Golden harvest

Core focus and capacity ramp-up lift capital goods P/Es to all-time highs

Capital goods stocks have had a phenomenal run over the past three years thanks to the renewed focus on infrastructure and capacity expansions across industries, particularly in the power sector.

At present, most capital goods companies are trading at multiple that they have never commanded before. The industry price-earnings ratio hovers around 50, based on trailing 12-month earnings "" Siemens (60), ABB (58), Crompton Greaves (47), BHEL (37) and Larsen & Toubro (30).

Construction stocks also commands high multiple with IVRCL at 47 and Nagarjuna Construction at 43. Based on FY07 earnings though, stocks are trading at a forward P/E of over 20.

At the end of the last quarter, BHEL's order-book stood at a staggering Rs 33,800 crore, enough to cover its business for the next couple of years at least.

The case is similar for most other companies. The biggest risk for these companies is not whether business would come or not, but whether they would be able to execute orders on time.

And since a large part of the capital spending, for instance in irrigation and power, is also from the government, they may be susceptible to delays. If interest rates rise substantially, that could also force companies to take a cautious view of capital spends.

Another risk for companies such as L&T could be a slowdown in West Asia, which is now a substantial portion of their business.

Even as the India growth story remains intact, cyclical risks remain. They would make money when capacity additions happen and stagnate when growth is dull.

During the technology boom, too, the market thought that the India outsourcing story would go on for many years and, hence, multiples of more than 50 were perfectly justified.

Capital goods stocks today seem to be at a stage where technology stocks were in the third quarter of 1999. While theoretically it is fairly clear that capital goods stocks need to cool a bit, given the strong momentum, one can avoid the sector only at the risk of under-performance for the next two quarters at least.

Essel Propack: Overseas boost

Essel Propack has posted an impressive 22.85 per cent rise in net sales in 2005, with a majority of the growth emanating from its foreign operations.

International sales went up 300 basis points to 65 per cent as a percentage of consolidated sales. Though the domestic FMCG industry-Essel's major customers""has been doing well, domestic sales growth of 11.5 per cent is a tad disappointing.

Despite this growth, consolidated operating profit grew only 11.56 per cent, as raw materials and staff costs surged about 25 per cent and 50 per cent, respectively. Operating profit margin went up by 6 basis points to 22.25 per cent.

But international operations have shown signs of improvement. Its acquisitions of Arista and Telcon in the UK have affected operating performance to some extent, but the management expects the performance to improve in the June 2006 quarter as the businesses get integrated. China has done well in 2005, and capacities have been expanded in the US in 2005. The stock trades at a trailing P/E of 14, which is not expensive.

Raymond: Stitch in time

Raymond has formed a joint venture with the Belgium-based UCO NV, the idea being to merge the denim businesses of both the firms.

Both the companies will have an equal stake in the new company and as of now, the Raymond management does not expect any infusion of cash for Raymond. This would mean an opportunity to globalise its denim business and move up the value chain.

With each company having a capacity of 40 million metre, the combined capacity would total 80 million metre.

While the turnover of Raymond's denim division for the nine months ended December 2005 was Rs 200 crore, it is estimated that the new company "" expected to be set up by Q2FY07 "" would post revenues of Rs 1,100 crore in the first year of operations. UCO specialises in colour denim and has almost a 70 per share of the European market and this would help Raymond upgrade its products.

Besides, since UCO has plants across the US, Belgium and Romania, the new company would be in a better position to cater to fashion retailers who demand low lead times. All in all, apart from retailing its denim in the lucrative markets of the US and Europe, Raymond will gain experience in operating in these markets.

Raymond is a good play on the textile sector in the post-quota regime. Its business model captures the entire value chain from yarn to fabrics and retail. While the company has been slow to exploit emerging opportunities, it has taken steps to scale up its operations in recent times and foray into new areas.

For instance it has increased the capacity of its worsted plant and also plans to enter the kidswear segment. It has also formed a JV with an Italian firm for high-quality shirting. At the current price of Rs 496, the stock trades at around 15 times estimated FY07 earnings and is reasonably valued.

With contributions from N Mahalakshmi and Shobhana Subramanian