Downgraded to hold rating on Larsen & Toubro; Growth outlook turns challenging

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Updated: November 9, 2015 6:45:12 AM

A combination of increased competition and slower-than-expected recovery in domestic infrastructure and industrial capex sectors hurt L&T’s new orders during Q2FY16 (down 28% y-o-y).

Larsen & ToubroL&T’s subsidiaries are valued at a combined Rs 575/share (incorporating a 10% holding company discount) as against Rs 606 earlier. (Reuters)

A  combination of increased competition and slower-than-expected recovery in domestic infrastructure and industrial capex sectors hurt L&T’s new orders during Q2FY16 (down 28% y-o-y). Consequently, the share of international orders within its Q2FY16 portfolio increased to c38% from 31% in Q1FY16 and 25% during FY15. The company expects to tap R3.7tn of new orders during H2FY16 of which c25%-30% are once again based in the international market and the Middle East in particular. However, a sustained focus on the Middle East market during the current weak business environment prevalent in the region could pose near-term challenges.

Industrial capex segment continues to hurt profitability

L&T reported 11% y-o-y (year on year) growth in overall sales during Q2FY16 along with a similar growth rate in its key segment —infrastructure. However, some of the industrial capex segments remained weak, deteriorating further, such as Heavy engineering (HE), Metals and Material Handling (MMH), and Electrical and Automation. Despite this weakness, the industrial capex portfolio managed to report a modest growth of 2% y-o-y driven largely by the Power and hydrocarbons segment. However, with one or two segments turning up losses every quarter in the industrial capex segments, we argue that the business environment seems much tougher than we had expected and a near-term recovery looks difficult.

Gr6

Execution pick up in infrastructure segment is encouraging, though not enough

While infrastructure segment growth slowed down to 11% y-o-y, we highlight the improvement in the domestic infrastructure segment, which after two quarters of weakness once again grew 6% y-o-y. This is important given that the segment has been showing weakness despite a strong order book growth (21% y-o-y) as against the overall order book being up 14% y-o-y. However, the pace of order book execution needs to pick up given the current strong order book position, which has not yet materialised. We argue that this could potentially be due to a growing share of slow moving orders.

Margin slide in the infra segment is temporary

Ebitda (earnings before interest taxes depreciation and amortisation) margin in the infrastructure segment fell 150bp during the quarter. While some part of the slide in margins, is led by a growing share of international revenues (c31% during Q2), management argued that the majority of the drop in margins is due to the fact that many of the projects are yet to reach the margin recognition stage while costs get booked during the early stages of the execution cycle.

Working capital intensity has stabilised

L&T reported a marginal improvement in working capital (ex-financial services) intensity of 24% of sales during Q2, which was an improvement over Q1FY15’s level. The improvement, although marginal, comes on the back of expectations that deteriorating working conditions in the Middle East could hurt L&T’s receivables cycle. The improvement was largely led by better receivables recovery. Operating cash flow during H1 FY16 almost doubled, while net capex fell 28% to Rs 24.2 bn during the same period.

Guidance downgrade along expected lines

L&T management cut its FY16 new orders growth guidance to c5%-7% from c15% earlier and sales growth outlook to 10%-15% from 15% earlier. Company management maintained its Ebitda margin (ex-services and IDPL) outlook of 100bp expansion. While the new order growth guidance cut was largely expected, the weak Q2 orders coupled with a slower-than-expected domestic investment recovery and weakening Middle East growth outlook suggest management could miss its revised guidance. We revise our FY16e order inflow growth outlook to -11%, below that of management’s guidance.

Cut earnings estimates by 6%-8% over FY15e-FY18e

We revise down our earnings forecast to reflect lower-than-expected Q2 earnings during FY16e and the impact of lower new orders outlook. Although our FY16e earnings have been cut by c6%, the impact is largely reflected in below Ebitda to factor in the higher-than-expected depreciation and interest expense. Our FY17e and FY18e earnings cut reflects the impact of the cut in new order growth.

Downgrade to Hold with a lower TP of Rs 1,490 (down 17%)

We continue to value L&T using a sum-of-the-parts methodology. However, we have revised our target PE (x) for L&T’s EPC business from 27x September 2016e earnings to 23x. The lower target PE (x) reflects Industrial stocks’ greater correlation with order inflow growth as against earnings. While we do expect the company to report a healthy 23% EPS CAGR over FY15e-FY18e, we account for this outlook by allocating a premium valuation to its past business cycle mean. Downside risks to our earnings forecast are now elevated from its high Middle East exposure and a slower-than expected domestic investment cycle recovery.

L&T’s subsidiaries are valued at a combined Rs 575/share (incorporating a 10% holding company discount) as against Rs 606 earlier. Our revised fair value TP declines to Rs 1,490 (from Rs 1,793), driven by: (i) 6%-8% downward earnings revision and (ii) lower target PE (x) reflective of a demanding business environment. Our new TP implies the stock will trade at 24.6x September 2016 EPS, while it is currently trading at 23.3x.

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