Saturday, April 3, 2010

>The Jury is Out on Capacity Utilization (MORGAN STANLEY)

Key Debate: How Soon is the Private Capex Recovery Coming? It is almost inevitable that we get the start of a new private capex cycle in 2010, in our view. However, its timing is still a debate. Indicators such as the non-oil trade deficit point to high capacity utilization and hence an immediate start to the capital spending cycle. However, other indicators suggest that we may still be a couple of quarters away from the start of a new private capital spending cycle.

Capacity utilization is still rising but probably not full: While the trade deficit suggests that domestic capacity utilization is running full, several other indicators (both lagging and current) suggest that capacity utilization is still a few months away from hitting the peak. Core inflation has only reverted to its long- term mean, corporate pricing power (defined as the gap between selling price and input costs) is coming off its low and the bank credit-deposit ratio is also just off the bottom. Anecdotal evidence we collected from our sector analysts support this view (see table below).

Pricing power has troughed and is likely to return strongly in the coming months: Unless we get punitive action from the RBI which causes growth to slow down considerably, we expect corporate pricing power to keep rising in the coming quarters. Pricing power troughed about six months ago and is already on a strong ascent. The implication is that earnings are likely to be strong in the coming quarters – an important foundation for capex.

Key capex drivers getting in place: We identify five factors that drive capex: a) Availability of capital; b) Cost of capital; c) State of the balance sheet; d) Capacity utilization; and e) Corporate profits and hence confidence on growth. The availability of capital is definitely improving whereas the cost of capital remains low relative to history. Corporate balance sheets are in good shape with debt-equity ratios reasonable, capacity utilization is rising thanks to acceleration in growth and the fall in capital spending over F2008 and F2009 and, most importantly, confidence in future growth is rising, epitomized by improving corporate profits.

Market implications – Continue to buy Industrials: Indeed, we believe industrial stocks will likely lead a capex recovery. Hence, we think the time to buy industrials is now even if the start of the capex cycle is out by a couple of quarters. The previous rate hike cycle suggests that industrials begin to outperform post the first rate hike. Valuations and ROE also favor industrial stocks over consumption stocks, in our view.

To read the full report: INDIA STRATEGY