish note with mutual funds garnering over Rs 8000 crore through new fund offerings in the first month of this calendar.

Net of chruning, the amount is around Rs 7500 crore which is a welcome change. While the foreign investors have displayed a greater leap of faith in Indian equities in the current rally, Indian investors are slowly but surely joining the bandwagon.

The Sensex may have crossed 10,000. But there is still money to be made. Make sure you enter the market before your neighbour does!