Capital goods: Orders and revenues rebound, sustainability key
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Compared with the earlier quarters, capital goods companies reported better order inflows and revenues. But as Kotak Institutional Equities Research points out, the reported numbers may have been perked up by a measure of stability coming back after the roll out of the goods and services tax (GST). So, sustainability of the momentum is important.
First, the facts. Aided by better execution, aggregate domestic revenues of six large capital goods firms calculated by Kotak analysts increased 8% in the December quarter, the fastest clip in at least one year. Order inflows expanded at an impressive pace. According to Motilal Oswal Securities Ltd, the order book as of December quarter registered notable growth.
However, the earnings of firms, such as ABB India Ltd, Siemens Ltd and Thermax Ltd, missed Street estimates as an increase in raw material costs crimped profitability or, as in Siemens’ case, revenues did not grow much. The rising cost of raw material is raising red flags. “The increasing steel prices could limit profit growth as most of the fixed price international orders were booked ~2-3 quarters ago,” Emkay Global Financial Services Ltd said in a note on Thermax.
But order inflow trends and commentaries are grounds for optimism. While the recent growth in order book provides good revenue visibility, commentaries from managements indicate an improvement in the investment environment in certain segments. “Management commentary in terms of ordering outlook has been cautiously optimistic,” Motilal Oswal said in a note.
Companies such as ABB India and Siemens are seeing improved prospects in brownfield investments, where clients look to augment capacities or invest in new solutions to improve efficiencies. As a consequence, they expect the order inflow momentum to continue. But the moot question is whether these brownfield investments alone will be sufficient to drive earnings growth. “Despite consistent growth in order inflows, the order backlog of Rs13,200 crore (around one time FY2018E sales) is not adequate for revenue visibility. Siemens will have to report strong order flows in next 3-4 quarters to maintain its revenue and profitability growth trajectory in FY19E and FY20E,” Emkay said in a note on Siemens.
That brings us to the stock valuations. In line with the broader markets, the capital goods stocks are also pricing in a strong recovery in revenue and profits. While the December quarter results did not throw up any major disappointments, current valuations leave limited room for earnings slippages. “We do not dispute the medium-term potential of investment in India but suspect that momentum in revenue growth will continue for the next few quarters,” Kotak Institutional Equities adds. “We do not rule out downside risks to our earnings estimates, especially if public capex sees a sudden slowdown, along with muted private investment trend continuing.”