Losing speed

Stock prices of engineering companies are expected to wait for fresh growth triggers before they appreciate further.

Backed by macro fundamentals and riding on continued euphoria over engineering sector, these companies have reigned over the stock markets for more than three years at stretch.

Over the past twelve months, the BSE Capital Goods index clocked returns of 75 per cent against Sensex gain of 55 per cent. It was a gala time for frontline engineering companies, which outperformed the markets by huge margins: BHEL (84 per cent), L&T (73 per cent), Siemens (141 per cent) and ABB (82 per cent).

Analysts vouch for strong business momentum for these companies, but don't seem comfortable with the current valuations at least in the short term.

Through FY04-07, while earnings have grown at CAGR of around 30 per cent, stock prices have spiraled at three times the pace.

As prices have run ahead of valuations, analysts expect these stocks to consolidate at current levels and few leading domestic as well as foreign research houses have come out with 'sell' reports on these stocks.

Dearly priced
While at Rs 2426, BHEL trades at 26 and 21 times it FY07 and FY08 earnings estimates, L&T looks relatively cheaper. At the current market price of Rs 1354, the scrip trades at 13.3 and 10.2 times its forward earnings estimates.

Compared to these two, ABB and Siemens look dearer and experts feel the stocks are likely to take a break for some time before they move northwards.

At Rs 3411, ABB's valuations stand at 43 and 30 times the forward earnings. Siemens trades at forward P/Es of 35 times FY07 earnings and 22 times FY08 earnings.

"Considering the FY08 earnings, valuations of frontline engineering companies like BHEL and Larsen & Toubro have peaked and we expect the stocks to remain at the same levels at least for next four to five months, till there is more clarity on FY09 earnings. We expect that the capital goods sector will underperform in the short run," says an analyst from a leading domestic research firm.

"ABB and Siemens have run up substantially, and for the next six months we should not expect any significant moves from the stocks. Though BHEL has moved up too, it looks relatively cheap and if the ultra mega power project bid materialises, it can spring positive surprise,''says Pradeepkumar, analyst, Anand Rathi Securities. 
 

RICH VALUATIONS
Company	Price (Rs)	PE 07	PE 08
BHEL	2426.10	25.59	20.78
Larsen & Toubro	1354.60	13.26	10.22
Siemens	1192.90	34.78	22.38
ABB	3411.10	43.15	30.24
ABB year ending December, Siemens year ending September

Powered by capex
The capex engines are going strong, so engineering companies will see sustained order inflows. Industrial capex is expected to grow at 22 per cent CAGR through FY06-10.

"Rising industrial capex levels will bring robust orders to engineering companies. Being the last year of the Tenth Plan, orders from government have also seen a major spurt. During H1 FY07, we have already experienced 40 per cent growth in order inflows and overall FY07 is likely to see the highest ever order book growth," says Vinod Nair, analyst, Brics Securities.

However major spurt in order inflows would require larger capacities, are the players equipped to deliver?

Says R Shankar Raman, executive vice-president, L&T, "We are going for major expansions in our Hazira, Coimbatore and Ahmednagar plants in India and are also setting plants in overseas markets like China, Saudi Arabia and Oman. We are geared to cater to increased order flows and capacities are not likely to be a constraint."

To cater to the rising demand, other players are also increasing capacities. In the last two years, ABB has set up manufacturing units in Bangalore, Vadodara, Nashik and Halol.

"We recently commissioned a low voltage distribution electricals unit in Haridwar. Our new Bangalore based control-gear and LV motors units are also gaining momentum. We have also set up a robotics application engineering centre and an analytical products unit in Bangalore," says Ravi Uppal, vice chairman and managing director, ABB India.

Capacities are not a concern for BHEL either. Currently working with capacity of 7,500 MW, BHEL should go up to 9,500 MW by December 2007. With a Rs 1600 crore capex programme, it will enhance capacity to 10,000 MW and may further increase capacity if required.

Low on manpower
Today growth is no longer the issue, what matters is the way these capital goods manufacturers manage the growth. Qualified manpower is one of the key drivers of business and high attrition rates seem to be a growing menace.

The IT sector is luring qualified engineers and poaching by MNCs are increasing salary pressures on engineering companies, which have seen substantial rise in staff costs.

"In H1 FY07, employee expenses have mainly increased as we have hired 2500 people in our plants. However talent management has no doubt been a challenge and our staff costs have increased from 6 per cent to 7.5 per cent in the past two to three years. But we don't expect major impact on the margins," adds Raman.

During H1 FY07, BHEL's employee expenses have increased 18 per cent due to an increase in incentive packages for employees and gratuity provisions. From FY09, wage bills will increase by 30 per cent and operating margins are expected to decline marginally.

Since employee costs are around 6 to 8 per cent of revenues, they may not hit margins in near future. However with increasing employee shortage, project execution risks may rise.

"Given the tremendous pace of top line growth, we don't see rising salary pressures impacting margins over the medium term. But over a two-year horizon, manpower crunch would increase execution risks and lead to cost overruns. This may result in some margin contractions," adds Nair.

Orders all the way
During the past three quarters, ABB's new order inflows were Rs 4210 crore, increase of 50 per cent. However due to shorter execution period the order backlog stood at Rs 3565 crore at the end of the September 2006 quarter.

Being a leading player in the transmission and distribution segment, ABB will continue to benefit from the buoyancy in power infrastructure and industrial projects.

The automation market is expected to grow at a CAGR of 20 per cent over the medium term.

For Siemens, this business contributes 40 per cent to its revenues. It has a 25 per cent market share, so it will benefit most from the corporate expansion plans of process and metal industries. Growing at CAGR of 35 per cent over past three years, power segment will continue to be the core business driver.

With order inflows of Rs 10,035 crore during September quarter, BHEL's order book grew by 42 per cent to a stunning Rs 45,700 crore.

In future, it will pocket bulk orders for super critical technology-based 800MW from NTPC and may also bag the 4000 MW Sasan ultra-mega power projects worth Rs 16,000 crore.

However, intensifying competition from Chinese manufacturers and other international players is a major concern for the company.

During H1 FY07, L&T's order inflows increased close to 50 per cent at Rs 13,340 crore, increasing the order book to Rs 30,670 crore at the end of September 2006, up 52 per cent y-o-y. The company expects its order book to swell by 30 per cent in FY07.

L&T is targeting large projects with specialised engineering content and better margins. Aerospace, defence and nuclear power sectors offer huge opportunities. L&T plans to benefit from the global shortage of ship-building capacities and gasifier exports to China is another promising avenue.

Comfort on inputs
Raw material prices have come off their highs, so input cost is likely to ease the pressure on margins front.

Says Mukul Jain, analyst, Prabhudas Liladhar Securities, "No doubt, prices of key inputs like steel and copper have eased around 30 per cent from their peaks, but they are much higher compared to last year. We expect the prices to be stable at least during the next two quarters. However overall we expect a 50 basis point dip in the overall operating margins in FY07."

Given long gestations and large sizes of engineering contracts, companies insist on price escalation clauses, to cushion themselves against volatility in raw material prices.

"Price escalation clauses are a part of our major projects with longer time durations. We also undertake supply management and outsourcing initiatives and continually review these to optimise our cost base," adds Uppal.

Future positive
This financial year, L&T's revenues are expected to increase 30 per cent and operating margins will see a 50 basis point expansion. ABB's revenues are expected to rise at 40 per cent and profits by around 50 per cent in CY06.

"BHEL's order inflows are set to slow down to around Rs 25,800 crore a year over FY08-12. We estimate revenue growth at 24 per cent for FY07, but then it would decelerate to 14 per cent over FY08-12. High base and long execution cycle would lead to a slowdown in earnings growth," says a report by Brics Securities.

Siemens will announce its FY06 fiscal results (year ending September) this week, and analysts expect good numbers, though like some other engineering companies, its margins could fall due to high input costs.

Automation segment revenues will grow at CAGR of 39 per cent through FY05-08. Power segment revenues will grow at 48 per cent, during the same period. Its net profit is expected to increase at about 30 per cent a year for the next two years.