India Infrastructure

If previous bull-market favourites such as Praj Industries or Suzlon Energy were no match for your automobile, metal or mid-tier IT stocks in this rally, brace yourself for some hard facts. The engineering and capital goods stocks may no longer be the front-runners in your portfolio.

While the broader Index for Industrial Production (IIP) has staged a convincing rebound from its lows, there are no clear signs of revival yet from its capital goods component. Growth in the monthly and quarterly average index levels shows that while the IIP may have drawn strength from consumer durables, the capital goods index remains a laggard.

The financial performance of listed capital goods companies too reinforces the above trend, and suggests that a turnaround in the sector may be a while away.

Until there is a clear revival, investors may be better off betting on companies benefiting from capex in the government-driven infrastructure space. Those dependent on industrial capex have been struggling to expand sales. Here are some trends in the capital goods index of the IIP that may help decipher what the prospects of capital goods stocks look like.
Growth in IIP but..

Monthly growth witnessed by the IIP in 2009 improved from a 1 per cent Y-o-Y growth in January to 10.4 per cent - a lively double digits, after a long gap of two years. While March 2009 saw the stock market rebound from the doldrums, the IIP too surpassed its earlier high of March 2008 in the same month. The stock market therefore re-rated companies in the manufacturing sector, including the capital goods stocks, in anticipation.

However, while most other use-based segments of the IIP are closer to, or have surpassed, their previous highs, the capital goods index is still a good 34 per cent away from its peak in March 2008.

… weak capital goods

While the IIP numbers cannot be brushed aside as a flash in the pan, given that they have remained in positive territory since January this year, the capital goods index contradicted this trend with a decline in March, April and May 2009, over a year ago numbers.

This decline is significant as it was the first year-on-year fall since the de-growth in 2001. The index then took two good years to recover and surpass its earlier peak of March 2000; perhaps an indicator that the excess capacity/supply situation can take longer to recover.

Revival cues

With the IIP Capital Goods index remaining weak, what cues can investors look for to gauge signs of a revival in the sector? Previous trends suggest a decisive move in the consumer durables index can be a lead indicator for a revival in private investment activity, which in turn can spur business for capital goods.

An interesting trend that emerges in the IIP constituents is that the consumer durables index is often ahead of the other segments, whether in peaking out or in recovery. For instance, the consumer durables index peaked in October 2007, after which it steadily declined. After nascent signs of recovery in September 2008, the index returned to a decisive growth track post March 2009.

This strong growth is reflected in the financial performance of consumer goods companies such as Voltas, V-guard, Bajaj Electricals and Whirlpool of India. Strong sales numbers by two-wheeler and passenger car companies are yet another clear consumer spending indicator.

On the contrary, the IIP capital goods index reached a high much later — in March 2008 — and is still lower than its last high (see Table for index movements from earlier highs). Earlier years’ trend also suggests that there is a lag of six months to a year between the recovery of consumer durables and capital goods. This suggests that strong consumer spending could drive investments made by industries, which in turn eventually flow to the capital goods industry.

Another indicator that can drive activity in the capital goods space is an expansion in the basic and intermediate goods indices. These segments are typically the user industries for the capital goods produced. These indices, while moving ahead of their March 2008 highs, have however not yet showcased strong growth.
Revenue growth

If the lead indicators do point to a slowdown/revival in the capital goods sector, how would they reflect in the company’s financial numbers? Revenue growth is the key trend for investors to watch out for.

The IIP seeks to reflect growth in the country’s industrial activity, excluding services. A surge or fall in this index, therefore, acts as an indicator of the production and sales growth of companies across industries; with sales sometimes coming with a lag. Specifically, any noticeable trend in the capital goods index, a constituent of the IIP, should translate into revenue growth/decline for companies in this sector.

While most companies have reported expansion in their operating and net profits as a result of relief on the raw material and interest cost front over the last two quarters, revenue growth may bring the first concrete signs of a recovery.

To determine the correlation between the IIP Capital Goods index and the revenue growth of companies, we also averaged the IIP and its constituents at quarterly intervals, and looked at year-on-year growth. This too clearly suggested that both the index growth and the revenue growth moved in tandem and were at their weakest in the June 2009 quarter.

While September’s IIP figures are not yet out, the average of the July and August index figures suggest that there can be a decline once again for the September quarter, unless the numbers for the awaited month are exceptional. The 7 per cent y-o-y growth in the September quarter revenues of about 65 capital goods companies have also not demonstrated a recovery in sales, although profits once again expanded as a result of cost savings. One in two companies continued to see decline in revenues over a year ago numbers. It is therefore small wonder that capital good stocks (taking the BSE Capital goods index), which consistently topped the stock market returns chart as a sector from 2002 to 2007, failed to do an encore this year.

However, not all the stocks in the sector wear a gloomy look. This is thanks to the diversified business profiles of these companies — ranging from bearings, electrodes, abrasives and grinding wheels to power equipment, electric equipment, automation and engineering turnkey companies. Investors may take cues from the following trends before assuming exposure to stocks in the sector:

Industrial equipment/machinery manufacturers such as Lakshmi Machine Works, Praj Industries, Apar Industries and SKF India dependent on a revival in capex spending by other manufacturing industries may have to take a longer road to recovery.

Construction equipment companies dependent on infrastructure spending are likely to see a revival in their and order book, what with highways and metro projects once again gathering steam.

Capacity additions in the power space and railway spending are largely driven by public-private participation and are therefore less affected by the slowdown. BHEL, Crompton Greaves and Kalpataru Power Transmission have already turned in strong numbers in the September quarter while others such as Texmaco and Stone India are showing signs of revival in their sales.

Engineering and turnkey service companies that serve the oil and gas space (BGR Energy Systems and Honeywell Automation India, for instance) have also notched up improved revenues.

via BL