Larsen & Toubro Execution revival continues::Macquarie Research

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Larsen & Toubro
Execution revival continues
Event
 Larsen & Tubro (L&T) reported strong revenue growth in its 3Q FY11 results.
Revenues, at Rs114bn, were up 41% YoY, while adjusted PAT, at Rs8.05bn,
was up 30% YoY. Management has hinted at a potential miss of 25% order
inflow growth guidance in FY11. We have factored in a 2% revenue decline in
FY12 to account for this and, hence, have reduced our target price to Rs2,215
from Rs2,260.

Impact
 Strong execution revival continues; upside exists to FY11 guidance:
L&T’s revenue of Rs114bn (up 40.5% YoY) was much ahead of our and the
street’s estimates. Domestic E&C revenues increased by a substantial 69%
YoY, indicating the strength of the underlying execution revival, which we
expect to continue. L&T has achieved 22% growth in 9M FY11, and we
expect it to deliver 23% top-line growth in FY11, beating its guidance of 20%
growth.
 Margins muted due to booking of early-stage projects, stable margin
guidance maintained: EBITDA margin, at 10.9% in 3Q FY11, was +150bp
YoY. L&T attributes this to commencement of work on long-gestation projects
that have not reached revenue-booking threshold. While the 9M FY11 margin
has improved 20bp to 11.6%, LT has guided for stable margins.
We maintain our FY12 EBITDA margin estimate: We have marginally
cut our FY11 margin forecast by 40bp to 12.9%. We believe that the
company has sufficient room to maintain its FY12 margin at these levels
given that 70% of its order book has pass-through clauses and the lag
effect of commodity price increase kicks in these contracts. We, however,
have built in some safety by building in a 20bp decline.
 Order inflow muted in 3Q FY11, may miss headline 25% growth
guidance: Order inflow in 3Q FY11, at Rs133.7bn, was down 25% YoY. 9M
FY11 order inflow, at Rs495bn, has been up 8% YoY. Management has
hinted at a potential slippage in its 25% order inflow guidance for FY11 given
the delay in project awards due to recent scams and environmental issues.
Too much concern on Hyderabad metro’s order inflow in FY11: While
we have built in Hyderabad metro order inflow in our FY11 estimates, we
think that even if this order slips by a month or two, it will not have any
meaningful impact on the revenue estimates for FY12.
Earnings and target price revision
 We have reduced our FY11 and FY12 standalone EPS estimates by 2–3%.
Our new target price, hence, is Rs2,215.
Price catalyst
 12-month price target: Rs2,215.00 based on a Sum of Parts methodology.
 Catalyst: Financial closure and order booking of Hyderabad metro.
Action and recommendation
 Valuations look attractive at discount, even to mid-cap capital goods
peers: We believe order book growth will continue to be strong despite a
potential order inflow miss in FY11. The stock is now trading at 14.5x FY12E
(adjusted for subsidiaries’ valuation), which is at a discount to other capgoods peers. We reiterate our Outperform rating with a revised target price of
Rs2,215.



Execution revival remains the theme for L&T in FY11
 Strong revenue growth in core construction business: L&T reported strong revenue growth of
43% in its core construction business, driven primarily by 69% growth in India revenues. As
domestic orders constitute 92% of the E&C order book, strong growth trajectory in the construction
business should continue. Revenue growth in the product businesses – Electrical and Electronics
& Machinery and Industrial products – was nominal at 10% and 15%, respectively.
Upside potential to our FY12 revenue estimates: We believe that there is upside potential
to our FY12 revenue estimate of 27% growth, as execution momentum is strong in domestic
market.
 Export markets remain weak in E&C and E&E segments: The domestic businesses of all three
businesses witnessed robust growth. However, the decline in export revenues in the E&C and
E&E segments continued due to weak order inflow in FY10. Order inflow in the export segment for
E&C has more than doubled to Rs51bn in 9M FY11. Hence, we do not see a decline in export
revenues in FY12. The MIP segment reported an increase in export revenues after seven
quarters.
 Maintaining guidance of 20% revenue growth: Despite achieving 22% growth in revenues in
9M FY11, the company is maintaining its 20% growth guidance for FY11. The company needs
26% revenue growth in 4Q FY11 to achieve this, which we think has an upside risk



Margins muted due to projects in early stage of execution
 Early-stage projects impact margins in 3Q FY11: The company has commenced work on longgestation projects. Since these projects did not reach the critical revenue-booking threshold, the
margins dipped by 150bp to 10.9%.
 Margin declines across all three segments: Margin in the three business segments declined by
100–180bp. While the margin of the core E&C business was hurt due to the booking of early-stage
revenue and the lag impact of passing on the increase in commodity prices in the orders with a
price-variation clause, product businesses (E&E and MIP) were impacted by high copper and
silver prices.
 Reducing our FY11 margin estimate while maintaining our FY12 estimates: We have
reduced our FY11 margin estimate by 40bp to 12.9%. However, we maintain our FY12 margin
estimate of 12.7%, as we expect the company to pass on the impact of the increased commodity
prices on 70% of its order book.


Order inflow pace slows down, LT may miss 25% growth guidance
 Order inflow activity impacted by recent scams and change in environmental norms:
Company’s order inflow of Rs133.6bn was down 25% YoY due to reduced ordering activities by
both the government and private parties. While recent scams and scandals have slowed
government projects, stricter environmental norms have slowed down private project awards.
 Company not sacrificing margin for securing order inflow: The company highlighted
instances of predatory pricing by Chinese and Korean companies in the hydrocarbon space with
14–65% lower prices than L&T. L&T has ensured that it will not sacrifice margins just for the sake
of winning orders.
 Hyderabad metro project financial closure may slip into 1Q FY12: Delay in Hyderabad metro
project could make the project award slip into FY12. However, we believe that this is a sentimental
negative for the stock, as a quarter’s delay does not impact revenue bookings in FY12. Moreover,
the concession period of 30 years starts from the date of financial closure, and, hence, the
valuation of Hyderabad metro is also not impacted.


Revising our FY11 and FY12 estimates by 2–3%
 Reducing our margin estimate for FY11 by 40bp: We have reduced our FY11 margin estimate
by 40bp to 12.9% to factor in the lag effect of passing the hike in commodity prices in the projects
and early-stage projects not contributing meaningfully to revenues.
 Reducing our FY12 revenue estimate by 2%: We are cutting our FY12 revenue estimate by 2%
following order inflow slowdown.
 Cutting our FY11/12 EPS estimates by 2–3%: We have cut our FY11/12 estimates by 2–3% to
account for the above two factors.


Valuation – L&T trading at discount to other capital goods peers
 Reducing our target price marginally to Rs2,215: We have reduced our target price by 2% to
account for our FY12 EPS estimate cut.


 Trading at 14.5x FY12E EPS, a discount to mid-cap capital goods peers: L&T is trading at a
14.5x FY12E EPS (adjusted for subsidiaries’ valuation), despite a 27% earnings CAGR over
FY11–13E. L&T is trading at a discount or in line with mid-cap capital goods peers like Thermax
(TMX IN, Rs736, Not rated) and Cummins (KKC IN, Rs725, Not rated), which are more exposed
to cyclical discretionary capex and trading at a 10–15% premium to L&T based on consensus EPS
estimates.