Moving in tandem with macro-environment

Updated: Oct 31 2011, 06:32am hrs
L&Ts Q2FY12 recurring profit after tax at R7.9 bn, +15% year-on-year, was 2% ahead of CIRA (Citi Investment Research & Analysis)s estimate of R7.8 bn (7% ahead of consensus of R7.5 bn) driven by solid execution, with sales growing 21% y-o-y. Ebitda (earnings before interest, taxes, depreciation and amortisation) margins contracted -34 bps (basis points), which was ahead of CIRA estimate of -53 bps. Lower-than-expected other income was compensated for by lower effective tax rates. Gross inflows at Rs 161bn, down 21% YoY, were ahead of CIRA R122 bn and net inflows at Rs 174 bn were up +2% y-o-y.

Whether L&T does +5% or -5% (R838 bn or R757 bn) is a function of (i) macro-environment remaining at current levels or deteriorating further in next six months and (ii) the competitive intensity in various sub-sectors. To meet the new guidance, L&T has to win R515 bn of orders in H2FY12e, +18% y-o-y. We believe sales growth of 22% YoY is possible, but maintain a 20% YoY estimate.

The company has cut the E&C (engineering & construction) margin contraction guidance to -75-125 bps, from -50 to -75 bps. We believe this is the primary reason why the stock corrected 4% post-results. According to the management, the company takes on fixed price contracts with 3-5% buffer for contingencies. The E&C margin cut was due to an unforeseen rise in commodity prices, beyond this available buffer. Due to longer gestation cycle and complexity of certain orders, forecasting margins accurately is also a difficult task.

We maintain a Buy (1L) rating, with the target price cut to R1,511 from 1,576 to factor in (i) parent and consolidated EPS (earnings per share) cut of -3% and -1% to 2% respectively, (ii) roll forward of parent target P/E (price-to-equity) to March'13e (Dec'12e), (iii) cut in target P/E to 15x (from 16x-times) to factor in a more challenging macro. L&T continues to be our top pick in the India Industrials universe (E&E-electrical equipment-and E&C).

L&Ts Q2FY12 recurring PAT was driven by solid execution with sales growing +21%. Ebitda margins contracted -34 bps. L&T ended the quarter with a backlog of R1,422 bn, up 23% y-o-y. Gross inflows at R161 bn -21% YoY and net inflows added to the backlog, which was up 2% y-o-y. The company ended the quarter with a backlog of R1,422 bn, up 23% y-o-y.

By the management, the backlog comprises fixed price (one-third) and variable price (two-thirds) orders. Typically, L&T takes on fixed price contracts with a 3-5% buffer for cost escalations. The downward revision in E&C margin contraction guidance was due to unforeseen rise in commodity prices.

We rate L&T a Buy given: (i) inflow guidance cut is already in the price; (ii) stock has underperformed the BSE Sensex; (iii) though more rate hikes cannot be ruled out, the rate hike cycle could be on its last legs; and (iv) the stock does not look expensive.

Our R1,511 target price is based on sum-of-the-parts. We use 15x (times) Mar13e earnings for the parent (R1,114), supported by EPS growth of 13% and average RoEs (returns on equity) of 18%. We also believe that the parent's numbers do not capture the value inherent in subsidiaries, which we value at R397, with L&T Infotech at R87 (12x Mar13e EPS, in line with second-tier peers), 51% stake in L&T-MHI JV at R38, L&T IDPL at R86 and L&T Finance Holdings at R127.

Downside risks include: (i) attracting talent; (ii) the E&C and EE businesses are sensitive to economic variables; and (iii) competitive pressures.

Citi