Bigger orders, better bets

The Indian markets have lost a third of their value in the past six months amid concerns that the slowing economy might lead to lower sales. These concerns are well-founded going by the performance of companies in sectors like real estate and automobiles. There is some good news, though. More and more experts are coming around to the view that companies with a definitive earnings visibility will be able to weather the downtrend better than the others. One way to identify such firms is to check their order backlogs. If these are strong, it will help them sustain the earnings growth.

“The earnings visibility through the state of order books is definitely a point of consideration in determining the growth potential of companies and in analysing their future performance,” says Deven Sangoi, head, equities, ICICI Prudential Asset Management Company.

Take Simplex Infrastructure. The company that booked orders worth Rs 2,000 crore in the previous quarter has seen its total order backlog for the year rise by an impressive 43% to Rs 10,016 crore. The order book, which is 3.6 times the company’s turnover for the previous year, provides a long-term earnings visibility for the company as the orders are executable over the next two years. Backed by a 71% growth in the first-quarter revenues and one percentage point expansion in margins to 10.83%, the company has seen a phenomenal 94% rise in quarterly profits. The stellar performance, experts say, is largely due to the company’s faster execution capabilities and a higher share of lucrative international orders. In the previous quarter, the company’s international revenues zoomed up 247% year-on-year.

Other companies that recorded a robust order intake due to a sustained expenditure in their respective user industries include Larsen & Toubro, Crompton Greaves and Welspun Gujarat. None of these firms has a substantial exposure to BOT (build-own-transfer) projects, which demand long gestation periods for their investments. There has also not been a significant deterioration of assets such as land holdings.

“If the current sales are worth Rs 100 crore and and the order book is worth Rs 400 crore, then even after a 5% cut due to a delay in execution and cancellation of orders, the company will be worth Rs 300-400 crore in twothree years as it executes the order backlog. These stocks are better bets as the companies have a good revenue visibility in the form of order books,” says Amar Ambani, vice-president, research, Indiainfoline.

Execution and margins: The problem with order books is that virtually all capital goods and construction companies have order backlogs. Does this automatically make them good picks? Sadly, no. Some companies might witness a slowdown in the order intake due to a deteriorating business environment in their user industries. Also, not all these companies demonstrate good execution capabilities, which is why firms like Gammon India, HCC and Madhucon Projects are seeing a slowdown in revenues. Slipping up on order deliveries has a cascading effect on the future contracts as a substantial amount of money is tied up in current projects, impacting the cash flow. So the company cannot take new orders due to a lack of leeway in infusing fresh working capital into the new contracts.

The key to identifying a good stock is looking for companies with good execution capabilities and ones that continue to have a healthy order intake. A proven track record of the management and generation of enough cash flow to support the new orders augurs well for a good investment. “There are a lot of companies with good order book positions which have not lived up to expectations. The lacklustre performance is clearly visible in the first-quarter results, as they couldn’t perform well due to high input costs and lack of timely execution of orders. So the companies that generate a good cash flow and have a sustained order intake make for a good buying opportunity at current levels,” says Jignesh Desai, head, institutional sales, SBICAP Securities.

Cost escalation clauses: Many companies opt for price escalation clauses to beat the rising input costs for sustaining margins. For instance, Simplex has a cost escalation clause in place for 90% of its domestic orders, while L&T has covered 70% of its orders with similar clauses. “As companies have to deal with issues like margin pressures, they are avoiding fixed price contracts and only taking those with price variation clauses for all the material contracts,” says Sangoi. “These firms are better equipped to handle margin pressures on account of high input costs,” he adds.

Stock performance: Barring companies like Thermax, ABB, Gammon and Nagarjuna Construction, which are witnessing a structural slowdown in their respective user industries, experts increasingly believe that stocks like L&T, Crompton Greaves, Simplex Infra, IVRCL Infra and Welspun Gujarat offer good investment opportunities as they continue to witness a robust order intake.

“It is a good time to buy as the correction has been steeper than the change in the fundamentals of these companies. They still generate good cash flows and have decent execution capabilities. The steep fall in stock prices is due to the desperate selling in markets. Fundamentally, nothing has changed significantly for these companies in the past six months,” says Desai.

So L&T, Crompton Greaves and Welspun Gujarat continue to grow at the same pace as last year and are not seeing any significant slowdown in order intake. They are in a sweet spot as they offer specialised services in fields like engineering and building of critical projects, where entry barriers are high in terms of technical and financial qualification. In fact, the order books of L&T and Simplex Infra are much better today than in the same period last year.

“It’s quite illogical that the same stocks were quoting about 50-90% higher on a lower order backlog in December 2007. For example, with an order backlog of Rs 47,500 crore in December 2007, L&T was quoted at Rs 4,300, but at a higher order backlog of Rs 58,200 crore in June 2008, it was quoted at Rs 2,200,” says Ambareesh Baliga, vice-president, Karvy Stock Broking. “It is this irrational behaviour of the markets that throws up good investment opportunities which investors should grab,” he adds.

To get the best price in the current choppy market, experts advise investment in small tranches. “Invest 10%, wait for a fall and then add another 10%. The Sensex is likely to touch 12,800 soon. So wait for a while and gradually build up your positions. You can take those positions with the the index at 12,000, go on a vacation, come back after a year or two and you will have enough money for another vacation,” says Ambani.