Rising value of subsidiaries could be a reason, as also defence segment; recovery in tendering activity augurs well; ‘Outperform’ retained
We try to contextualise the underperformance of L&T, with one of the possible reasons being increasing value of subsidiaries, driving up the holdco discount. The stock has upside even if we build in 50% holdco discount (from 25% currently). Tender activity data seems resilient and has recovered from the sharp April-June decline and bodes well for L&T’s inflow recovery also (FY21 target Rs1 trn; Rs 350 bn done as per CSe in H1).
While Defence is a small component of business (2.5% of consolidated revenue), some restriction in specific mandates may be limiting participation and holding back value discovery. CS HOLT suggests 0% revenue growth by 2024 at current price. HOLT suggests 41% upside now compared to the average HOLT suggested downside of 30% earlier.
We retain an Outperform on sector/geography diversification, balance sheet, track record, likely normalisation boosting prospects, and attractive valuations. Downside risks are weak cycle (the Middle East, government finances) and project issues (compensation costs, etc.).
Subsidiary valuation up; diluting EPC and driving higher holdco discount: Subsidiary valuation has gone up and a larger proportion of value in the stock is now ex-EPC. This has been driving up the holdco discount. Subsidiary valuation has particularly gone up during COVID-19 as the IT business has re-rated upwards while Finance has sustained its value post a sharp decline in end-March. We build in a 25% holdco discount on the current price to get our TP (implied discount is higher ~35%).
Upside even at 50% holdco discount: If we use the average holdco discount (50%) for three key companies listed in the market, then the fair value TP changes to Rs 1,020 and implied P/E of the core business EPC is ~13x.
Defence is small (2.5%) but could be driving ESG resistance: Defence is small at ~2.5% of consolidated revenues, but the stock is restricted in some mandates, which limits participation. While the overall shareholding has been stable past several years, it could still be holding back full value discovery. ESG has driven meaningful derating in many stocks such as NTPC, Coal India, and ITC.
HOLT suggests stock prices in nil revenue growth at current levels: Historically, L&T has traded at a 30% premium to the HOLT-warranted price (between 2014 and 2019) but is now showing a 41% upside potential post its de-rating this year. Using our estimates of sales and Ebitda margins for the next two years, L&T is now priced for a 0% long-term sales growth by 2024, which appears overly pessimistic.
Overall announcement/tendering/awarding activity resilient: Data suggests that the overall announcement/tendering and award activity has recovered from a sharp drop in the April-June period. Some revival is visible, with L&T reporting inflows of Rs 125 bn in Q2FY21 so far, implying a total EPC inflow of Rs 225-250 bn in Q2FY21 (~45% y-o-y decline in H1EPC inflows). We have a full-year target estimate of Rs 1,069 bn of EPC order inflows . EPC orders may amount to Rs 350 bn (CSe) in H1FY21e—thus, Rs 650-700 bn needs to come through in H2FY21. Depending on restoration of normalcy, this is still within reach.