Capital goods stocks could surge on order visibility, pick-up in exports

Near-term trigger is the strong Q4 results led by revenue growth and expanding margins

A huge jump in order inflows has led to a fair amount of investment into the capital goods sector. Indeed, the BSE Capital Goods Index has risen by 5.5 per cent this year comfortably outperforming the Sensex and Nifty. The rise in orders is largely driven by policy initiatives from the government. There is the budgetary thrust on infrastructure and mining. The other is the emphasis on defence indigenisation coupled to the interest in the related aerospace and space sectors. In addition, there is some pickup in export orders for EPC companies like L&T and KEC Int.

The FPIs have started to bet big on this sector, after years of being underweight. Are the new valuations sustainable? Well, for one thing, the new valuations are based on clear visibility of revenues through the medium term given the full order books. However, they may be underestimating factors like potential delays and holdups as well as overestimating the potential margins. Commodity inflation for example, could lead to high raw material costs.

On the other hand, if private investment does pick up, that could be a further boost. There are signs of this with a rise in project announcements by the private sector and this is also reflected in an increasing share of manufacturing orders which might mean an improvement in the investment climate. But bank credit to industries has remained near-flat in the last 4 months, leading to YoY credit growth to this segment falling from 15 per cent to 5 per cent over the same period.

The Q4 results could provide clues as to future directions as the order build-up has started. Fast execution and low receivables would be ideal. Analysts estimate strong execution growth with up to around 12 per cent YoY rise in revenues for infrastructure companies such as L&T, KEC International, BHEL due to the order buildup and revenues could rise by around 25 per cent for pure capital goods players.

The operating profit margins could improve QoQ for many companies due to lower commodity prices and lower freight costs. However L&T guidance was that Q4FY23 may be soft and BHEL could be hit by a margin decline due to base effect, since Q4 FY22 saw provision reversals boosting bottomline. Among MNC-promoted electrical majors, Siemens has robust order flows but ABB India could be a laggard in this space.

Inflows are expected to grow 20 per cent YoY driven by large project awards in Railways PPP to Siemens and a surge in orders in the defence sector. Midcap EPC players like KEC have good traction in order inflow and KEC may exceed guidance. Thermax has a high base in Q4, FY22, which may lead to flatness YoY in Q4, FY23. Defence oriented players such as HAL, BEL, Garden Reach and Mazagaon have been strong price performers.

This could be the early stages of a strong upcycle given order visibility. In segments like EPC and capital goods, early stages of the cycle can see net profit growth outpacing price. That is, share price rises but PE ratios can fall because EPS growth accelerates even more. We haven’t seen this yet, but strong Q4 results could set up this situation. L&T, CG Power, Thermax and AIA Engineering look technically strong.