The BSE Capital Goods index has risen 13% from its lows in mid-February, slightly more than the 10.5% gain in the BSE 500 index. This is despite the recent news on weak order flows in the run-up to the general elections and the sluggish capital expenditure (capex) cycle.
The optimism on the Street is riding on the hope of strong execution in the March quarter. Typically, this is the best quarter in any fiscal year for the sector. Besides, companies in the sector are sitting on decent order books of 18-24 months of their current revenue.
Most brokerage firms forecast a 12-15% year-on-year revenue growth for capital goods firms. The larger among them such as Larsen and Toubro Ltd (L&T) could do better. That apart, power transmission and distribution firms that have bagged orders from both Power Grid Corp. of India Ltd and state distribution companies are also expected to report strong revenue growth.
Barring some strain on the working capital front, most firms should also clock decent double-digit growth in profits.
However, this is not to say that capital goods firms are on safe terrain. Order flow momentum, which is of utmost importance to sustain revenue growth, has been woefully low for some firms. According to ICICI Securities Ltd, “The announced order inflow for our coverage universe (ex-L&T) at ₹12,500 crore had witnessed a reduction compared to ₹22,400 crore in Q3FY19." That said, short-cycle orders may trickle in by virtue of energy-efficiency related capex in cement, steel and energy-intensive industries.
The moot question is: Will the rise in capital goods share prices sustain?
It is clear that order flows from government bodies will be low-key until the elections. Recent data from the Centre for Monitoring Indian Economy (CMIE) paint a gloomy picture on private sector capex too. “In 2017-18, net fixed asset investments of non-finance companies grew by 7.9% in nominal terms. At the same time, investments in plant and machinery grew by a significantly lower 6.8%. These were the lowest growth rates since 2004-05 in 13 years," said a media release dated 25 March. Decent execution of existing order books means that utilization levels could drop in ome industries, which actually makes the case for capex being weak in the near term. This is especially so, given that demand hasn’t really caught up.
In other words, investors must recognize that revenue growth in Q4 FY19 will be driven by the strong order book of the past. It would be prudent to observe how order flows shape up after the polls, which will give a more realistic picture of the health of the capital goods sector.