Larsen & Toubro (L&T) met FY19 guidance on P/L and orders; however, Q4FY19 operating margin missed estimate. Despite the challenging environment, working capital improved 200bps (18% in FY19)—which is commendable—highlighting management’s sharpened focus on growth and cash flow. While L&T continues to maintain a cautious stance given macro challenges, we believe the RS 10-trn overall opportunity and healthy order book will enable it to comfortably meet FY20 guidance— 10-12% order inflow and 12-15% revenue growth.
We retain our conviction on the stock as we believe the company has significant cash flow and ROCE expansion headroom over the ensuing two-three years. While we revise down FY20/21e EPS 2/3% given Q4FY19 margin miss, we maintain Buy with SOTP-based TP of Rs 1,875 (earlier Rs 1,850) as we roll forward to September 2020 assigning 25x PE to core.
Ebitda margin takes a hit; improvement likely in FY20
L&T’s consolidated revenue grew 11% in Q4FY19 aided by 20% spurt in the service businesses. While infra revenue grew 11%, its margin was impacted (down 130bps) on account of cost provisions (conservative approach) and execution challenges (RoW, mining bans, design changes) in the transportation segment. With a large number of projects crossing the 25% threshold and fixed-price projects provided for, we estimate infra’s operating margin to improve in FY20.
Strategic preference: RoCE and large–ticket projects
L&T reiterated focus on large-ticket projects, clearly reflected in FY19 orders (order value >Rs 25 bn at Rs 400 bn versus Rs 150 bn y-o-y). Even as it targets geographical diversification beyond Middle East, focus on building capabilities to handle mega projects with better RoCE will take precedence over absolute operating profit.
Outlook: Competitive moat intact
While L&T’s growth prospects remain solid given its strong competitive MOAT, we see a significant value unlocking potential for stakeholders given healthy cash flow visibility and limited growth investment. We maintain ‘BUY/SO’.
Diversified business dominance imparts unique flexibility: L&T has a dominant position and market share in most operating verticals, be it oil & gas, factories & building, process projects, roads, bridges and industrial structures. This imparts flexibility to cherry-pick projects, which helps optimise overall profitability.
Transportation and factories & buildings segments to drive growth: Strong projects pipeline over the next five years in verticals like transportation and factories & buildings augurs well for L&T. Moreover, proven execution record and huge balance sheet equip it to garner higher share of the huge Rs 40-trn infra capex opportunity over FY19-23e.
Cash flow/RoE focus: Investment in three non-fungible assets apart from IDPL resulted in RoE declining to 12.5% in FY17. A clear shift in management strategy to capital allocation is apparent with exit from non-core assets/businesses (Rs 90 bn equity released over past three years) apart from ~Rs 210 bn worth of assets for sale.
Economy slowdown: Weakness in domestic investment could impact our current growth assumptions and award of large projects and thus pose a downside risk.
Capital allocation: L&T has been able to exit non-core assets and release equity. In addition, Rs 210-bn worth of assets are currently up for sale. Utilisation of these sale proceeds remains a key monitorable.