Capital idea

Seetharaman R | Updated on January 13, 2018 Published on February 18, 2017

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Higher public spending has improved the outlook for some capital goods manufacturers. Here are three segments that you can bet on

Fresh capacity expansion by the private sector has been in the slow lane over the last few years. Contraction in demand, coupled with mounting debt, has made companies defer their plans to expand operations.

But even as the private sector has been on the back foot, greater public spending has resulted in improved order flows for companies that manufacture capital goods. The profitability of many capital goods manufacturers has also shown a marked improvement in recent quarters.

It’s probably for this reason that the capital goods stocks listed on the Indian stock market have been making merry over the last year. The BSE capital goods index has gained 33 per cent since March 2015, outperforming the Sensex that gained 23 per cent in the same period. Specific stocks in this segment, such as AIA Engineering, IFGL Refractories, KEC International and Kalpataru Power Transmission, have gained more than 60 per cent in this period.

Here are some segments within the capital goods space that appear promising.

Transmitting it right

While power producers continue to grapple with slowing industrial demand and lack of uptake, power transmission and distribution companies are in a different milieu. The stocks of companies that distribute power have, therefore, been performing well in recent quarters.

Both the Centre as well as some of the State governments appear keen on improving the reach of power across the country, thus boosting the prospects of power transmission and distribution companies. Power Grid Corporation of India (PGCIL) is expected to construct power transmission projects worth more than ₹15,000 crore every year. Also, some of the big state electricity boards (SEB) such as Karnataka, Tamil Nadu, Uttar Pradesh, Madhya Pradesh, West Bengal and Maharashtra are expected to tender more than ₹20,000 crore of T&D projects to be constructed every year.

Moreover, the Railways’ renewed impetus to build its own transmission lines at a faster pace and the increasing interest from private players such as Adani and Sterlite in the T&D business, should further aid revenues for the players in this space. The acceptance of UDAY scheme across States, which reduces the debt of SEBs substantially, can improve SEBs’ financials in the long run, helping the transmission and distribution segment further.

Major players in the transmission and distribution space such as KEC International Ltd (KEC), Kalpataru Power transmission Ltd (KPTL) and Techno Electric and Engineering (TEECL) are witnessing an improvement in financial performance in the last few quarters, thanks to these measures.

KEC, a leader in constructing T&D projects, with a strong domestic and international presence, has an order book close to ₹15,000 crore. Domestic orders contribute nearly 60 per cent to the order book. Of this, about 85 per cent of the order book is from the T&D business.

The company’s order book is well-diversified, with PGCIL, State Electricity Boards and private players accounting for a third each in the T&D business. The healthy financials and visibility is reflected in the company’s recent rating upgrade by India Ratings and improvement in its account receivables in the current fiscal year. The company’s own tower manufacturing facility also aids in optimising cost.

KEC’s adjusted net profit increased nearly three times between FY 15 and FY 16. For the nine months ended December 2016, operating margin stood at 8.8 per cent compared to 7.5 per cent for the same period a year earlier. Profit after tax has increased nearly 120 per cent to ₹159 crore.

Increasing momentum in the transmission and distribution space should also help the diversified infrastructure player, Kalpataru Power Transmission. The company operates both in the short-term construction format (engineering procurement & construction--EPC) as well as in the long-term leasing (build own operate transfer--BOOT) format to run transmission networks.

The company’s domestic transmission order book accounts for around 33 per cent of the total order book. A meagre contribution, at a mere 3 per cent, from State Electricity Boards in the transmission orders protects the company from delayed payments and default risks. For the nine months ending December 2016, the operating profit and net profit of KPTL’s standalone (T&D division) was 16 and 42 per cent higher, respectively, than for the same period a year earlier.

The manufacturers of transmission and distribution equipment such as ABB India should also gain from heightened activity in this segment. ABB India recorded an order intake of ₹12,466 crore, an increase of 54 per cent in 2016 compared to 2015. The investments in power transmission and growing customer interest in solar inverters will be the driving factor for this company in the long run.

Of the planned 100 GW of solar power capacity to be set up by 2022, only 10 per cent has been installed by now. ABB stands to gain if this drive towards solar energy gathers pace. Also, ABB has doubled its capacity to manufacture solar inverters to 2GW in India. The expertise to seamlessly integrate power transmissions between renewable and traditional power systems should stand it in good stead. Besides, increasing investments in railway and urban infrastructure should push demand for traction transformers used in train service operations and other energy-efficient power equipment.

With a revenue of ₹8,648 crore, the operating profit margin and net profit margin for the fiscal year ending December 2016 stood at 8.6 and 4.3 per cent, respectively. Both operating profit and net profit for 2016 grew around 6 and 25 per cent, respectively, during the same period.

Similarly, Techno Electric and Engineering is a prominent player in generation equipment (Renewable Energy) and the transmission and distribution space. The company has an order book of ₹2,700 crore; about 2.5 times FY16 revenue. For the nine months ending December 2016, revenue and profits grew 29 and 48 per cent, respectively, compared to the same period a year earlier.

Engineering growth

With capacity utilisation in manufacturing plants low, capital investments of the private sector are not expected to revive any time soon. But once the impact of demonetisation reduces and demand revives, companies manufacturing industrial consumables (goods that get used up or discarded during the manufacture of higher value added goods) — such as abrasives, ceramics and refractories — will be the first to rebound. A trend of improvement is already being witnessed in some of these companies.

Historically, the growth in the abrasives market has been 1.5 to 4 times the index of industrial production growth rate. Abrasives that are used to give a better finish to the final product are broadly of two types, bonded abrasives and coated abrasives. These are used across industries, including auto, auto ancillaries and other such applications.

Ceramics and refractories are used as anti-erosion and anti-corrosive materials in high-temperature applications such as manufacture of cement and steel and in power generation. These segments should also continue to show improvement with the Centre’s support to affordable housing, boosting demand for cement and steel and with the ongoing structural demand for automobiles.

The gradual increase in domestic demand, along with the near ₹2.4 lakh crore of transport infrastructure investment planned by the Centre, should also help manufacturers of high chrome grinding media. This is used in crushing, mining and grinding applications to separate ores from sand particles, cement manufacturing and thermal power applications.

In the abrasives segment, the two major manufacturers in India, Carborundum Universal (CUMI), and Grindwell Norton (GN), address more than 50 per cent of the market.

CUMI, with strong presence in the abrasives and ceramics segment, is well placed to tap the market, with its domestic abrasive segment growing 9 per cent in 2015-16. Also, plans to move overseas plants located in Japan and South Africa to India are expected to aid domestic operations. Besides, the company is also trying to improve capacity utilisation with the use of improved production technology in its other segments.

Owing to the winding down of refractories in South Africa and transfer of some Russian business units in India, CUMI’s consolidated revenue was flat for the year ending 2015-16. But, for the nine months ending December 2016, both revenue as well as net profit have shown growth of about 8 and 25 per cent, respectively. The revenue and net profit for the nine months ending December 2016 stood at ₹1,639 and ₹122 crore, respectively.

Similarly, another major manufacturer of abrasives and ceramics, Grindwell Norton, is expected to benefit from a revival. The company’s abrasives segments contributes nearly 65 per cent of the total revenue. In the abrasive segment, nearly 45 per cent of the revenue is derived from the auto and auto ancillary sectors while industrial machineries, metals and other segments constitute the rest. The abrasives segment, for the nine months ending December 2016, showed revenue and profit before interest growth of about 12 per cent each. But for the ceramic segment that contributes 26 per cent of the revenue, profit before interest and tax decreased 8 per cent for the same time period despite a revenue growth of 5 per cent in that segment.

Once utilisation levels in thermal power plants improve, the demand for refractories can go up too, helping the profitability of this segment. The revenue and net profit for the company for the fiscal year ending 2015-16 stands at ₹1,234 and ₹105 crore, respectively.

AIA Engineering, which manufactures high chromium corrosion and abrasion resistant parts used in cement, steel and mining industries, witnessed a flat growth in profit for 2015-16. This company is expected to benefit from the recent thrust on infrastructure. Also, AIA is expected to increase its capacity by 30 per cent to 4,40,000 tonnes per annum before the end of 2017.

Other smaller manufacturers of refractories such as Orient Refractories, IFGL Refractories and Vesuvius India also need to be on investors’ radar.

Building up steam

Continuing the momentum to speed up transportation infrastructure, the allocations to road, rail and port were sizeable in this Budget. The huge allocation planned for these segments should transform into a good order flow into the books of companies in this space.

Cummins India, which predominantly caters to the construction, textiles, auto ancillaries, mining and rail segments, should make strong revenue and earnings gains over the next few years. Despite a weak export market, a strong domestic demand for equipment and after-sales service from the construction segment aided revenue and profit. In the last four quarters ending December 2016, revenue increased from ₹1,102 crore to ₹1,401 crore while the adjusted profit after tax grew steadily from ₹167 crore to ₹198 crore. We can expect the increase in earnings momentum to continue over the next year too.

Similarly, Crompton Greaves Ltd, which is into manufacturing of power and distribution transformers used in railway transportation, is at an advantage. Besides, the company also manufactures and provides turnkey solutions for renewable energy products. For the nine months ending December 2016, revenue is up 18 per cent to ₹3,895 crore, with the company managing to reduce its losses considerably compared to the same period a year earlier.

Also in the rail segment, Texmaco Rail & Engineering (Texmaco) and Titagarh Wagons (Titagarh), in the freight, wagon and coach manufacturing space, should benefit from the ₹1,31,000-crore expenditure planned for railways in the Budget.

Titagarh Wagon and its group companies are well-diversified, especially across Europe and Africa. The company also has a strong steel foundry division, considered India’s biggest. The order from Indian Railways in May 2016 to deliver 1,338 wagons helped both companies to post healthy financials.

The Centre’s intention to develop rail infrastructure in an accelerated manner through an all-time-high Budget allocation and opening of dedicated rail freight corridor should further increase the demand for wagons, going forward.

Texmaco’s acquisition of two EPC companies, Kalindee Rail Nirman Engineers and Bright Power Projects, should give the company a competitive advantage.

For the nine months ending December 2016, Texmaco’s gross revenue and profit before tax, at ₹897 crore and ₹36 crore, is about 20 per cent and nearly five times higher than for the same period a year earlier. In the case of Titagarh, during the same time period, the total income was ₹1,077 crore, 65 per cent higher than for the same period a year earlier. The net profit turned positive to ₹15.5 crore compared to a loss of ₹12.5 crore a year earlier.

Besides, smaller players like GPT Infraprojects, which manufactures steel-reinforced concrete for laying railway lines and executes civil and infrastructure projects, should also get a boost.

Too pricey?

Some of the stocks mentioned above have already raced higher over the last 12 months, making them stiffly valued. For instance, Crompton Greaves trades at 55 times its trailing 12 months earning which is far higher than its three-year average PE multiple of 25 times. Other companies such as Carborundum Universal, AIA Engineering, Kalpataru Power Transmission and Techno Electric & Engineering also appear pricey at this juncture. While some of these stocks could have been re-rated due to their improving prospects, investors need to be a little cautious about stocks whose prices have run up without corresponding improvement in their businesses.

Published on February 18, 2017

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