Capital goods as an index underperformed the broader index by more than 7 per cent in the past one month. However, the sector presents a ray of hope over the coming quarters as it stays highly underinvested, while growth targets remain way too high.

Market experts believe that inflation would come down to 6.8 per cent by March 2012, which may lead to a pause in the rate hikes as indicated by the Reserve Bank of India in the latest policy statement.

The ensuing reversal in rate hikes could be the beginning of the investment cycle, which would once again bring foreign investors back into India, along with affirmative policy decisions on various heldup infrastructure projects. However, in transit, things may get worse due to the crisis in global markets like Europe.

Amar Kedia and Indrajit Yadav senior analysts with Nomura Equity Research in a report, said, “Coupled with the fact that India is chronically underinvested in infrastructure, we maintain our long-term positive outlook on the sector. However, a nervous global market implies a worsening of the situation before it turns for the better. Further, internal issues such as the slow pace of reforms and fuel shortages will also continue to hurt sector growth over the medium term.”

For the capital goods sector as a whole, there are significant growth opportunities for equipment suppliers in India’s transmission and distribution (T&D) segment. The working group on power estimates 100 per cent-plus growth in T&D capex in the 12th Five Year Plan (2013-2017) over the 11th Five Year Plan.

Morgan Stanley in a report said the government is focusing on reducing aggregate technical & commercial (AT&C) losses, which are at present around 27 per cent in India, well above the 6-8 per cent in the US, the UK and China. This, together with the planned setting up of a national transmission grid, should boost T&D capex over the coming years.

“T&D capex has historically been 0.3-0.7 times of generation, against an industry recognised ratio of one times. The working group estimates a 34 per cent rise in generation capex in the 12th plan,” the Morgan Stanley report said.

Despite strong estimates, there are challenges and risks for the only segment that has strong potential for power equipment manufacturers from India as well as foreign players. The weak balance sheets of the state T&D companies represent the key challenge. In addition, land acquisition and forest clearances also entail execution risk, which has led to slower-than-expected growth in T&D infrastructure historically. Industry players point out that transformer and substation prices have fallen 20-25 per cent in the past couple of years because of increased competition, from both local and foreign rivals. However, the rebound in prices is not likely over the near term.

Apart from equipment manufacturers, even independent power producers are having huge pricing, resource and interest-related issues, which have led to dismal investment in the power sector. In addition, new project announcements are heading to touch a five- year low figure of Rs 230,000 crore in the first quarter of 2010.

Rabindra Nath Nayak, a senior analyst with SBI Capital Market Securities, says, the rupee depreciation by around 19 per cent and high inflationary trend above 9 per cent would reduce investment visibility over the next two-three quarters. “We do not feel a significant reversal in the investment sentiment in the near term, despite the expected ease in interest rates,” he said.

Big players will resort to aggressive pricing to increase order inflow, which would lead to pressure on margins over the long term.

Small players are expected see low orders, due to slow pickup in order inflows, both at the customer and sub-contracting levels. Hence, “we have downgraded our sector outlook from overweight to neutral,” Nayak said.

Rahul Garg, a senior analyst with HSBC Global Research, says that the strength in Power Grid orders supports their preference for domestic and Middle East and North Africa (MENA) region exposure over the west. However, rising competition in the substation space underlines our hypothesis that equipment suppliers are likely to face significant pricing pressure. The EPC space offers better value picks, he said. “We maintain our preference for EPC players and reiterate overweight on Kalpataru Power and KEC and underweight on ABB,” Garg said in the report.

Company performance: Experts say that the biggest problem with capital goods companies is that pace of execution of projects, which fails to give confidence for the near-term order inflows. However, brokerages maintain their positive view on Bhel due to attractive valuation, Tecpro Systems on robust order book, McNally Bharat on its stable margin and steady execution, Thermax for its increased activity in industrial captive energy and a satisfactory business guidance and BGR Energy on expected pickup in order inflows after three-four quarters of dismal order inflows.

Bhel’s second quarter order inflow had grown 393 per cent to Rs1,430 crore compared with the first quarter, Tecpro Systems order flow grew 224 per cent compared with the previous quarter to Rs1,800 crore, Thermax order inflow was, however, lower 12 per cent quarter-on- quarter at Rs 1,200 crore.

Stock performance

Capital goods stocks have underperformed the broader market in the past one year. Scrips such as Usha Martin, Suzlon Energy, Punj Lloyd and Crompton Greaves have plunged 63.98 per cent, 63.96 per cent, 60.77 per cent and 57.69 per cent, respectively. BEML, Bhel and L&T dropped 45.29 per cent, 45.29 per cent and 41.47 per cent, respectively. ABB and Siemens fell 24.80 per cent and 15.70 per cent, respectively. The BSE capital goods index declined 41.63 per cent in the past one year, against 19.52 per cent drop in BSE Sensex.

Most brokerages have a negative outlook on the power sector. AT present, most of the capital goods stocks are trading at a 30-50 per cent discount to their five-yearly average one-year forward multiple.

“The third quarter of FY2012 would bring no respite for the capital goods companies due to the macro-economic issues and lack of a pickup in the execution of infrastructure projects, particularly in the power

sector. These concerns are also reflected in the severe underperformance of the capital goods index, compared with the broad market indices. Most of our coverage companies are expected to report sluggish revenue growth for Q3FY2012 led by low execution of their sluggish order book and an unfavourable base effect,” said brokerage Sharekhan in a note.

(With inputs from Amit Mudgill)

vikassrivastav@mydigitalfc.com