>ENGINEERING SECTOR (MOTILAL OSWAL)

Free cash flow contraction ahead
During past 5 years, the strong earnings growth has provided strength to the capital goods sector balance sheet. Scenario is set to change with earnings moderation and increased working capital requirement. We expect the earnings quality to undergo deterioration during FY09-FY11, given lower free cash flows of Rs32b during FY09-FY11 vs Rs100b during FY06-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, which had moved from net debt of Rs37b in FY02 to net cash of Rs68b in FY08, is expected to lose net cash status by FY11/FY12; but still maintain a comfortable DER of almost -0.03x in FY11E. Given the weak earnings outlook and lower free cash flow generation, we expect capital goods sector to be a market performer. We have no Buy recommendations in the sector.

Free cash flows set to decline to Rs32b during FY09-FY11, v/s Rs100b during FY06-08#: The listed capital goods sector over the past 7 years has gradually reduced investments in fixed assets and working capital has been tightened. The current downturn should reverse this shift towards an asset light model, as working capital deteriorates and investments in capex increases. We expect free cash flows (post capex and working capital) to decline from Rs100b during FY06-FY8 to Rs32b during FY09-FY11. This could mean lower valuation multiples as compared to FY06-FY08 for the sector.

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% in FY08, mainly on account of (1) reduction in inventory from 107 days in FY01 to 68 days in FY08 and (2) increased client advances from 60 days in FY01 to 96 days in FY08. Going forward, we expect net working capital to increase from 3.1% in FY08 to 16.9% in FY11 driven by (1) lower customer advances (as % of revenues) triggered by stagnation in order intake, (2) shift towards government projects (v/s private projects) as well as towards projects as against products and (3) weakening of vendor finances.

To see full report: ENGINEERING SECTOR