'Sell' rating Larsen & Toubro as cash flow generation weakens: Ambit Capital

Mumbai | Updated: Jun 9 2014, 14:53pm hrs
Larsen & Toubro's Q4FY14 standalone revenues of R200.8 bn were in line with our estimates, but Ebitda margin of 14.4% (vs est. of 12%) was higher due to higher margins in the power (up 772 basis points), infrastructure (up 100 bps) and others segment. But cash conversion remained poor, as working capital-to-sales increased to 22% vs 17% in March 2013, leading to an increase in debt to R114 bn vs R88 bn in March 2013.

Whilst the standalone results (ex-hydrocarbon) were a surprise, L&Ts FY14 standalone+ hydrocarbon revenue of R666.5bn and Ebitda margin of 10.4% were in-line. We have marginally upgraded our FY15/16 Ebitda margin estimates by 10bps/16bps to 10.6% /10.8% due to a rise in margins of power and others segment.

We expect FY14-17 working capital, excluding cash, as a percentage of sales to be 19.1% (10-year median of 14.4%) due to the high interest rate environment. Hence, despite 17% FY14-17 revenue CAGR, RoCEs (returns on capital employed) would marginally rise by 90bps from 14.2% in FY14 to 15.1% in FY17e. We reiterate our Sell stance with a revised TP (target price) of R1,325/share (vs R1,271/ share earlier).

Growth Earnings

In-line standalone execution: L&Ts order intake was flat year-on-year at R269bn on a high base of Q4FY13, resulting in a book-to-bill of 2.8x. The total order intake was at R941bn (up 15% y-o-y) driven by the infrastructure sector (order intake of R762bn). As a result, the companys order book increased 13% y-o-y to R1,630bn. Its revenues increased 11% y-o-y to R200.8bn. Standalone revenue growth was driven by revenue growth of 18% y-o-y in infrastructure and 42% y-o-y in the heavy engineering. But revenue growth in short-cycle industries declined: power (down 29% y-o-y) and metals and material handling (down 11% y-o-y).

Standalone Ebitda margins increased 267bps y-o-y to 14.4%, due to (i) a 100bps rise in infrastructure Ebitda margins to 11.6%, (ii) a 772bps increase in power Ebitda margins to 14.1%, (iii) Ebitda of R2bn in others vs Ebitda loss of R245m in Q4FY13, and (iv) exclusion of hydrocarbon revenues.

Reported PAT increased 69% y-o-y due to a 36% y-o-y increase in Ebitda, a 25% y-o-y increase in other income and a R4.8 bn gain from the stake sale in L&T Finance Holdings. The L&T standalone entity invested R43 bn in its subsidiaries in FY14, materially higher than the R12 bn invested in FY13. The investments were made in the Nabha power plant, IDPL and realty project.

Working capital-to-sales of 22% higher: According to the management, the comfortable range of working capital-to-sales was 15-20%. However, the ratio was higher in the last two quarters (21.2% in Dec. 2013 and 22% in March 2014). The key reason for an increase in working capital is a decline in creditor days. Our economist expects RBI to hike interest rates by another 25-50 basis points over H1FY15. Thus, L&Ts working capital would continue to be under pressure, as the borrowing cost would continue to be high for its vendors. As a result of the higher working capital, the companys total debt increased from R88 bn in March 2013 to

R114 bn as on March 2014. Thus, L&Ts standalone operating cash flow was 29% lower in FY14 at R10.47 bn despite an 18% y-o-y increase in operating profit.

In-line standalone + hydrocarbon margins: The order intake of L&Ts hydrocarbon segment increased 37% y-o-y to

R97 bn but the segments revenues declined 2% y-o-y. In addition, L&Ts hydrocarbon FY14 Ebitda margins decreased by 860 bps y-o-y to 3% due to cost over-runs in international projects and higher localisation requirements.

FY15 management guidance: The consolidated order book increased 23% y-o-y to R1,270 bn, higher than the standalone order intake growth, as the company recognised the large metro orders of Doha and Riyadh worth R150 bn in subsidiaries. However, the company cancelled R150 bn worth of slow-moving orders. The management expects consolidated revenues excluding services business and IDPL to report revenue growth of 15% y-o-y and order intake of 20%in FY15, driven by international geographies and domestic pick-up.

Where do we go from here We believe L&Ts Ebitda margins would improve due to an increase in the share of the infrastructure segment, lower losses in the others segment and increase in hydrocarbon margins. We have increased our PAT estimates by 14% in FY15 and by 7% in FY16 due to an increase in other income estimates and higher Ebitda. Overall, we have increased our target price by 4% to R1,325/share (vs R1,271 earlier), comprising R956/ share value of the standalone and hydrocarbon business and embedded value of R329/share.

Key catalysts: L&Ts working capital as a percentage of sales increased to 21.2% vs 15.6% in March 2013. The infrastructure orders long payment cycle and lower advances have led to higher working capital requirement. We believe that continued high working capital cycle could lead to lower operating cash flow.

Lower Ebitda margins of projects won in the last 18 months: The y-o-y decline in Ebitda margins in the last nine months was due to orders won two years ago. In the last 18 months, L&T has won orders worth R 1.4 trillion in a highly competitive domestic market and in the Middle East, which generally has lower Ebitda margins than domestic orders. Hence, if L&T had compromised its profitability to win these orders then L&Ts margins and RoCEs could decline in the next two years.

- Ambit Capital