Output of capital goods rose 18.6% in September 2007 compared with 9.5% a year ago. Compared to Industrial; growth is 6.4% vs 12 %.

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Capital goods: Challenging times are up ahead

Capital goods, as a sector, suffered a severe de-rating in the recent correction. While weak investor sentiment was also a factor, the decline was primarily driven by the expected moderation in the growth of capital goods companies, linked to the slowdown in economy. The price earning multiples of most companies collapsed significantly in the last few months, from a band of 22-72 times in January 2008 to the present levels of over 17-43 times their FY08 earnings. This de-rating is despite the sector reporting a 23 per cent and 27 per cent growth in earnings and revenues in 2007-08.

Inflation in input costs, rising interest rates and slackening growth in user industries have put the sector fundamentals at cross-roads. The cost of commodities such as steel, copper, coal and crude oil have skyrocketed in the last few months. And since most companies in the sector are mid- or small-sized, they don’t have significant pricing power to pass on the increases to users. So, depending on which user industry they cater to, capital goods companies may be in for challenging times ahead. Companies which predominantly cater to the auto industry, real estate and construction, may post tepid growth, as there is a discernible slowdown in demand from these users. Cummins India, Kirloskar Oil Engines, smaller construction equipment manufacturers such as Action Construction Equipment may figure in this category.

It however bears attention that most of the capital goods companies still enjoy healthy order-books and so far, have not reported any worrying slowdown in earnings or revenue growth.

Preferred picks: Companies that serve industries such as coal, mining, oil or power, which are expected to see healthy growth, may fare much better. Thermax, Elecon Engineering, AIA Engineering and Aban Offshore are some of the companies with relatively stronger prospects. Also, companies with a diverse user segment or a sizeable export presence may merit investment, on a case-by-case basis. Carborundum Universal, Praj Industries and companies such as Titagarh Wagons and Texmaco that cater to the Indian Railways can also be considered for investments. The steel pipe maker, PSL given its dominant domestic presence and Welspun Gujarat Stahl Rohren, which has a huge export exposure also appear attractive investment candidates.

Source: BL