>INDIAN ENGINEERING (MOTILAL OSWAL)

Sector outperformance of 32% since March 2009; valuations running ahead of earnings
Our Engineering and Capital Goods universe, comprising ABB, BHEL, Crompton Greaves, L&T and Siemens, has delivered 81% returns since March 2009, v/s 49% by BSE Sensex. The recent outperformance had been driven by expectations of positive impact on business environment with continuity of government. Post the recent outperformance, 1-year forward sector P/E now stands at 22x FY11 and is in-line with 21x, average during FY05-09. The period between FY05-09 was one of the best periods in terms of power and industrial capex, resulting in earnings CAGR of 38%. During FY09-11, we expect earnings CAGR of 17%, and thus the current P/E of 22x leaves limited room for further outperformance, until visibility improves further on order intake and thus earnings.

Valuation multiples converge in uncertain earnings outlook period
Our analysis indicates convergence of valuation multiples for Engineering and Capital Goods sector during periods when earnings outlook is uncertain. For instance, in FY02 and FY03, P/E multiples (1-year forward) had converged at 7.5-9.0x. These periods coincided with beginning of the revival of the industrial cycle, and sector reported earnings growth of 57% YoY in FY02 and 15% YoY in FY03 vs negative earnings growth of 17% CAGR during FY98-01. Similarly, we notice that currently, the sector P/Es have largely converged, again given the uncertain earnings outlook.

Current valuations partly factor in industrial recovery; ABB, Siemens and L&T more leveraged

• ABB, Siemens are highly leveraged to private capex. Thus, the valuation will expand in the event of industrial capex recovery. Currently, both companies already quote at 30% premium to sector average.
• BHEL’s recent sector underperformance of 33% since March 2009 is driven by moderate earnings upgrades expectations as compared to peers, post continuity of government.
• L&T trades at premium of 10% to sector average and we believe that any further premium expansion is contingent on industrial capex rebound and success of new ventures like ship building, power equipment, nuclear, railways.

Valuation and view: We remain Neutral on the sector since it trades at one year forward P/E of 22x, in line with average during best period of earnings CAGR for the sector (FY05-FY09).

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