>CAPITAL GOODS SECTOR (RBS)

While the outlook has improved in recent times, we feel stocks are trading at the upper end of their valuation bands and are unlikely to rerate further. Hence, we are Neutral on the sector. Stock picking is a judicious balance of long-term outlook and low risk in meeting near-term numbers. Thus, Buy BHEL and CGL.

Sector trading at the upper end of its valuation band; initiate coverage at Neutral
The capital goods and engineering space has seen a fundamental shift over the past six months, with a new government promising more on infrastructure, improved liquidity conditions and softer commodity prices. However, this structural shift is already reflected in share prices, in our view, and the sector is trading at the upper end of its valuation band, capping near-term upside potential. Stocks appear to be pricing in medium-term valuations, on a two- to three-year horizon. Hence, we initiate coverage at Neutral on a 12-month view.

Stocks unlikely to touch past valuation peaks, in our opinion
The bull argument for the sector, from a valuation standpoint, is that stocks are still trading well below historical highs seen in 2007, at which time valuations were explained by PEGs. While stocks may yet see some liquidity-driven PE expansion, we believe they are unlikely to repeat 2007 PEs when viewed from the PEG angle. If one compares the growth exhibited by these companies over FY05-08 with that in FY09-12F, one finds that sales, EBIDTA and PAT growth is much slower now. Similarly, the operating leverage story that played out in the earlier period will now be much more muted. Finally, the delta we saw in RoE and RoCE earlier is unlikely to be repeated because capital goods companies are themselves in capex mode. Slowing order books and stretching working capital cycles also means free cash flow generation is much lower than in the past. What is different this time around is the global cost of capital. At an all-time low, this variable is driving up the valuations of many sound companies. Could this be the dark horse in the valuation game?

Relative stock picking is the order of the day; Buy BHEL, Crompton Greaves
In the current scenario, we believe stock picking has become relative instead of absolute. Of the core bellwether stocks, BHEL and Larsen & Toubro, we prefer BHEL on a 12-month perspective. This is based on our view that downside risk is greater than upside, thus we advocate stocks with lower beta. While Larsen has multiple drivers to fire when the going is good, it is precisely this that increases its beta. Among the T&D stocks, we pick Crompton Greaves, because we believe the traditional valuation gap between Crompton and its MNC peers should shrink within the next year. The other key reason for choosing BHEL and Crompton is that we believe they are the least likely to disappoint in terms of FY11 numbers.

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