Conversations around our L&T upgrade on February 2, 2015, reveal a deeply divided buy side, with skeptics outnumbering believers. Here, we try to address some of the concerns raised by the skeptics.
Not repeating ourselves: We answered quite a few typical questions in our Feb 2 report: (i) Why are we upgrading now? (ii) Are we late to the party? (iii) Why are our F17e earnings 25% ahead of consensus? (iv) What impact do we think the oil price fall could have on the MENA (Middle East and North Africa) business? and (v) What are the drivers to look out for to take L&T up 50% to our price target?
What are we addressing here, then? We seek to address the key concerns that the skeptics have raised, both on our upgrade and the recent (Q3) results disappointment. For example: (i) Why do we like a company with a bad balance sheet and poor return ratios? (ii) Has L&T been an aggressive bidder in the Middle East, and hence could there be a lot more pain to come in loss terms? (iii) Why are we not worried about the ballooning working capital at L&T? (iv) Are we worried about the huge fall-off in MENA orders in the last two quarters? (v) Won’t L&T lose market share as domestic capex returns? (vi) Do we believe the management’s explanation of zero-margin orders for the Q3 margin pain? (vii) Do we have any worries at all?
So, should we switch from developers to L&T? Given our preference for the developers over the constructors, and the buy side’s execution of the same over the last two years, this is a key question that we have been getting. The answer is…yes and no. The point is, we are also thinking about this from a portfolio perspective. We now have enough visibility on the capex/macro recovery for us to recommend adding risk to portfolios through exposure to an executor (L&T).
Stars aligning for a multi-year bull run: India is on the cusp of a capex cycle, and two things make us believe that it might be stronger than anticipated: (I) The recent burst of policy measures to ease the environment for capex, and (ii) Our economics team’s call for a big rate cut cycle. We still believe that a full-fledged recovery will be only in FY17e, but we expect L&T’s inflows, revenue growth and margins to start firing from FY16e onwards, starting a multi-year bull run.
New upgrade cycle: We remain concerned about the MENA business (26-27% of sales and backlog in H1), but given the weakness in material prices, the fixed-price contracts create a cushion for margins. We expect 28% year-on-year growth in our FY16 EPS (earnings per share) estimate and 47% in FY17e. Our FY17e EPS is 25% ahead of consensus, with upside risk, and our price target implies 40%+ return from current levels.
More upside to come: Though L&T’s share price has moved up 72% in the past 12 months, outperforming the Sensex by 30%, we believe its bull run is just beginning: (i) The buy side has not mirrored the sell side’s bullish stance; (ii) Our FY17e EPS is well ahead of consensus. (iii); In the last upgrade cycle, the stock was up 24x (between January 2003 and January 2008); (iv) Within the industry, we expect underperformance vs. the asset owners over the last 12 months to reverse.
Views on the Q3 results
If recoveries happened in straight lines, life would be a lot easier but opportunities to make money a lot fewer. We believe Q3 numbers were much better at first glance, and consider the negative reaction a good entry point for the stock.
Disappointing operational numbers, but… Adjusted for stripping out Integrated Services (IES) into a subsidiary, L&T managed only 7% y-o-y growth on a standalone basis. Ebitda margin fell 90 bps y-o-y (to 10.5%), and Ebitda (earnings before interest, taxes depreciation and amortisation) declined by 1% y-o-y. L&T stated that pain in the infra vertical reflected the start of new contracts and, hence, booking of revenues, but no profits. That will reverse when it hits the margin recognition threshold (25% completion).
…domestic order flows are coming back: E&C (ex-hydrocarbon) inflows were up 16% y-o-y, vs. the 19% growth reported in consolidated inflows, in line with the 16% growth in H1. Moreover, 85% of the inflows came from India,, a sign of an incipient Indian recovery. The strength in flows pushed the international share of the backlog down to 25% (the first decline in seven quarters). The share of international sales also dropped to 25% of Q3 sales, from 29% in Q2.
Cutting revenue estimates: We built in a 2% cut in our revenue forecasts for FY15-17, and a slight 10-20 basis points margin cut for FY15-16e to account for the zero-margin contracts. However, we fully expect these contracts to hit margin recognition by FY17, so we left those margins unchanged. These changes brought our EPS estimates for F15-17 down 2-4%, and our price target down by 1.3%, to R2,363.