Orders in spate

Updated: Feb 4 2013, 07:35am hrs
Slow capex in economy for next two years could weigh down on company

L&T continues to surprise on order inflows but with the relative P/E (price-to-earning ratio) at 1.33x (times) and margin pressure coming through, the stock seems fully valued. The TINA (there is no alternative) factor and exceptional management quality keep us EW (equal weight).

Raising EPS estimates by 1-2%: With 22% order inflow growth in 9m(month)FY3, L&T is on its way to meeting its guidance. We move our order inflow growth estimate up slightly (to 17% year-on-year) to account for the surprise in this quarter. However, given the increase in slow-moving orders, and the higher than expected margin decline, our EPS (earnings per share) goes up only 1-2% for F13-14e (estimates). Our valuation of the base business moves up by 5%, but given the strong rise in subsidiary values (mainly finance and IDPL), our target price moves up 8% to R1,555, implying 2% downside from current levels.

Challenges still high: With elections coming up in F14e, we expect public capex to start drying up. Private sector capex seems likely to start up only from FY15e (post-election year). Along with the rest of its peers, L&T continues to highlight high competitive intensity, which we believe will continue to bring margin pressure over the next 6-12 months. Against this backdrop, we stay EW.

Disappointing margins: The broad P&L (profit and loss) numbers were weaker, with L&T increasing sales by 10% y-o-y, 2% behind our estimates. Margins slipped 20 bps y-o-y (on an already low base), to 9.6%, 70 bps (basis points) lower than our expectations, which meant that Ebitda (earnings before interest, taxes, depreciation and amortisation) came in 9% lower than our expectations. Strength below the line (high other income led by real estate sales) coupled with lower tax rates helped the net profits (up 10% y-o-y) come in only 1% below our estimate. Another worrying issue remains the build-up of slow-moving orders. While the metric tracked by L&T was flat quarter-on-quarter at 11%, we prefer to use the 14% number, which includes the GMR and GVK mega road projects, in which the companies have submitted termination notices to the National Highways Authority of India.

What could change our view We could become more bullish if policy action continues to come through, especially a resolution on the fuel security for utilities, or easing of environment clearances. On the other hand, a step back on some of the recent policy announcements, a return to the risk-off trade globally, or a further strengthening of capex-unfriendly provisions in the land acquisition bill could lead us to turn more negative.

Investment thesis: Our Indian banking team believes that rates are likely to remain at levels that will stifle growththus, we believe that capex might take much longer to come back in India. However, with macro indicators stabilising at lower levels, downside risks are clearly easing. The increase in orders from the competitive Middle East market could compress L&Ts margins. On the other hand, real estate orders, while margin-neutral to accretive, add risk to the portfolio in terms of execution cycle and cancellation. Trading at a 33% premium to the Sensex on 12-month forward P/E, slightly below the five-year median of 41%

Key value drivers: L&Ts ability to increase its order book even when the capex cycle is slowing. Initiatives in relatively uncontested areas. Ability to turn around the loss-making international subsidiaries.

Potential catalysts/upside risks: Decrease in steel/other material prices. Policy action impetus, especially on environment clearances. Increased access of the corporate sector to equity funding.

Key downside risks: Slowdown in corporate capex/government infrastructure spending. Increase in competition in the Middle East. Increased cancellations cutting into the order book, slowing L&Ts top-line growth beyond our expectations.

Morgan Stanley