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The 8-25% decline in key stocks since our January 20 note has lowered the difference in implied future and historical business CAGR to 1.5% over a 20- year period, still a tall ask. The decline has been more discerning across the spectrum, versus the 16-20% fall in the prior month, with Cummins declining the least and ABB/Siemens the most. We remain constructive on stocks where salience and growing relevance of business themes beyond recovery in private sector spending stand out. Upgrade Carborundum Universal and Praj Industries to BUY, ABB and Thermax to ADD and SIEMENS to REDUCE; retain BUY on Cummins, REDUCE on L&T and SELL on CGPOWER.

Last leg of pain ahead for the sector to reach sane implied growth expectations

The average capital goods stock in our coverage is factoring in ~1.5% higher PAT CAGR than the historical revenue growth over the next 20 years. This difference has become 30% of the >5% levels over the past seven months, the majority of which has happened over the past two months. The absolute quantum of PAT CAGR factored in is averaging >14% over such a period, a tall ask. Select stocks such as L&T, Praj Industries and Carborundum Universal are factoring in lowerthan-historical business CAGR. ABB, Cummins and Thermax are in the 1-1.6% range on this metric, while Siemens and CGPOWER (lower RoIC than ABB) continue to factor in 4-7% higher-than-historical business CAGR. The key aspect to consider is a long 20-year call the sector has become. Just to put it in context, this compares to a lower 12-year call on business CAGR that the transportation sector is.

Key private sector plays saw large correction; KKC and L&T were more resilient

As anticipated by us, the key private sector plays in ABB, Siemens and Thermax got hit the most, declining 24-25% over the past 40 days. Cummins and L&T declined 7% and 11%, respectively. L&T’s decline, though, needs to be seen in context of very strong order inflows in 3Q and then in 4Q to date. Mid-cap stocks with company-specific risks saw sharp corrections - Carborundum declined 32% on weak results and Russia overhang while Praj Industries declined 39% on weak results and overhang of commissioning of the underutilized Mangalore facility.

Upgrade Carborundum, Praj to BUY and TMX to ADD; KKC remains top BUY idea

The above four stocks are all diversified plays on themes beyond private sector spending. Also, the difference in growth expectations over the next 20 years for these stocks is much lower versus the rest of the pack. Carborundum Universal and Praj Industries have a low base of near-term earnings as well. We upgrade Carborundum Universal to BUY (from REDUCE), Praj Industries to BUY (from ADD) and Thermax to ADD (from REDUCE).

Upgrade ABB to ADD, SIEM to REDUCE; CGPOWER (SELL) still expensive

We upgrade ABB to ADD with an unchanged FV. Upgrade Siemens to REDUCE from ADD as recent results have brought out risk margin in Digital Industries that we were concerned about. For Siemens, the risk emanates from the upcoming demerger—a potential change in license fee/royalty terms as promoters change hands in the demerged entities. CGPOWER remains expensive in the context of a limited span of growth opportunity in domestic T&D and Kavach opportunity.

Implied growth expectations are moderating

The guiding light for us in terms of value continues to lie on the difference between growth expectations factored in existing businesses versus the growth delivered in the past. Even post the recent stock price correction, the difference for the average capital goods stock under coverage is 1.5% over the next 20 years, a long growth period. The same has reduced from 5%/4%/2.5% levels in July 2024/December 2024/January 2024. The absolute growth expectation is still >14% over the next 20 years.

Some more downside for the market ahead

The exhibit below aims to back-calculate the implied growth expectations in stock prices. The same takes into account the value of businesses not captured inside near-term estimates, on which such growth expectations are calculated. For instance, the value of the semiconductor business and of impending QIP for CGPOWER is taken out of its current market capitalization to derive growth expectations. Similar is the case for Thermax’s Green Energy Solutions where EPS is currently negative and the value of the same (at 1.3X P/B) has been taken out of CMP.

We come to an implied PAT CAGR numbers based on a long 20-year growth period (terminal growth of 5.5-6% ahead), the company-specific FCF-to-PAT conversion ratio and a cost of equity that takes into account inherent risks in the business.

We compare the implied PAT CAGR to the historical revenue growth for the capital goods companies and come to an average difference in the future and the past at 1.5%. We note the implied revenue CAGR expectations would be different (potentially higher) than the implied PAT CAGR expectations on account of margin movement (already at high levels) and other income (typically moves slower than revenue growth). The difference, thus, would be higher than 1.5% suggested by our analysis below.

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