Some bluechip stocks from the capital goods sector are available at attractive valuations. Find out why their long-term business prospects are looking good.
Getty ImagesThe capital goods sector plays a significant role in employment generation and economic growth.
The capital goods sector has underperformed during the past few years, which is evident from the difference in the returns of the BSE Capital Goods index and the Sensex. The BSE Capital Goods has underperformed the Sensex by 2.9% in the past one year, by 12.4% in past three years and by 20.5% in past five years.
The reasons for this underperformance include lack of demand for the large scale equipment, increase in stalled or abandoned projects that were in implementation, very few new projects, and weak capex cycle of both government and the private sector. In addition, weak consumption activity in the economy and liquidity pressures have also negatively affected the prospects of the sector.
The capital goods sector plays a significant role in employment generation and economic growth. Due to the reluctance of the private sector, government capex is necessary to kickstart the investment activity. Such government expenditure fell 28% in the first quarter of 2019-20. However, recent data on the government capex has ignited hope for the revival of the capital goods sector.
According to a report by SBI Cap Securities, the capital expenditure of the government has significantly picked up in the month of July 2019 and stood at approximately Rs 45,000 crore. This translates into a year-on-year growth rate of 83%, bolstered mainly by a pickup in road and defence sectors. The report also highlights the strong order books of some players which will cushion them from a decline in earnings in the near term. The management guidance for some of these players expects 10-15% order inflow growth in 2019-20.
Another report by Elara Capital has expressed confidence in the electrical equipment (EEI) sub-segment of the capital goods sector. The volumes of the segment are growing in double digits for the past two years and the ongoing electrification programme and T&D capex (Central & State) along with growth in infrastructure and metros will continue to fuel growth for the EEI. On the other hand, a report by ICICI Direct expects that there will be a pick-up in order inflows in the capital goods sector from the third quarter onwards. Increased order inflows will be due to the expected stronger tendering pipeline across infrastructure, T&D and power segments. Also, the revenue and profitability growth of the established players are expected to remain steady for 2019-20 due to the strong present order backlog.
Even after the recent bounceback, some capital good players are available at compelling valuations in terms of their PE multiples. We have selected seven companies whose PE multiples, based on their future 12-month blended forward earnings, are at a reasonable discount relative to their past five-year and 10-year historical averages. These seven companies reported an year-on-year growth of 11% in aggregate consolidated sales and 25% growth in operating profits in the June 2019 quarter. Comparatively, the BSE Capital Goods index aggregate sales and operating profit grew at -1.7% and -9.3% respectively during the same period. Let us look at the inancial of these seven companies in detail:
1. KEC International
Current PE: 11.4 10-year average PE: 23.8 Current price (Rs ): 250 1-year target price (Rs ): 354 Potential upside: 41.8%
An infrastructure EPC player with a presence across the power transmission and distribution, railways, smart infrastructure, cables and solar segments. Its strong diversified order book across segments and geographies, steady operating performance, better execution capacity and growth recovery in T&D segment are key growth catalysts. Moreover, orders from the railways for track laying, signalling, OHE and station building are likely to see traction in 2019-20. Also, the government’s long term capex targets will help the company to improve its sales and margins going forward.
Current PE: 17.5 10-year average PE: 28.3 Current price (Rs ): 1,314 1-year target price (Rs ): 1,661 Potential upside: 26.4%
A conglomerate with a presence in over 30 countries, it addresses critical needs of key sectors, including infrastructure, construction, defence, hydrocarbons, heavy engineering, power and shipbuilding among others. JP Morgan is bullish on the stock due to the company’s strong earnings growth track record, efficient and profitable execution capabilities, improvement in working capital management and RoE enhancement. The research house feels that guidance for 2019-20 appears achievable in terms of revenue growth and EBITDA margins. The profitability is likely to improve due to the sale proceeds from real estate monetisation (e.g. Hyderabad metro real estate). Even in a tough macro environment, L&T has won a larger share in the limited big order opportunities. Sebi’s nod to the share buyback proposal could be a near term catalyst.
Current PE: 12.2 10-year average PE: 17.7 Current price (Rs ): 368 1-year target price (Rs ): 488 Potential upside: 32.5%
A manufacturer of electrical and telecommunication cables, lighting products, electrical accessories, switchgear, fans and water heaters, Finolex Cables is in a sweet spot. A report by Firstcall Research says its electrical cables segment is likely to get a boost from the government’s rural and infrastructure push. On the other hand, government’s focus on Digital India and its ambitious Bharat Net initiative will improve the prospects of the communication cables segment.
Analysts’ recommendations- Buy: 8 Hold: 2 Sell: 0
4. Bharat Electronics
Current PE: 15.5 10-year average PE: 19.8 Current price (Rs ): 108 1-year target price (Rs ): 126 Potential upside: 16.6%
A navratna PSU, it is engaged in the design, manufacture and supply of electronics products & systems for the defense requirements. Operational excellence, superior R&D, improved order execution, higher cash flows, and better working capital management are the key positives for the company. In addition, the focus on technological innovation which involves upgradation of machinery and infrastructure provides the much needed competitive advantage. It reported good numbers in the June 2019 quarter, with 16.9% year-on-year growth in operating profit and 13.9% growth in net profit. Analysts say the company will be the main beneficiary of the government’s reforms in the defence sector and its healthy order book provide strong revenue visibility going forward.
Current PE: 15.8 10-year average PE: 43.3 Current price (Rs ): 467 1-year target price (Rs ): 552 Potential upside: 18.2%
A wires and cables manufacturer, Kei Industries offers a wide range of cabling solutions. AnandRathi is bullish on the company due to its leading position in institutional cables, strong earnings growth and improved balance sheet. Strong order book of Rs 4,530 crore offers robust revenue assurance in 2019-20. The brokerage house expects that the cables segment mix of EHV cables, retail and exports will aid margin expansion in the future and its ability to generate free cash flows will help in the stock’s re-rating.
Current PE: 22.7 10-year average PE: 54.5 Current price (Rs ): 814 1-year target price (Rs ): 1,107 Potential upside: 35.9%
This miniratna category-1 PSU has three major business verticals: mining & construction, defence and rail and metro. According to a report by Antique Stock Broking, the metro rail projects will continue to provide large scale opportunities to the company as both the Centre and the states have stepped up their efforts towards increasing the metro network not just in big cities but also in tier II and tier III cities. In addition, BEML’s mining and construction business is expected to remain steady given robust Coal India capex outlook for 2019-20. The company expects to drive margin expansion through operating leverage, cost cutting measures and other operational excellence initiatives.
Analysts’ recommendations- Buy: 4 Hold: 0 Sell: 0
7. Kalpataru Power Transmission
Current PE: 13.6 10-year average PE: 29.2 Current price (Rs ): 453 1-year target price (Rs ): 548 Potential upside: 21.1%
A diversified conglomerate, Kalpataru is engaged in the global power transmission and infrastructure EPC space. ICICI Direct believes that the strong order book with good traction in non-T&D business (railways, pipeline), improved subsidiary performance and operating leverage gains are likely to support consistent growth. Moreover, diversification in international T&D markets would provide good opportunities. The returns ratios are expected to improve because of the company’s strategy to monetise non-core assets and sales proceeds from the transmission assets.
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