Domestic revenues remain flat as Middle East sees pick-up
L&T’s Q1FY16 results have disappointed with 200 basis points year-on-year margin decline. Losses in Metallurgical and Heavy Engg. indicates the margin stress L&T is facing. Our thesis on project declines in the Middle East impacting order flow is reflecting with a 45% y-o-y decline in the international segment in Q1FY16. Also, as Middle East execution in P&L (profit and loss) from FY13-15 order flow is picking up, and margin upside surprise remains capped. We maintain Hold with a TP (target price) of R1,650. Consolidated E&C (engineering & construction) margins drop 70 bps ex-hydrocarbon.
L&T has reported 1.8% Ebit margins in Q1FY16 vs losses y-o-y and the last three quarters also. However, the management on its result call cautioned there are three more hydrocarbon projects which could potentially face cost overruns. This impact net of some favourable claims is yet to be ascertained. Consolidated E&C Ebitda (earnings before interest taxes depreciation and amortisation) margins in Q1FY16 rose on expected lines as hydrocarbon losses were stemmed, but the drop in ex-hydrocarbon reflects the margin pressure L&T is likely to see over the next 12 months.
ME drives 12% y-o-y E&C revenue growth: A 42% y-o-y growth in hydrocarbon, followed by a 13-14% y-o-y in both infrastructure and power contributed to the revenue growth in consolidated E&C. Middle East revenues rose by 50% y-o-y, while domestic remained flattish in the quarter. Ebitda margins in Middle East projects tend to be 300-500 bps lower than domestic, and will cap margin upside prospect, going forward. On a consolidated basis, L&T has maintained its revenue guidance of 15% y-o-y, pinning hopes on H2 recovery.
Order flow guidance maintained at 15% y-o-y growth: L&T’s domestic order flow has seen a marginal decline of 2% y-o-y. Despite the 45% y-o-y decline in Middle East, it still accounts for a chunky 31% of order flow. New Middle East projects continue to be under pressure with the volatility in crude oil; 25% y-o-y order flow growth is needed in the next nine months for L&T to meet its maintained FY16 guidance.
Valuation/risks: We believe L&T’s upside surprise potential on P&L and order flow are limited, with downside risks on both counts from Middle East. Maintain Hold with a SOTP (sum of the parts)-based TP (target price) of R1,650. Upside risk—Strong domestic order flow recovery. Downside risk—Hydrocarbon losses.