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Identifying key themes for CY19
Capex recovery to gain momentum post general elections in May’19
As we step into the last month of CY18, we present the key themes that are likely to play out in the Industrials’ space over next year. In this note, we list down our thoughts on CY19 and our preferred stock ideas.
CY19 a two-faced coin: Orders to slow in 1HCY19 and bunch up in 2HCY19
Orders are the lifeline for the Industrials’ sector companies as these provide revenue visibility and have typically led the re-rating /de-rating of stock prices in the sector. While 1HFY19 witnessed preponement of orders due to the upcoming state and central elections, Q419/1HCY19 should witness a visible slowdown from both the government (as the government machinery gears up for the general elections) and the private sector (deferment of orders till after the elections). However, historically there is a bunching-up of orders in the quarters following elections; and in the case of 2HCY19, we don’t believe it would be otherwise (See Exhibit 1). It is imperative that investors position their portfolios for the impending revival in orders in 2HCY19 while seeing through the transient slowdown in 1HCY19.
Finally, a revival of industrial/private sector capex
The much delayed and widely discussed revival in private capex is finally starting to materialize, in our view, and would gain further momentum after the general elections. While we have already seen a pick-up in consumption-oriented sectors (Auto, Pharma, Consumer Electronics, F&B), the recovery is set to get more broadbased with Refining, Cement and Steel also joining in (See our recent note: ‘India Industrials: Reminisces from the past cycles; pockets of recovery evident’). Moreover, we do expect momentum in the cycle to continue for the next few years as a pick-up in end-market demand drives higher capacity utilizations and resultant capex (Exhibit 2 and 3). Thermax, L&T, Cummins India and Engineers India are our key BUY ideas to play the industrial capex recovery.
Refocus on Construction and Defense as general elections get priced in
The past few quarters have seen a sharp de-rating in stocks, which have significant end-market exposure to Central government-related ordering, especially in Infrastructure and Defense (Exhibit 4 and Exhibit 5). Ordering for the Industrials’ sector are typically back-ended and elections in May’19 has already led to the street worrying about order deferments and a slowdown in execution in Q4FY19/Q1FY20. Moreover, we have been sensing a general risk aversion by investors towards the aforementioned sectors pending clarity on the outcome of the general elections in May’19. In our view, as the Street factors in a favorable verdict for the ruling coalition implying continued momentum in spends for road, rail and defense, we expect a significant re-rating in stocks from the road and rail construction, and the defense sector. Our key picks are KNR Constructions (BUY, TP: INR 280), Ashoka Buildcon (BUY, TP: INR175) and BEL (BUY, TP: INR105).
Demand for cooling products (air conditioners and coolers) to revive on above normal summer temperatures
CY18 witnessed a weak summer season leading to high inventory levels with manufacturers of air coolers and air conditioners. YTD FY19 sales for both coolers and air conditioners have declined in high single-digit to low double-digit. This has led to pricing pressure and discounts hurting margins of manufacturers who are under pressure to clear inventory. Expectations of a revival are set with eyes on the CY19 summer season. Further, the IMD in its recent forecast (Nov’18) indicated a higher probability of an El Nino by Feb’19, implying a higher-than-normal summer temperature with increased chances of strong/severe heat waves. Key beneficiaries of an intense summer and resultant high demand for cooling products are air conditioner manufacturers (Voltas, Blue Star, Havells, Johnson Hitachi) and air cooler manufacturers (Symphony, Voltas, Bajaj Electricals).
Margins to bounce back for consumer durable/electrical players on price hikes, stronger INR and lower commodity prices
A weak summer season with resultant fall in volumes and prices, along with a decline in the INR and higher commodity costs led to a sharp fall in margins for consumer durable companies in 1H19 (See Exhibit 6). Additionally, lighting segment margins (primarily for Crompton Consumer) were impacted due to price cuts by competition. To offset this, price hikes have been implemented in Lighting products, Refrigerators and Washing Machines from Oct’18, and there are plans for price hikes in Air conditioners from Jan’19. Plus the INR appreciation and fall in commodity prices should further support margins. Crompton Consumer witnessed a sharp de-rating on the back of lower margins in its lighting segment (See Exhibit 7), and we expect a sharp re-rating once margins bounce back over the next few quarters.
Spike in power demand prior to state and central elections belie a revival in power eqt demand
Given the upcoming state and central government elections over the next few quarters, we expect power demand to increase. Already current spot power prices are heading north due to ongoing state elections spread over Nov-Dec’18. As seen historically, power demand from state DISCOMS increase prior/during elections due to reduced load-shedding and power-cuts as the respective states head into elections which leads to higher spot power prices (See Exhibit 8). While the street may get excited on higher spot prices and higher plant-load factor (PLF) being a precursor for a revival in power equipment ordering, we remain circumspect currently as we believe it to be a temporary phenomenon until elections get over. We are structurally bearish on coal-fired power capacity addition over the mediumterm, which drives our SELL call on BHEL (TP: INR60).
Industrials sector: Valuation and view
Our preferred plays in the Industrial sector are L&T (BUY, TP: INR1, 550), Bharat Electronics (BUY, TP: INR105), Cummins (BUY, TP: INR920), Thermax (BUY, INR1, 210), and Engineers India (BUY, INR150), driven by our view of capex revival in the Industrial and Infrastructure space over the next few years. Given our bearish view on new coal-fired capacity, we retain our SELL rating on BHEL (TP: INR60). We retain our BUY rating on Crompton Greaves Consumer (TP: INR250) as a margin recovery play over the next few quarters and our Neutral rating on Voltas (TP: INR510) and Blue Star (TP: INR620). Key risks to our ratings include (a) delayed recovery in corporate capex beyond 2HCY19, (b) an unfavorable outcome for the incumbent party in the upcoming general elections, and (c) sharp rise in commodity prices over the next few quarters.
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