Thursday, September 10, 2009

[Investors Please Listen] Engineeing, Capital Goods & Infrastructure Sector Update ;we prefer BHEL, McNally, TRF and IVRCL over Thermax, Punj Lloyd and Elecon.

For Engineering, Capital Goods and Infrastructure (ECI) companies, the old adage and popular notion that "investment spending in the trough period will witness sharp reduction and subsequent recovery will be more gradual" seems unlikely to hold true and is likely to surprise everyone positively. Stable economic growth, albeit at lower levels and the promise of a strong demand momentum in FY11E and FY12E, are likely to result in the period of slowdown in investment spends remaining 'Brief' and 'Momentous' versus the earlier fear of a prolonged downturn. Further, the three pre-conditions for broader participation in capital spends i.e. (1) underlying demand momentum (2) willingness by private sector to install capacities and (3) ability to achieve project-financing closure, are at work.

We have forecasted nominal growth in capital spends at 13% in FY10E, thereafter strengthening to 17% and 18% in FY11E and FY12E respectively. It is public spends that will drive capital spends in FY09-12E period with nominal growth of 16%, 18% and 19% in FY10E, FY11E and FY12E respectively. Private spends are likely to report lower nominal growth at 12% in FY10E and rebound thereafter to 16% and 18% in FY11E and FY12E respectively. Thus, the expected growth in capital spends at 16% CAGR in FY09-12E period is likely to translate into an earnings CAGR of 22% for our ECI universe. We expect our ECI universe to report an earnings growth of 19% in FY10E, thereafter strengthening to 24% in FY11E and broadening to 23% in FY12E.

We have valued the companies in our ECI universe on FY11E earnings to capture their true growth potential. Further, we have solely focused on the single valuation method of PER to value core engineering business, which in turn, is derived from three different measures i.e. (1) Average PER in FY04-08 period (2) Average PEG in FY04-08 period and (3) Average premium to index valuation in FY04-08 period. Further, we have added the embedded values (BOT, subsidiary and JV businesses) to the target valuation of core engineering business to arrive at the target value of the ECI companies under coverage. Consequently, we have assigned target prices of Rs2378/Share, Rs1525/Share, Rs242/Share, Rs417/Share, Rs81/Share, Rs222/Share, Rs579/Share and Rs427/Share for Bharat Heavy Electricals (BHEL), Larsen & Toubro (L&T), Punj Lloyd, Thermax, Elecon Engineering (Elecon), McNally Bharat (McNally), TRF and IVRCL Infrastructure (IVRCL) respectively. We believe that the 'Best Plays' in the current capital spend cycle are companies exposed to 'STRUCTURAL CAPEX'. Hence, we prefer BHEL, McNally, TRF and IVRCL over Thermax, Punj Lloyd and Elecon.


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