Larsen & Toubro Rating: Buy; Q2 earnings largely met estimates

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November 3, 2020 8:41 AM

Sequential improvement likely to continue; market’s undervaluing stock; ‘Buy’ retained

Despite low revenues, the company has managed its working capital cycle and generated free cash flow.

While earnings were largely in line with our expectations (revenue slightly weaker, offset by improved profitability), the stock ended down 5% post-results. Order inflow (OI) of Rs 280 bn was down y-o-y on expected lines, although slightly higher than our estimates, but the recent announcement of a big high-speed rail order should address some of that concern.

We believe L&T disappointed expectations on the dividend, as it allocated cash for further deployment in its financial services business and restructuring of Hyderabad metro while giving out c25% of free cash generated from the sale of its E&A business. On the accounting side, we believe it used the opportunity to allocate extraordinary income for its thermal power business, its recently commissioned hydro power plant, and its nuclear power shop. Although there are no cash implications, none of this was expected by us.

Operationally decent: Despite low revenues, the company has managed its working capital cycle and generated free cash flow. Collections for work remain healthy. While hydrocarbons and power business OI disappointed along expected lines, the infrastructure business managed to report only a 7% y-o-y OI decline. Of the existing order backlog, only 18% is from the private sector, and c43% of central and state sector projects are funded by multi-lateral agencies. Technology businesses and financial services have become important pillars, accounting for 51% of Ebit.

Investment view: We believe it is unjustified for L&T to trade at a bottom-of-cycle multiple on bottom-of-cycle earnings. Given the strong performance of the company’s technology business, its core business trades at a FY22e PE of 9x (far below its historical range of 15-24x) despite a decent ROCE of c17% and historically strong growth. We see few immediate catalysts for the stock, but expect sequential growth to continue. With a pipeline and plan already in place, the start of infrastructure capex could be the single most important catalyst.

Retain Buy and Rs 1,160 TP: We keep FY22e and FY23e earnings and our sum-of-the-parts valuation unchanged.

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