Mid-cap capital goods companies discounting recovery ahead
Shares of the firms have rallied sharply on expectations that they will be the first ones to benefit from shorter cycle orders and strong export growth
Mid-cap capital goods companies have rallied sharply in the past three months, outperforming the broader markets, on hopes of a turnaround in the economy and expectations that they will be the first ones to benefit from shorter cycle orders and strong export growth.
Shares of companies such as Voltas Ltd and Crompton Greaves Ltd have gained over 60%.
Some fundamental signs of improvement are evident. Order booking in financial year 2013-14 was ₹ 1.9 trillion, up 18% year-on-year. This is important as growth returned to positive territory for the first time post 2011, said Motilal Oswal Financial Services Ltd. In the March quarter, these new orders were led by mostly mid-sized capital goods firms. A lower base, some orders from state-owned firms, strong momentum in export orders owing to favourable currency movement and a gradual recovery in demand from global industrial firms helped.
However, the March-quarter results will continue to show weakness because projects which have been awarded might still see a slow pace of execution because of the general election. Earnings for capital goods firms are expected to worsen with revenue declining between 1-4% from a year ago and net profit declining by around 20%.
Will the improvement in order inflows continue? Analysts are expecting double-digit growth for Larsen and Toubro Ltd (L&T). The company is expected to start work on several large orders won over the past year, which is likely to trickle down to medium and small firms in the coming quarters. They are also banking on the continuing exports to the Middle East, Africa, South-East Asia and Latin America. However, while the rupee has remained more or less stable in the past couple of months, it is showing an appreciating trend. A strong currency will derail export growth and earnings. Note that a firm such as Thermax Ltd depends upon overseas sources for one-third of its revenue; the proportion is 15-17% for ABB Ltd, according to management interactions in March.
For now, the stocks of firms such as Crompton Greaves, Kirloskar Oil Engines Ltd, and Voltas are trading at 20 times their expected earnings for the current fiscal. At those valuations, they seem to be discounting a revival in the macro environment and continued exports. A delayed recovery and the strengthening rupee pose a distinct threat to the sustainability of this rally.
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