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Larsen & Toubro (LT)
OW: Q3 FY11 in line; price correction overdone
Q3 earnings were 5% above HSBC est, as strong top line
growth made up for higher than expected margin fall
Concerns on weak Q3 order inflows overdone. Book to bill at
3x (Q2 FY11) sufficient to manage a few qtrs of volatility
23% correction over past two months offers a good entry
point. Reiterate Overweight rating and INR2,341 target price
Q3 earnings surprise, though EBITDA margin disappoints. L&T’s Q3 FY11 recurring
earnings grew 16% y-o-y to INR8.1bn, 5% above HSBC est. and 4% above consensus. This
was driven primarily by 40% top line growth (HSBC est of 26%), which made up for a weak
EBITDA margin of 10.8% (155bp compression against expectation of 20bp). While order
inflows of INR133bn (-25% y-o-y) were below market expectation, the stock sold off post
results as management indicated that there could be downside risk to its FY11 guidance.
Concerns on order inflow slowdown seem overdone. We believe order inflow slowdown in
the system has been evident over the past six months as Real Estate, Oil and Gas, Roads,
Water & Irrigation, and Railways have witnessed delays / lower capex. This, though, was
already reflected in our FY11-13 order inflow CAGR of only 16% (10% growth during FY11
and a 20% CAGR during FY12-13), while consensus in our view seems to have been
optimistic. We make no changes to our earnings or order inflow expectations over FY11-13.
Additionally L&T’s book to bill at 3x (Q2 FY11) has the ability to support 2-3 quarters of
order inflow volatility. Hence a revival during FY12 (except in Real Estate) in most laggard
sectors (delays were primarily due to technical / policy issues) coupled with contribution from
in-house projects (Metro and Roads) should improve the business outlook for L&T.
Stock correction makes valuation attractive. Reiterate OW with TP of INR2,341.
L&T’s share price has corrected by 23% over the past two months and is now trading at
15x Dec 2012e earnings while it has traded at an average of 23.8x one-year forward
earnings over the past five years. Our target price of INR2,341 values L&T at 21.3x its
Dec 2012e earnings, which includes INR1,855 for the standalone entity (20.6x Dec 2012e
EPS) and INR486 for the subsidiaries (SOTP). We reiterate our Overweight rating. Macro
slowdown is the key downside risk to our investment thesis.
Valuation and risks
L&T’s share price has corrected by c23% over the past two months and is now trading at 15x Dec 2012e
earnings, offering an attractive opportunity to buy the stock. Our 12-month target price of INR2,341
includes INR1,855 for the standalone entity (implied PE of 20.6x Dec 2012e EPS) and INR486 for the
subsidiaries. At our target price, L&T would trade at 21.3x Dec 2012e earnings. L&T in the past five years
has traded in a range of 11-47x, and at an average of 23.8x its one-year forward earnings.
Under our research model, for stocks without a volatility indicator, the Neutral band is 5ppt above and
below our hurdle rate for Indian stocks of 11%, or 6-16% around the current share price. Our target price
suggests a potential return, including prospective dividend, of 37%, which is above the Neutral band;
thus, we reiterate our Overweight rating.
Key risks include a sharp slowdown in economic growth and the resultant impact on government
spending and industrial capex, higher-than-anticipated EBITDA margin erosion over FY11-13, and a
meaningful rise in interest rates, impacting project timelines.
Investment thesis
We expect L&T to report a robust 26% consolidated EPS CAGR for FY11-13, driven primarily by
improvement in the business environment and increased contribution from subsidiaries, c21% in FY13
from c12% in FY10. We believe the strategic steps taken by L&T over the past 3-5 years to diversify into
structural growth segments like power equipment manufacturing, nuclear power, defence, and asset
ownership will start yielding results over the next 3-5 years. The company, in our view, has put all the
building blocks in place in these businesses, and the next few years should see L&T gain critical mass in
these segments. This would reduce cyclical business risk and improve the company’s earnings profile.
We expect L&T to report a c24% revenue CAGR for FY11-13.
While EBITDA margins may fall by c100bp in FY11-13e — we believe operating leverage has peaked
— robust top-line growth at a 25% CAGR in the same period would still result in impressive 21% growth
in the standalone earnings CAGR for FY11-13e. The full impact of the entry into new businesses will be
reflected in consolidated earnings, which we expect will report a c26% earnings CAGR for FY11-13e.
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