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Engineering
BSE Sensex: 11,876S&P CNX: 3,621
11 May 2009
Free cash flow contraction ahead
During past 5 years, the strong earnings growth has provided strength to the capital goodssector balance sheet. Scenario is set to change with earnings moderation and increasedworking capital requirement. We expect the earnings quality to undergo deterioration duringFY09-FY11, given lower free cash flows of Rs32b during FY09-FY11 vs Rs100b duringFY06-FY08. This will be driven by increased working capital requirements to 16.9% of revenues in FY11 as compared to 3.1% in FY08. Thus, the capital goods sector, whichhad moved from net debt of Rs37b in FY02 to net cash of Rs68b in FY08, is expected tolose net cash status by FY11/FY12; but still maintain a comfortable DER of almost -0.03xin FY11E. Given the weak earnings outlook and lower free cash flow generation, weexpect capital goods sector to be a market performer. We have no
Buy
recommendationsin the sector.
Free cash flows set to decline to Rs32b during FY09-FY11, v/s Rs100b duringFY06-08#:
The listed capital goods sector over the past 7 years has gradually reducedinvestments in fixed assets and working capital has been tightened. The current downturnshould reverse this shift towards an asset light model, as working capital deteriorates andinvestments in capex increases. We expect free cash flows (post capex and workingcapital) to decline from Rs100b during FY06-FY8 to Rs32b during FY09-FY11. Thiscould mean lower valuation multiples as compared to FY06-FY08 for the sector.
EXPECT A MEANINGFUL REDUCTION IN FREE CASH GENERATION DURING FY09-11E (RS B)*
Free cash flow fromoperations (post capex) hasincreased from negative Rs4b in FY01 to Rs38b inFY08. We expect the same todecline to Rs8b by FY11
*Details in Annexure ISource: Company/MOSL
Working capital deterioration imminent during FY09-FY11:
During FY01-08, NWC(Net Working Capital, percentage revenue) has improved from 36.4% in FY01 to 3.1% inFY08, mainly on account of (1) reduction in inventory from 107 days in FY01 to 68 daysin FY08 and (2) increased client advances from 60 days in FY01 to 96 days in FY08.
-420242292834389815-142183450
     F     Y     0     1     F     Y     0     2     F     Y     0     3     F     Y     0     4     F     Y     0     5     F     Y     0     6     F     Y     0     7     F     Y     0     8     F     Y     0     9     E     F     Y     1     0     E     F     Y     1     1     E
Decline in FCF due toincreased working capitalrequirements and highercapex (by BHEL/L&T)
#All the data points for ABB, BHEL, CG,L&T and Siemens unless stated otherwise
Sector Update
Shridatta Bhandwaldar (
Shridatta.Bhandwaldar@MotilalOswal.com 
); Tel: +9122 39825417Satyam Agarwal (
Agarwals@MotilalOswal.com 
); Tel: +9122 39825410
 
Engineering
11 May 2009
 
2
2324271618171717222322242610101112131512111111111011612182430
     F     Y     9     9     F     Y     0     0     F     Y     0     1     F     Y     0     2     F     Y     0     3     F     Y     0     4     F     Y     0     5     F     Y     0     6     F     Y     0     7     F     Y     0     8     F     Y     0     9     E     F     Y     1     0     E     F     Y     1     1     E
% of Revenues% of Order Book
Going forward, we expect net working capital to increase from 3.1% in FY08 to 16.9% inFY11 driven by (1) lower customer advances (as % of revenues) triggered by stagnationin order intake, (2) shift towards government projects (v/s private projects) as well astowards projects as against products and (3) weakening of vendor finances.During FY03-FY08, customer advances as a percentage of revenues for the capital goodscompanies increased from 16% to 26%; and has led to meaningful savings in terms of working capital requirements. This increase in customer advances was associated with355% increase in order intake during the same period, as the phase of acceleration inorder intake is typically accompanied by higher customer advances. Going forward, duringFY09-11, we expect order intake CAGR of -1% YoY, as compared to 131% during FY06-08. Deterioration in the bargaining power will also entail that quantum of advances onincremental orders will be impacted, and thus we expect customer advances as a percentageof revenues to decline from 27% in FY09 to 23% in FY11 i.e. increase in working capitalby 15 days.
CLIENT ADVANCES (AS % OF REVENUES) HAVE PEAKED
With expected stagnation / decline in order intake, thecustomer advances as a % of revenues will decline duringFY09-FY11 from 27% to 23%
Source: Company/MOSL
BHEL, L&T to be affected; ABB has already witnessed deterioration:
BHEL,L&T and ABB had witnessed the largest improvement in net working capital (NWC)during FY01-FY08 due to increased advances from clients (on accelerated pace of orderintake) and better terms with creditors. Going forward, during FY09-11E, we expectBHEL's NWC (as % revenues) to increase to 15.8% in FY11 from -2.6% in FY08 (drivenby lower customer advances) and for L&T at 19.7% in FY11 from 6.7% in FY08 (drivenby vendor financing and marginal increase in debtors days). For ABB, NWC has alreadyincreased to 15.1% of revenues in December 2008, v/s 7.9% in December 2007; and weexpect the same to increase further to 21.9% by CY10.
EXPECT WORKING CAPITAL DETERIORATION DURING FY09-FY11 (DAYS)FY01FY08CHANGEFY11ECHANGE(FY01-08)(FY08-11E)
ABB10629-778051BHEL189-9-1995867CG8519-665132L&T12824-1047448Siemens-654692016
Industry13311-1226251
Source: Company/MOSL
 BHEL / L&T are likely towitness meaningfuldeterioration in NWC cycleduring FY09-FY11 givenstagnation in order intake,vendor financing and shifting of business mixtowards projects / government orders
Substantial increasein order intakeOrder intake haspeaked indicatingdecline in clientadvances
 
Engineering
11 May 2009
 
3
Valuation and view
Capital Goods sector quotes at PER of 18x FY10, vs. historical average of 16.5x (1yr-forward earnings) during FY94-09. We estimate earnings CAGR of 16.3% during FY09-FY11 (3.6% CAGR excluding BHEL). We note that during FY98-01, when the earningswere declining (earnings CAGR -17%), the average P/E (1 year forward earnings) stoodat 16x.Thus, while the weak earnings outlook and lower free cash flow generationexpectations is negative, we expect capital goods sector to be a market performer. We donot have any
Buy
recommendations in the sector.
COMPARATIVE VALUATIONRATINGCMPTARGET PRICEEPS (RS)PER (X)P/BV (X)ROE (%)RS/SHRS%FY09FY10%YOYFY09FY10FY09FY10FY09FY10
ABBNeutral472429-925.823.8-7.818.319.84.73.929.221.5L&TNeutral990879-1155.457.43.517.917.34.74.124.320.8BHELNeutral1,6461,391-1666.486.930.924.818.96.35.127.629.8CromptonNeutral166155-614.515.57.311.510.75.04.035.529.3SiemensNeutral335258-2314.618.526.822.918.15.53.628.523.0
Source: MOSL
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