Capital goods stocks: Time for a pause post the rally?

In the first half of FY24, the sector saw a robust 52% increase in aggregate order inflow year-on-year, largely driven by industry leader Larsen & Toubro (L&T), which logged a 65% growth, according to Incred Research Services Pvt. Ltd. So far so good, but with the upcoming general elections, some caution might prevail, possibly hampering order inflows until elections are out of the way.

Analysts at Prabhudas Lilladher anticipate frontloading of orders before the Union Budget. So, there could be some caution in awarding orders between the Budget and the general elections. “Since the companies are sitting on a robust order backlog, strong execution of these orders will contribute to healthy revenue growth for companies in the capital goods and engineering and infrastructure sector. However, order book might see some moderation, given the absence of new orders because of caution during February-May,” said Amit Anwani, an analyst at the brokerage firm.

So far, the government has maintained its strong investments in infrastructure-related sectors like roads, railways (including metro rail), water, and power transmission and distribution. That said, a wider belief is that renewable energy, electrical vehicles, battery technology, data centres, and hydrogen will be the dominant themes in capex over the next few years. 

“We believe infra plus industrial capex should see 16% CAGR in FY23-26E, vs 6% in FY11-20. Power, railways and industrial capex have the highest visibility,” analysts at Jefferies India said in a note dated 29 November. 

The government’s capital expenditure has been substantial even as private capex has been on a relatively weaker footing. The production-linked incentive scheme-led capex is expected to increase going ahead, thus aiding private players.

For now, there is some comfort in the sector’s near-term revenue visibility. “We expect for our infrastructure coverage universe (including L&T) earnings growth of 12% for FY24E, 21% for FY25E and 13% for FY26E,” said Ankita Shah, vice president of institutional equity research, Elara Securities (India). 

Companies with diversified presence across sectors are expected to benefit. Further, balance sheets are healthy with low leverage and continued monetization of long gestation assets is positive for freeing up capital for future growth, she added.

Correction in raw material prices should also aid the margin profile of companies that have a higher share of fixed price contracts. Thermax anticipates better profitability by steering clear of orders with a weak margin profile, while KEC International expects its Ebitda margin to improve to 7% in FY24 from 4.8% in FY23. In the case of L&T, margin was impacted due to legacy orders, which are likely to be completed by Q3FY24. 

For EPC companies, increased competition and investments in building capabilities could restrict margin improvement in the near term.

But the sharp rally in most key capital goods stocks indicate that the market has factored in the tailwinds in the form of strong order inflows, revenue growth and margin improvement to a large extent. No wonder that the anticipation of sustained high growth and improved margins has led to a valuation re-rating for some of these companies.

However, there is a slew of downside risks that investors remain watchful of, such as a slowdown in order inflows, significant rise in raw material prices, subdued exports and muted international revenue growth. Of course, the outcome of the general elections is crucial, but further consumption recovery, geopolitical tensions and the trajectory of global interest rate scenario are also critical in determining the future of these stocks.