Over the last 18 months, macroeconomic data has all been flashing red—signalling rising inflation, rising cost of capital and a slowdown in industrial activity. Naturally, this has raised concerns on the outlook for the capital goods sector. A key indicator—revenue generated for every unit of capital employed in the business—has gradually slid over the last five years, implying less effective utilization of capital. But the moot question is: has it touched bottom and will we see a reversal, albeit perhaps a gradual one, from these levels?
Data sorted from about a hundred firms in this space shows that the ratio of net revenue to capital employed (which is the difference between assets and liabilities) during fiscal 2011 (FY11) was down by around 27% compared with that in FY07. Put this in perspective over a 10-year horizon and it is close to the bottom seen in early 2000. This is in spite of the fact that revenues grew at twice the rate in 2011 when compared with the previous year. Likewise, net profit growth rates were better. What this implies is that while revenues did grow, the rise was not commensurate with the rate of increase in the capital used for generating the same. More importantly, since the ratio of net revenue to capital employed is at a 10-year low, perhaps it has reached a bottom and a bounce is now in order? This metric reflects the state of the investment cycle and it’s possible, therefore, that the cycle may soon start to turn up.
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Industry circles explain this differently though. For instance, some of them believe the industry trend towards outsourcing is responsible. Higher loans and advances given to vendors could lead to higher capital employed. But this is debatable as outsourcing is not a new development.
What is worrisome is that the cost of capital has been rising. This is reflected in the falling ratio of profit to interest paid by companies (interest coverage ratio), despite most large and mid-sized firms (barring contracting companies) being comfortably leveraged at this juncture. Besides, the working capital needs of capital goods firms may rise in the near term as customers are resorting to higher credit periods instead of resorting to expensive bank finance. However, most analysts believe interest rates are near their peak and will level off soon and the reduction in uncertainty could help boost the capital expenditure activity.
Analysts are mulling over a possible reversal in the sector, as revenue growth is gradually gaining momentum, with firms beefing up execution. Order intake of capital goods firms has picked up, driven by mega infrastructure projects, although the manufacturing sector is still in a “wait-and-watch” mode.
The Street, too, seems to have sensed an improved outlook. After a blip in the beginning of 2011 and a time period correction in valuations, which have come off significantly over the last 12 months, the capital goods index is gaining ground in relation to the benchmark indices.
Graphic by Ahmed Raza Khan/Mint
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