1. Kotak rates Larsen & Toubro as ‘Reduce’ as core E&C performance margins fall

Kotak rates Larsen & Toubro as ‘Reduce’ as core E&C performance margins fall

L&T’s 2QFY17 core E&C EBITDA declined 4% y-o-y led by sharp margin decline in the infrastructure segment.

By: | Published: November 28, 2016 6:06 AM
Execution impacted by bunching-up of projects facing hurdles: As per the analysis of projects done by L&T, the execution for the quarter could have been higher but for 30-40 projects where hurdles impacted revenue booking. (Reuters) Execution impacted by bunching-up of projects facing hurdles: As per the analysis of projects done by L&T, the execution for the quarter could have been higher but for 30-40 projects where hurdles impacted revenue booking. (Reuters)

L&T’s 2QFY17 core E&C EBITDA declined 4% y-o-y led by sharp margin decline in the infrastructure segment. The company retained its overall guidance, including margin uptick by 50 bps y-o-y, which may be difficult to achieve. We remain cautious given known unknown risks/challenges to order inflows, margins, Middle East and domestic execution. Reduce.

2QFY17 – core E&C margin below estimate

L&T reported 2QFY17 core consolidated E&C revenues at Rs 193 billion (up 9% y-o-y), broadly in line with our estimate. Lower-than-expected growth in infrastructure, E&A and others segments was compensated by better revenue growth in power, heavy engineering and hydrocarbon segments. Core consolidated E&C EBITDA declined 4% y-o-y to R14.3 billion; EBITDA margin at 7.4% (down 100 bps y-o-y) was below our estimate of 9.3%. Key segments where margin declined — infrastructure where margin declined by over 200 bps y-o-y to 7.1% (time overruns and delayed approvals leading to cost increases), power margin declined by 200 bps y-o-y to 3% (job mix change and stage of project execution), and others segment margin declined by 800 bps y-o-y to 6.5% (inventory write-down in shipbuilding business and cost overruns in MMH), partially compensated by better margins in hydrocarbon, E&A and heavy engineering segments.

lnt1

Order inflow up 12% yoy in 1HFY17; company maintains overall guidance

Core consolidated E&C order inflow stood at R258 billion (up 12% y-o-y) in the quarter and at R499 billion (up 12% y-o-y) in 1HFY17. Order backlog as of Sep 2016 is up 4% y-o-y to R2.5 trillion (29% international). Order inflow was led by infrastructure (up 13% y-o-y; 17% are international orders), E&A segment (up 51% y-o-y) and power segment (up 20% y-o-y). The company maintained its overall revenue growth guidance of 12-15%, 50 bps improvement in E&C EBITDA margin and 15% growth in order inflows. We think the former two will be difficult to achieve given 1HFY17 performance and near-term impact of demonetisation, among other reasons.

lnt2

Revise estimates; maintain reduce

We revise our estimates by 0-4% for FY2017-19E to reflect Ind-AS led changes and delayed commissioning of Hyderabad metro (which increases consolidated earnings for FY2017). We reduce our one-year forward SoTP-based target price to Rs 1,400 (earlier Rs 1,500) to factor the aforesaid changes and incorporate sustainable target multiple of 16-18X on normalised earnings. Recent stock correction provides some valuation comfort through we still remain cautious given known unknown risks/challenges to order inflows, margins, Middle East and domestic execution. Near-term impact of demonetisation, recurring Ind-AS-led downward changes to impact in next two quarters and likely volatile financial trajectory for the next 1-2 years (difficult to model) could keep the stock performance in check.

lnt3

2QFY17 earnings call takeaways

Execution impacted by bunching-up of projects facing hurdles: As per the analysis of projects done by L&T, the execution for the quarter could have been higher but for 30-40 projects where hurdles impacted revenue booking. Such hurdles included both client-side issues, external issues and restraint from L&T for executing projects where there had been a build-up of working capital. The normal execution of such projects could have added about Rs 8-9 billion of revenues or yielded a double-digit growth in execution (reported growth of 8%) and added an additional Rs 2 billion of EBITDA or an E&C EBITDA margin of 8.1% (vs reported level of 7.4%).

One-offs and slow execution mask improvements in cost structure: The sharp disappointment in E&C margin (down 220 bps y-o-y) was attributed to a combination of large forex income booked in the base quarter, another Rs 1 billion of inventory write-down losses taken in shipbuilding and bunching-up of execution issues in 30-40 projects. These issues masked improvement on account of lower under-recoveries (Heavy Engineering and Hydrocarbon segment) and modest 3% growth in employee cost (downsizing leading to 14,000 lesser employees). L&T also highlighted improvement in the interest cost on refinancing of loans done in 2HFY16.

Steady growth in order inflows: Order inflows growth was driven by a strong 38% y-o-y growth in domestic order inflows and decline in international order inflows. E&C order backlog at

Rs 2.5 trillion is up 4% y-o-y. This implies a modest quantum of orders that have been taken out of the E&C backlog. Order backlog provides a steady 2+ years of visibility on trailing 12 month E&C revenues. Working capital improves though near-term trajectory remains uncertain. Working capital for the E&C division has improved to 22% of sales from the high of 26.5% in recent years and the company shared its long-term target to reduce it to 18% of sales by FY2021. For the E&C business, the company shared receivables declining to 129 days from 135 days at start of the year. The management was less clear on the impact of demonetisation on the working capital requirements.

Improving RoE profile enthuses: The correction in working capital tightened capex spending and the proceeds from the recent IPOs (Infotech and Technology Services) resulted in a minimal increase in net borrowings in 1HFY17. The company had added Rs 75 bn of borrowings in 1HFY16. This has helped prop up the RoE to 11.72% in 2QFY17 versus 9.78% in 1QFY17 and 9.84% in 2QFY17.

Management maintains guidance: 12-15% growth in revenues—L&T expects a growth of 15% for the consolidated revenues versus 8.6% growth in 1HFY17, implying a 16-20% growth requirement for 2HFY17. We note the downside risks to maintaining the current pace of execution growth due to demonetisation-led pressures and related impact on labour availability.

50 bps improvement in E&C EBITDA margin: L&T expects to grow its E&C segment margin by 50 bps on a yoy basis to 10% in FY2017 versus 9.5% in FY2016. We note that over 1HFY17, EBITDA margin for this business has declined by 70 bps to 7.3% and do not expect any one-off items to help move closer towards 10% mark.

15% growth in order inflows: For order inflows, L&T has maintained 15% growth guidance versus 12% growth achieved in 1HFY17. This would imply a 17% yoy growth in 2HFY17 or order inflows of Rs 819 billion.

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