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Eyes on execution growth and margins

The capital goods sector stocks have declined over the last six months on account of concerns around order inflow improvement, the sustainability of execution growth, as well as high margins. With FY25 being an election year, order inflow was expected to be weak, but it is anticipated to ramp up from 4QFY25 onwards. However, ordering has remained strong across thermal power, renewables, T&D, data centers, buildings, and factories, while it has been weak in water and railways. Defense sector ordering is also expected to ramp up based on recent approvals. For genset players, as highlighted in our recent note, demand was initially impacted in October and November for low-to-mid kVA nodes but has started to recover. Overall, we believe that despite selective order inflow improvement, the strong existing order books provide healthy revenue visibility for companies in the sector. We expect a 19% YoY growth in execution for 3QFY25. We expect margins to remain largely stable QoQ, given the benign commodity prices. As a result, we expect a ~20bp YoY expansion in EBITDA margin for our coverage universe. For 3QFY25, we estimate our coverage companies to report revenue growth of 19% YoY, EBITDA growth of 21% YoY, and PAT growth of 26% YoY.

Expectations line up for inflow revival in 4QFY25

Due to the impact of elections (center and state) during 9MFY25, ordering activity was selective. We have witnessed continued traction across sectors such as power T&D, renewables, thermal, semiconductors, data centers, and electronics, while ordering from traditional sectors remained weak, although there is a build-up in the inquiry pipeline now. However, despite weaker ordering, strong inflows during FY24 have supported order books. We expect ordering to pick up from 4QFY25, primarily from government capex, which has been weak so far. The upcoming union budget is expected to provide more clarity regarding the government’s policy direction. Defense sector ordering is also expected to materialize in 4QFY25 as the focus on indigenization continues. During the quarter, LT bagged an ultra-mega order from NTPC for thermal power plants in MP and Bihar, addressing some concerns on domestic ordering ramp-up. LT announced orders worth ~INR225b, BHE won ~INR23.6b, KECI secured ~INR60.1b, and KPIL acquired ~INR54.3b worth of orders. With strong existing order books, we estimate 19% YoY growth in execution in 3QFY25 for our coverage universe

Stable margins to be supported by benign RM inflation

EPC companies are expected to continue reporting sequential margin recovery, in line with their guidance, as execution takes place at favorable terms and commodity prices remain at comfortable levels. We expect EBITDA and gross margin for select large product companies to be either flat or witness slight moderation QoQ due to pricing corrections amid select demand weakness. Product companies are continuously focusing on high-margin areas, tech-led offerings, and deeper penetration in tier 3 and 4 markets; hence, we expect margins to remain high YoY. Prices of key inputs continue to be at manageable levels. Since May’24, copper/aluminum/HRC prices have corrected by 12%/1%/13%, respectively, while zinc prices have risen 3%. We expect ~20bp YoY margin expansion in 3QFY25 for our coverage universe.

Exports bottom out; expect to improve QoQ

International ordering has remained healthy during the quarter, primarily backed by the global push for renewable energy and infrastructure investments, as reflected in inflows for KECI and KPIL. The ongoing situation in the Middle East merits a closer observation as the trajectory of crude prices has a direct bearing on the fiscal health, and consequently on the capex outlay of key markets such as Saudi Arabia, Qatar, and the UAE. For companies such as KKC, the exports trajectory has shown a sequential uptick and appears to have bottomed out, with improved traction from Europe and LatAm, while other markets are still experiencing weakness. On the other hand, TRIV is clocking healthy export growth, driven by its focus on expanding its international presence.

Long-term capex cycle remains intact

While there have been some near-term hiccups, we believe these are transient in nature. Our long-term thesis on the capex cycle remains intact, supported by policy continuity and a relatively stable macro environment. Sectors such as renewables, transmission, PLI, and defense continue to witness robust traction, wherein the government has already initiated policy measures that provide long-term visibility. These factors, along with healthy bank and corporate balance sheets, create an enabling environment for private sector capex, which has so far been selective. Companies are sitting on healthy order books, which should provide visibility for a healthy revenue CAGR going forward.

Our top picks Our top picks

in the sector are ABB, LT, and BHE. We expect ABB to be a key beneficiary of an improved addressable market for short-cycle orders from the private sector, as well as transmission, railways, data center, and PLI-led spending. We expect LT to continue benefiting from international spending and a potential revival in domestic spending, while maintaining strong control over its working capital. We favor BHE for its strong presence in defense electronics, ability to grow revenue and PAT in mid-teens CAGR, and improving return ratios.

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