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Reflecting on high-growth and low-growth areas

Our analysis of 3QFY25 commentary from 25 companies, both from covered and uncovered universe in the capital goods space, indicates that the last two years were extremely good in terms of overall performance of companies, resulting in a high base for most players. Before companies embark on another leg of the high-growth phase, we expect near-term moderation in growth. Macro drivers continue to remain strong from T&D, renewables, electronics, data centers, etc., while some weakness is seen in government and core private sector-related ordering. Going ahead, we will watch out for 1) growth in segments beyond Electrification/Energy for players like ABB and Siemens, 2) conversion of inquiries to orders for Private sector companies like Thermax and Triveni Turbine, 3) ramp-up in ordering from the Defense sector, where various large projects are already closer to finalization, and 4) normalization of the powergen market for players like Cummins and KOEL, which is already improving sequentially. Our preference remains for players that are able to tide through this near-term volatility with a well-balanced revenue mix, control over margins, and the ability to maintain or improve their growth profile going forward. We remain selective on the sector and maintain our positive bias for LT, ABB, and KKC in the large-cap industrial space and BHE in the defense space.

Sector performance remains mixed

During 3QFY25, the capital goods sector’s performance on PAT was ahead of our estimates for large companies such as ABB, Siemens, Cummins, BEL, and Triveni Turbine, while a large miss was seen among mid- and small-sized players on execution and profitability. Execution was healthy while inflows were patchy, resulting in a cut in our order inflow assumptions and overall earnings for the future. Outliers in this regard remained LT with a marginal cut, Bharat Electronics (no change in earnings), and Cummins (no change in earnings).

Outlook on growth areas – high hopes from T&D and defense

Ordering was strong from areas like renewables, T&D, and urban infra, while defense, railways, and water have remained lower than last year so far. For companies like LT, KEC, KPI, and Hitachi Energy, a focus on renewables and international geographies has helped in growing order inflows. However, apart from HVDC orders, large-sized order inflows, mainly from government projects, were missing in the quarter due to delays in the order finalization. Private sector companies like Thermax and Triveni Turbine have witnessed weak inflows from base industries. The pipeline continues to remain strong from T&D, while railways, road, water, etc. are dependent on government capex. Going ahead, we will watch out for: 1) growth in segments beyond Electrification/Energy for players like ABB and Siemens, 2) conversion of inquiries to orders for Private sector companies like Thermax and Triveni Turbine, 3) ramp-up in ordering from the Defense sector, where various large projects are already closer to finalization, and 4) normalization of the powergen market for players like Cummins and KOEL, which is already improving sequentially.

Most companies are optimistic on exports

LT and Triveni Turbine have outperformed in overall performance on international projects driven by renewables, resulting in an increasing share of revenues from international geographies. ABB, Siemens, and Hitachi Energy are expecting to gain from mandates from their parent entities, while KEC/KPI are also benefiting from international renewable opportunities. GE T&D, CG Power, and TRIL are looking to increase their share of exports, particularly on the power transformers side. On potential US tariffs, companies are still evaluating the situation and will work around logistics. However, it is too early to quantify any potential impact from this

Overall margins are still higher than at the beginning of the capex cycle

EBITDA margin performance for product companies in the Industrials universe has remained fairly strong during 3QFY25 as well as over the last two years. This was driven by strong demand, pricing gains, low-cost RM inventory, and operating leverage gains driven by cost-efficiency measures along with higher volumes. Going ahead, we are baking in a 50-150bp EBITDA margin contraction over the next few years as: 1) some benefits of pricing gain will be offset by demand softening, and 2) the benefits of low-cost RM inventory will diminish. We expect EBITDA margins to still remain higher than the period of FY19-22 on better product mix, improving share of high-growth sub-segments, higher share of exports, and fairly stable commodity prices. For EPC companies, we expect 50-100bp improvement for LT, KEC, and KPI on the completion of legacy projects. These margins are still lower than the 10%+ levels seen in the past due to increased competition and expenses towards newer geographies.

Recommendation

Our preference remains for players that are able to tide through this near-term volatility with a well-balanced revenue mix, control over margins, and the ability to maintain or improve growth profile going forward. We remain selective on the sector and maintain our positive bias for LT, ABB, and KKC in the large cap industrial space and BHE in the defense space.

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