Our numbers suggest that India Inc has heavily underinvested in the past 7-8 years. In the early ’90s, when the last capex cycle took place, annual capex averaged over 20% of the previous year’s gross block. This means India Inc was almost doubling capacity every 4-5 years (though part of the capex is always for replacement). This rate of capex was sustained for at least 5-6 years, between 1992 and 1997. Then the market tanked, the economy went into a tailspin, and India Inc stopped investing. Annual capex fell to a mere 5% of gross block by FY01.

With a volatile item like capex, annual numbers can be misleading. We checked various rolling averages. Consider this: on a rolling five-year average basis, capex was nearly 16% of total assets in 1997 and onwards till ’00; it fell to 7% in ’05 and rose to about 10% in FY06.

We checked many other ratios, like cumulative five-year capex to gross block — they all showed the same trend. India Inc’s rate of capex fell by 70-80% between the mid-’90s and FY03. It has recovered only slightly since then. Till FY06, the investment rate was still less than half of what we saw in the mid-’90s. This gives us reason to believe that we are just at the beginning of the investment cycle.There is still a lot of steam left in the current cycle before we assume it’s topping out.

Moreover, capacity utilisation levels of Corporate India continue to border on or exceed the 100% level, which leaves ample scope for further expansion.

Tell Tale Signs

If You scour through projects announcements, there are signs that we’re headed for a capex boom. According to Projects Today, a firm which tracks fresh project investments, there were around Rs 2,72,306 crore worth of new projects announced by the private sector in the 12-month period ended September ’06. This represented a growth of 40% over last year’s base. According to data from Crisil, installed capacities in industries like cement, steel, aluminium and power have been growing at a CAGR of just 3-5%. While making companies extremely capital efficient, this has also led to some amount of under-investment in these sectors, which has resulted in a mad rush to put up capacities to fully exploit the demand.

Crisil estimates that steel itself could see a capacity addition of around four times the current installed capacities (flats and longs included). Power is expected to see a sharp jump of 44,000 mw by the end of FY11, on the current installed base of 1.24 lakh mw. Aluminum is also expected to add an amount equivalent to its current capacity by FY11. So, it’s hardly surprising that India Inc could potentially double its entire asset block by FY10.

Ample Funds

CAPEX cycles can get derailed due to lack of funds or if funds get too costly. This time round, India Inc has some leeway. Thanks to extraordinarily high profitability and a buoyant equity market, domestic companies can potentially fund their capex without further deterioration in their gearing. ETIG’s analysis suggests that keeping debt-equity ratio at the current level of 0.5, our sample of around top 600 companies may have as much as Rs 800,000 crore or more to invest over the next four years. So, lack of funds may not be an issue for quite some time. Even if there is a lot of M&A (mergers and acquisitions) activity, which will account for a significant chunk of these figures, there could still be substantial capex, going ahead.

However, as we have argued in our earlier editions, higher capex could mean lower dividend payouts and falling free cash flows for most companies.

Even return ratios could moderate from their current highs, given the strong addition to asset blocks, resulting in lower asset turns. However, the same is the case with any cycle as fresh capacities come online, and assets depreciate and get replaced. But look no further, for there is still hope. The impending capex boom could throw up opportunities in hitherto unknown sectors and that’s where the smart money is.

(Economic Times 30 Oct. 2006)