Trend of revenue growth lagging order backlog growth continues
Larsen & Toubro
L&T’s Q2 FY15 standalone Ebitda (+4% year-on-year)/ consolidated Ebitda (-7% y-o-y) missed our estimate by 11-14%. Revenue for the standalone and consolidated entity grew 3% y-o-y (our est: +10% y-o-y) and 11% y-o-y, respectively. Ebitda (earnings before interest, taxes, depreciation, and amortisation) margins fell across all E&C (engineering and construction) segments, but it was partly-offset by a sharp margin jump in the “Others” segment (lower shipbuilding losses, higher realty income).
Hydrocarbons Ebit stayed negative; the management cautioned against the possibility of incremental closure costs on onerous contracts over the next few quarters. It also pruned its FY15 revenue guidance to 10-15% growth from 15%. While maintaining its margin guidance (-150 basis points y-o-y), it clarified this does not take into account any closure costs in the Hydrocarbons segment.
L&T’s WC (working capital) rose (>25% of revenues) further in Q2, which meant FCF (free cash flow) stayed negative. We cut our consolidated PAT (profit after tax) by 9% for FY15e (estimates) and 4% for FY16e. L&T’s weak subs’ (subsidiaries) performance, rising WC and possibility of further losses in the Middle East continue to concern us. Maintain Neutral with a new FV (fair value) of R1,550/share (R1,515).
Weak execution: L&T’s standalone revenue rose a modest 3% y-o-y (7% excl. the IES—Integrated Engineering Business—business from base quarter), vs our estimate of a 10% growth. Consolidated revenue growth was also weak (+11% y-o-y, +4% y-o-y in E&C businesses). The management highlighted that revenue recognition at some large/long execution cycle projects (Doha/ Riyadh metros, highways) is yet to pick up, and suggested it could take another 9-12 months. It trimmed its consolidated revenue growth guidance to 10-15% growth from 15% earlier.
Sharp drop in E&C margins: All E&C segments in Q2 saw margin declines, and standalone Ebitda (R13.4 bn, +4% y-o-y) was 11% below our estimates. This was despite a 39% y-o-y reduction in SG&A (selling, general and administrative) overheads; gross profit fell by 9% y-o-y. The consolidated entity’s E&C businesses’ Ebitda/Ebit margin also declined by 520bps y-o-y and consolidated Ebitda fell 7% y-o-y to R23 bn, 14% below our estimates. The management highlighted that the base quarter had the benefit of claims received from the NHAI (about R1 bn), which partly explains the decline. The management has maintained its margin guidance (-150bps y-o-y), though this does not factor in any further closure costs in the Hydrocarbons business.
Execution pace remains sluggish: The trend of L&T’s revenue growth lagging its order backlog growth continued in Q2 FY15. The company’s standalone revenues rose a modest 3% y-o-y, compared to our expectation of a 10% increase.
Revenues in all E&C segments declined (by 13-24% y-o-y), except the Infrastructure vertical (+23% y-o-y). In H1 FY15, standalone revenues have risen at only 4% y-o-y, despite the opening order backlog being 13% higher than the preceding year. The management highlighted that revenue recognition at some long-execution cycle projects (Doha/Riyadh metros, highways) has not yet picked up, and could take another 9-12 months to gather pace.
Ebitda margins decline across all E&C segments: All E&C segments saw margin declines, and standalone Ebitda came 11% below our expectations. This was despite a 39% y-o-y reduction in sales and administration overheads (from R6.3 bn in Q2 FY14 to R3.8 bn in Q2 FY15); gross profit in Q2 fell by a sharp 9% y-o-y.
‘Others’ segment partly offsets margin fall in the core business: As expected, the impact of margin declines in the E&C segment was partly offset by a sharp Ebit margin recovery in the Others segment, where standalone Ebit margin improved from -3% in Q2 FY14 to 17% in Q2 FY15. This was on account of reduction in losses in Shipbuilding (R3 bn in H1 FY14) as well as a sharp increase in realty income. The base of the Others segment profitability will get tougher in H2 FY15, and its ability to offset any margin decline in the core E&C business will consequently reduce.
BS (balance sheet) worries: L&T’s WC (standalone) rose to >25% of LTM (last 12 months) revenues (FY13: 15% of revs, FY14: 22% of revs, Q1 FY14: 23% of revs). This resulted in negative FCF and contributed to net debt rising by R38 bn in H1 to R95 bn. Even for the consolidated entity, WC consumed >R20 bn cash in Q2 FY15, resulting in negative op-cash flow. Despite Dhamra Port stake sale in Q1 (R27.5 bn inflow), L&T’s consolidated net debt rose sharply from R693 bn at FY14-end to R741 bn.
Cut EPS by 4-9%; maintain Neutral: We now build-in higher losses in the Hydrocarbons segment and assume a slower execution pace. This lowers our consolidated PAT by 9% for FY15e and 4% for FY16e. We revise our FV to R1,550/sh (R1,515) as we roll forward our valuation by six months to Sep-16. We see limited scope for a meaningful valuation re-rating as L&T’s average annual P/E (price-to-earnings ratio) has been higher only once in the last ten years, despite its RoEs (return on equity) being higher, gearing lower, and order flow/EPS CAGRs being better in the past.