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Engineering Sector Analysis Report

[Key Points | Financial Year '16 | Prospects | Sector Do's and dont's]

  • Engineering is a diverse industry with various segments. A company from this sector can be a power equipment manufacturer (like transformers and boilers), execution specialist for Engineering, Procurement and Construction (EPC) projects or a niche player (e.g.: providing environment friendly solutions like waste water and air pollution treatment plants). The company can also be an electrical, non-electrical machinery or static equipment manufacturer too.
  • Order book size is the biggest determinant of the company's performance in engineering sector. The same holds true for construction companies as well. It indicates companies' revenue visibility. In order to bag big contracts, companies need to have a strong balance sheet and proven execution capabilities. Companies in these sectors need huge working capital to execute bigger contracts. In most cases, they receive only part payment at initial stages and the remaining comes as projects get executed.
  • Indian capital goods manufacturers have been facing competition from foreign players; particularly Chinese and Korean manufacturers since the onset of 11th five year plan. Currently, despite increased domestic capacities, low cost foreign manufacturers still give tough competition to domestic manufactures in some segments of the industry.
  • Power sector contributes almost 70-75% to the engineering companies' revenues. The government plans to add large generation as well as transmission and distribution (T&D) capacities in view of the paucity of power in the country. Barring the short term challenges, there is enormous potential for the engineering majors in both generation and T&D space.
  • Given the lack of quality infrastructure in India, the construction industry has over the long term been witness to a strong growth wave powered by large spends on housing, road, ports, water supply, rail transport and airport development. The sector's growth has however remained quite subdued over the past few years - especially when compared to the boom years. A big reason for this is the stalling of various big ticket projects in recent years due to myriad reasons. Infrastructure is also a key area of operation for major Indian engineering companies.

How to Research the Engineering Sector (Key Points)

  • Supply
  • Supply is abundant across most of the segments, except for technology intensive executions. However, supply of equipments face bottlenecks such as logistics and lack of manpower for timely assembly and erection of equipments; etc.
  • Demand
  • Demand growth in this sector is fuelled by expenditure in core sectors such as power, railways, infrastructure development, private sector investments and the speed at which the projects are implemented. The pipeline for projects are down to a trickle due to the current slowdown and the pace of project execution has been lumpy in the year gone by due to many delays in execution and cash crunch on the part of clients.
  • Barriers to entry
  • Barriers to entry are high at upper end of the industry as skilled manpower and technologies as well as ability to execute large projects are a prerequisite in engineering sector. However, in few construction businesses like road business, which are not very technologically inclined, the company's expertise in execution is the key differentiator.
  • Bargaining power of suppliers
  • Bargaining power of suppliers is low because of intense competition amongst them. However, in technology driven high-end segments, suppliers have the upper hand.
  • Bargaining power of customers
  • Bargaining power for technology driven and highly skilled segments is low. However, fierce competition has increased bargaining power of customers in power generation and T&D equipments.
  • Competition
  • Majority of the companies compete in terms of pricing, experience in specific field, quality of equipment, capabilities with respect to size of projects that can be handled and timely execution. Nevertheless, competition is higher in the industry as companies of all sizes have been trying to move towards scaling up their technology and capacity.

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Financial Year '16

  • FY16 was yet another disappointing year for the Indian engineering industry. Order inflows were weak due to delays in project awards, land acquisition problems and environmental issues. Due to the low demand environment, operating margins came under pressure. Thus just like the previous year, slowdown in order inflows along with lower pace of project execution proved to be a double whammy for the engineering companies.
  • Due to low capacity utilization across the industrial sectors, the much anticipated capex failed to pick up during the year. The fall in commodity prices has further lead to weakness demand for capital equipment. This could further impact the momentum in industrial capex. There remains a lot of uncertainty about when the much awaited revival in the capex cycle will come in.
  • The situation in the construction industry remained subdued in FY16 - given the slowdown in the overall economy. A key issue faced by private players has been financial pressures in terms debt servicing coupled with errors in estimation and delays in execution across segments. This has led to a lot of stress in the balance sheets of many of these companies.

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Prospects

  • World class infrastructure is of utmost importance for unleashing high and sustained growth. In fact, it is the long term driver for the construction sector as well. While short term factors may keep sentiments subdued, over the long term, demand will remain strong. The government's stated commitment to improving the country's infrastructure should translate into a business for construction companies as and when the black clouds clear-up. However, its recent demonetisation move is likely to push a whole hearted recovery in capital investments further into the future.
  • From a policy perspective there has been a growing consensus that a private-public partnership is required to remove difficulties concerning the development of infrastructure in the country. The realisation finally seems to be setting in with numerous BOT (build, operate and transfer) projects being awarded to various private sector companies. The government has also put in place dispute resolution mechanisms for PPP projects. The long term future of the Indian engineering and construction sector remains promising.
  • The government's initiative to bring clarity to the power sector reforms is a welcome sign for the industry. As per Government official reports, regulatory delays have stalled projects large projects in the road, power, coal and mining sectors. The government has been working on trying to fast track large sized infrastructure projects. It will work to expedite these projects which have been stalled due to delay in clearances, funding and various other reasons. These initiatives may help revive the Engineering and Construction sector going forward.
  • The next couple of years may remain challenging for the engineering and construction companies. While execution pace is slowing down due to various internal as well as macro issues, margins have also come under enormous pressure due to anemic demand, rising competition and over capacity in many sub sectors. Thus, unless the macro-environment shows significant improvement, overall growth will continue to remain sluggish in the near term.

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Related Links for Engineering Sector
Quarterly Results | Sector Quote | Over The Years

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