Deterioration in capex will slowly seep into weak order flows for capital goods firms
One may argue that while the government lowered fiscal deficit estimates for the year to 3.3% from the interim budget’s 3.4%, it may rely on off-balance sheet financing for central expenditure
The lack of a fiscal stimulus to boost near-term growth in the union budget has dimmed hopes of a sustained recovery in the capital goods sector. As it is, the pace of project execution and order flows for these firms had slowed down in the run-up to the general elections. But, this was expected to be a blip, with an improvement expected from the second half of FY20.
“The quality of government spending seems to have deteriorated with capital expenditure, including that by central public sector enterprises, projected to slow by 30bps to 3.7% of gross domestic product (GDP), while revenue expenditure is estimated to go up to 11.6% of GDP in FY20BE (from 10.6% of GDP in FY19)," said UBS Securities.
Deterioration in capex will slowly seep into weak order flows for capital goods firms. Note that firms such as Larsen & Toubro Ltd, Siemens Ltd, ABB Ltd and KEC International Ltd rely on government infrastructure orders too, directly or indirectly.
"The budget has given a broad vision on infrastructure spend, but lacks the detailing needed across sectors. This has worried investors on how and when capex recovery will pan out, and when it would translate into meaningful order flow growth," says Harshit Kapadia, analyst, Elara Securities India (P) Ltd.
One may argue that while the government lowered fiscal deficit estimates for the year to 3.3% from the interim budget’s 3.4%, it may rely on off-balance sheet financing for central expenditure.
But analysts are quick to point out that in government entities such as the National Highways Authority of India (NHAI), there isn’t much scope for sizeable spend, given that its debt has already mounted to unmanageable levels.
Further, a moot question is if economic momentum fails to pick and revenue receipts are weak, will actual expenditure be even lower than the subdued figures that are penciled in by the government?
Already, the increase in June quarter order flows is likely to be tepid. This is due to low government spending in the run-up to general elections and wobbly growth in private sector capex too. A report by JM Financial Services Ltd explains that June quarter Ebitda (earnings before interest, tax, depreciation and amortization) for its capital goods firms in its universe (ex-BHEL) may decline by 5% year-on-year (y-o-y). Margins may decline due to a drop in capacity utilisation levels, an adverse sales mix (absence of high margin contracts) and high competitive intensity.
The Street has been discounting a pick up in the sector. The Nifty Infrastructure index has fallen 5.5% since the budget was announced, and gave up most of its gains earlier in the year. Still, it has risen about 2.3% in a weak market this year, at a time when the Nifty Consumption index is down about 7.5%.
To be sure, the government’s allocation to the roads and railways segments is modestly higher. Diversified conglomerates with strong overseas reach such as L&T are expected to be better placed than others. The company has an order book that is nearly thrice its FY19 revenue. Others such as Voltas Ltd and Blue Star Ltd that have a decent mix of both large engineering projects and short-cycle industrial and consumer (retail) orders are also expected slightly less affected compared to peers.
From the looks of it, capital goods stocks may be volatile until the management commentary after the June quarter results provides clarity on the road ahead. After all, capital goods firms gain when there is momentum in economic growth, which is when capex by both the private and public sector are northbound.