Capital Goods Sector: Golden Harvest

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

by Niraj Bhatt / Business Standard

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.

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