1. Add rating on Larsen & Toubro: Another weak quarter

Add rating on Larsen & Toubro: Another weak quarter

Weakness continues: L&T reported another weak quarter, with execution and margin below estimates in several segments.

By: | Updated: February 8, 2016 2:44 AM

Weakness continues: L&T reported another weak quarter, with execution and margin below estimates in several segments. Improvement in engineer & construction (E&C) order inflow after two weak quarters and stable working capital provided partial succour. Our revised target price of R1,300 (from R1,450) reflects cuts to both earnings (5-6%) and target price to earnings (P/E) ratio multiple (18Xvs 20X). This perhaps captures the known unknowns (ME risks, continued weak near term) without losing sight of medium-term opportunities. ADD retained.

Q3FY16 consolidated E&C: revenue and margin sharply below estimates

Core consolidated E&C revenue grew ~6.7%, below our estimate of 8.3% led by (i) execution challenges in some sectors (domestic remains weak), and (ii) non-linear nature of execution of the project business (pick-up expected in Q4FY16). E&C Ebitda (earnings before interest taxes depreciation and amortisation) margin at 7.7% (down 220bps y-o-y) was below our estimate of 8.3%, led by lower margin in Infrastructure (higher proportion of projects executed where margin recognition threshold was not reached), Heavy Engineering and MMH (metallurgical & material handling) segments (under-recoveries and cost provisions). Overall consolidated Ebitda margin too was below estimate, led by weaker than expected margin in E&C, financial services and developmental projects businesses. The silver linings in the quarter were (i) core E&C order inflow was up 11% y-o-y versus consensus expectation of a decline, and (ii) NWC (ex-financial services) remained flat q-o-q at 24% of sales versus expectation of an increase led by ME projects.

larsen

FY2016 guidance will not be easy to be meet

For FY2016, the company has guided for flat order inflow y-o-y, which may be difficult to achieve (our estimate: negative 14% overall and 19% for core E&C business) given (i) weak 9MFY16 (E&C order declined 17%) and (ii) our analysis of order prospects/competitive intensity across key segments and likely inflow for L&T. We note that, as with any E&C company, a couple of large orders could change the estimate dynamics. The company has also retained its revenue growth guidance of 10-15% (we estimate 7.6% growth for E&C business), while E&C margin is expected to be better than that of last year (we model decline of 60 bps y-o-y).

Cycle path: more pain before gain

L&T’s results over the past few quarters reflect (i) the nature of the business model (competitive bid-based), where order book quality can only be judged post facto (lasting advantages difficult to evaluate for E&C companies), (ii) the resilience shown by E&C companies in the early part of a difficult economic environment could be a mirage (given multi-year project execution) and getting back to sustained profitable growth could take time (late cycle). This is where analysing how an E&C business performs over a whole cycle becomes really important. Over the past one year or so, L&T’s three segments have reported losses in one or more quarters and pain in some segments could last for some more time. We revise our EPS estimates to R41.5 and R53.6 from R43.7 and R57.2 for FY2016e and FY2017e respectively, largely led by lower order inflow and margins

Q3FY16 earnings call takeaways

w Execution in domestic infrastructure remains challenging. Slow customer payments and delayed clearances led to L&T holding back execution in some infrastructure projects.

w Legacy hydrocarbon projects getting phased out. L&T’s loss-making legacy hydrocarbon projects in the Middle East are close to completion and will gradually get phased out. As the completion approaches, the company may incur certain closure costs and will make corresponding compensation claims against customers. If there is a timing mismatch between the two, the Ebitda margins for the segment can show a volatile trajectory.

w Margin volatility a characteristic of project-businesses and the company’s exposure to various sectors. The company attributed the quarterly Ebitda margin volatility to several factors :

w Recognition of accrued margins. The company recognises project revenues only to the extent of costs incurred till 25% of the project is completed. Once this threshold is crossed, the company can recognise the accrued profits on the completed share of work, which can be quite lumpy. As a result, for project-business companies like L&T, margins can be volatile on a quarterly basis.

w Changes in business mix. The company reported higher employee costs at 9.4% of sales during the quarter (up from 8.0% in 3QFY15). The increase in employee costs was on account of higher share of international execution that led to the deployment/hiring of more manpower in other geographies.

w One-off items. The company sold its Elante shopping mall in Chandigarh and recognised the profit as other operational income during the quarter. Further, it also had a reallocation of expenses in one of its joint ventures. Such factors further contributed to Ebitda margin volatility.

w MMH and Heavy Engineering to remain muted, focus on new product launches in E&A. Given weak metal and commodity prices, investment in the metal industry remains weak. As a result, Metallurgical and Material Handling segments are likely to face muted environment. Similarly, the heavy-engineering business is dependent on process plant & equipment (Oil & Gas investments), nuclear power plants and defence. All these three end-markets currently remain weak. The Electronic & Automation segment, however, can provide meaningful support to margins.

w Outlook unchanged, broad-based ordering expected in 4QFY16. The company maintained the guidance of 10-15% revenue growth and flat y-o-y order inflows for the full year FY2016. It expects broad-based ordering to materialise in 4QFY16, which is also in-line with historically observed annual cycle/trends. If the ordering and execution improves, the company believes that the core E&C margins could improve on a y-o-y basis. Further, it said that despite the decline in oil price, social infrastructure spending in the Middle-East is continuing. Overall potential prospects across various segments are:

Transportation, urban infrastructure and water— R900 bn

Power generation and T&D—R550 bn

Metallurgical and Material Handling—R80 bn

Hydrocarbon—R80 bn

Others—R350 bn

—Kotak Institutional Equities

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