Divergence between top-down and bottom-up views on the investment cycle is increasing. While the top-down view expects a cyclical revival led by macro recovery, potential reforms and interest rate easing, our bottom-up analysis suggests continued weakness in the investment cycle in FY14. Hence, we downgrade L&T to Equal Weight (Price Target R1,750) and downgrade Cummins to EW (PT R563). We recommend switching into interest rate sensitive stocks JPA and Adani Ports (both rated OW?Overweight).
Cycle view: While our overall view on cycle recovery is negative, in terms of relative end-market positioning, we are negative on the power (boiler/turbine) cycle, while we expect T&D (transmission and distribution) to weaken in FY14 and the industrial capex (capital expenditure) revival to remain elusive. Cement, steel, and downstream oil & gas should all be weak.
We are positive on the infrastructure order pipeline but the land acquisition/ approval process is constraining ordering and there is limited progress on easing bottlenecks. We expect road/dedicated freight corridor and metro orders to be strong. Within industrials, we expect fertiliser and upstream oil & gas capex also to be strong.
Key OW/UW picks: We prefer infra asset owners over capital equipment names. Our OW ideas in the infra sector are JPA and Adani Ports. Our key UW (Underweight) is BHEL. While we prefer L&T relative to BHEL, we downgrade it to EW to reflect the weak FY14 outlook. We also downgrade Cummins to EW due to steep valuations.
How are end-markets faring in FY13? In FY13 year to date, power boiler/turbine ordering has been weak while T&D ordering was strong. Infrastructure witnessed a mixed ordering trend across its various end-markets with roads being weak (only 1,000km ordered YTD in FY13), and airports and ports not seeing much ordering. However, metro and building orders have been strong. Industrial capex was weak with limited ordering in most end-markets so far. Sector valuations at the start of FY13 at 11.5x forward P/E (price-to-earnings ratio) were favourable but valuations have expanded by 40% to 16.5x forward P/E now.
Top down view: We are positive on macro recovery and start of interest rate easing. Barclays India economist expects GDP growth to increase to about 6.6% in FY13-14 from 5.6% in FY12-13. This is on the back of expectations of more accommodative monetary policy and government policy initiatives. An absence of headwinds from weather aberrations (such as in 2012) should help agriculture and consumption demand, while industrial growth will enjoy favourable base effects. On interest rates, Barclays economist expects policy rates to start softening gradually from Q1CY13 and forecasts an overall 100bps (basis points) cut in the policy rate in H1CY13.
Bottom-up view: We expect the investment cycle to remain weak in FY14, with the power BTG (boiler-turbine) pipeline being weak, T&D (transmission & distribution) orders peaking and the pace of conversion of the strong industrial and infra pipelines to remain slow, given no organised efforts to speed up project activity. Substantial efforts aimed at easing land acquisition, coal constraints and speeding up approvals could, however, impact the cycle view. Policy initiatives until now are below our expectations and, hence, we are cautious.
Stock positioning: While we continue to prefer L&T over BHEL, we are of the view that absolute potential returns in FY14e (estimates) will be limited for L&T. We started CY12 with L&T as our top sector pick largely on account of: (i) supportive valuations; and (ii) our expectation of L&T achieving its order inflow growth guidance for FY13. Following the strong Q2FY13 results, we were of the view that L&T would exceed guidance for FY13e and likely reform measures by the government would lead to better-than-expected order growth in FY14e. However, with reforms disappointing expectations and continued delay in conversion of infra order pipeline into orders, we now expect L&T to just about meet consensus expectations and to have slower growth in FY14. Hence, we downgrade L&T to EW from OW and reduce our PT to R1,750 (from R1,851).
Prefer interest rate sensitive stocks over capital goods: We prefer interest rate sensitive stocks JPA and Adani Ports over capital equipment companies. There is not much impact to be seen from interest rate easing on stock prices of capital goods companies. This is on account of the view that order inflows are being impacted by weak policy and poor on-the-ground execution of the order pipeline.
Where are we different from consensus? We believe the key difference is our continued expectation of a weak cycle in FY14, largely driven by our bottom-up view on order pipeline strength and the likely pace of conversion of this pipeline. While the top-down view suggests a recovery in investment cycle led by easing momentary policy and base effects, we believe that continued weakness in ordering over the past few years should lead to an impact on execution and hence, gross capital formation.
Furthermore, order inflows are currently weak not due to weak macro growth but due to: (i) cycle impact?most of the ordering meant for 12th Plan delivery in the power sector has been completed; and (ii) structural impact?infrastructure and industrial orders are slow due to the bulk of projects being Greenfield in nature, making them prone to delays on account of lengthy approvals and land acquisition issues. The structural impact can be eased by firm policy and its implementation, but the cycle impact changes only over a period of time. (The 13th Plan orders will commence only in FY15/16).
Infrastructure?strong pipeline but downside risks near-term: While FY12 was a steady year for the infrastructure segment, owing to healthy road and metro ordering, FY13 order activity was mixed, with metro ordering strengthening and roads deteriorating (NHAI awards of 1,000km year-to-date FY13 vs. 6,500km of roads in FY12). New order activity in other segments such as railways, airports and ports remained weak. Our bottom-up analysis of the order pipeline in infrastructure sectors such as airports, ports, railways and roads suggests that although the order pipeline is large, order activity in FY14 may remain weak on account of (i) a lack of environmental approvals for key projects; (ii) delays in project execution due to land acquisition issues; and (iii) a lack of funding/financial closures.
Barclays
