The $41 bn Indian Capital Goods industry has seen production grow at just 1% CAGR (compound annual growth rate) over the last three years. Imports have grown at 10% CAGR over the last five years and the share of imports in the Indian Capital Goods market has increased from 34% in FY10 to 40% in FY15. At the same time, the capacity utilisation of domestic manufacturers is only 60-70% across sub-sectors. The recently issued National Capital Goods Policy 2016 aims at increasing production of capital goods at CAGR of ~12.5% over FY15-25, growing share of exports from 27% to 40% of production and reducing import share from 40% to 20%. The domestic market is fragmented with a large number of SMEs, beyond a few large players. The listed space has underperformed Sensex over the last year.
* Growth is lagging: In FY15, the size of the capital goods market was $41 bn and total production was $33.4 bn. The growth of the sector has been lagging, with domestic market size de-growing at 3.6% p.a. and total production increasing by only 1.1% p.a. over the last three years. Heavy electrical equipment is the largest sub-sector (56% of market), followed by process plant equipment (9%) and earthmoving & mining machinery (8%).
Growing exports, but significantly sub-scale global share: The capital goods sector contributed $8.9 bn to exports in FY15. Export growth CAGR over the last three & five years has been 14.8% and 16.5% respectively. However, India’s share of global exports of capital goods is still significantly sub scale at 0.8% only.
* India a net importer across sub-sectors: Around ~$16.5 bn of capital goods were imported in India in FY15. Imports decreased at the rate of 5.2% p.a. over the last three years but this was due to a high base effect.
* 40-45% demand met by imports: This implies relatively low self reliance for capital goods. Capacity utilisation is only about 60-70% across sub-sectors indicating a need for creation of demand from domestic sources and import substitution.
* Low technology depth: India’s current level of technology depth ranges from basic to intermediate. India currently ranks 30th world wide on research intensity. Low technology depth results in relatively poor manufacturing competitiveness for India.
* Highly fragmented sector: The capital goods market is fragmented with a majority of operational units in the SME sector. These cater to small segments of a sub-sector and are challenged vis-à-vis large foreign competitors. In the exchange listed universe there are 10 odd capital goods companies with market cap of >$1 bn. The sector has largely underperformed the Sensex over last one year, led by BHEL (UW). We have been UW ABB, SIEM owing to high valuations and recently upgraded CG (CRG IN) to OW. CG stock is likely to trade ex-consumer by end-Feb-16, so value discovery of underlying components is likely to improve, in our view. Investing in CG allows investors to tap into potential value-unlocking on CG’s consumer business listing (~Apr-16, per management) and affords access to a potential open offer by the new consumer business promoters.