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Larsen & Toubro: Short-term pain, long-term gain:: Nomura
Action
We believe the recent correction in the stock price presents an attractive buying
opportunity from a long-term perspective. In the short term, the stock performance
may be impacted by macro concerns. However, we remain convinced on the longterm growth potential and believe the risk-reward is favourable. We recommend a
Buy rating from a 12-month perspective.
Catalysts
News flow on new order wins, value unlocking of subsidiaries, decline in interest
rates and commodity prices.
Anchor themes
L&T is a play on investment in infrastructure and a pick-up in corporate capex. It
participates across various infrastructure and corporate sectors. The company is
unparalleled in scale and capabilities among Indian contractors and developers, in
our view
Short-term pain, long-term gain
Results beat expectations
L&T reported revenue growth of 41% YoY in 3Q FY11, above our
forecast of 26% growth, implying a substantial pick-up in execution.
Although operating margin was lower on account of a higher
proportion of early-stage revenues and high commodity prices, net
profit was higher by 13% compared to our estimates. The company
has maintained revenue growth guidance at 20% for FY11.
Slippage in order inflows
Order intake at INR134bn for the quarter was lower than our estimate
of INR150bn. As expected, the post-results commentary suggests the
possibility of some slippage in FY11 order intake compared to
guidance. Ex-BTG, ex-development order intake has failed to show an
improving trend since December 2007. We now build in order inflows
of INR827bn in FY11F.
Change FY11/FY12 ests; introduce FY13 ests
We cut our FY12/FY13 earning ests by 3-6% to build in lower order
intake, 50bps lower EBITDA margins and higher interest rates. Given
an order backlog ratio of 2.72 and current accretion rate, we expect
L&T to deliver ~20% revenue growth over FY11F-13F.
Valuation attractive; Reset 12m TP to INR1966/sh
The stock currently trades at 16.85x FY12F EPS. We believe
valuations are attractive given the long-term growth potential.
However, until the macro headwinds ease, we expect the stock to
trade at 15-20x one-year fwd EPS (compared to 20-25x expected
earlier). We now value the standalone business at INR1,517/sh (12-
month target) based on17.5x FY13F earnings. The subsidiary target
price is unchanged at INR449/sh. Maintain BUY
Early stage projects drag down EBITDA margins
L&T reported core EBITDA at INR12,379 mn vs our estimate of INR11,921 mn. Core
EBITDA margin was reported at 10.8% vs our expectation of 11.6% and 3QFY10
margin of 12.4%. According to management, a large proportion of revenues from
early-stage projects which haven’t yet reached the margin recognition threshold as
well as higher raw material prices, resulted in the y-y decline in margins.
Management has maintained its guidance of stable margins for FY11F vs FY10.
We estimate core EBITDA margins of 13.0% for FY11F, in line with FY10 margins.
Net profit above expectations
L&T reported net profit of INR8,405mn above our expectation of INR7,189 mn. Note
that this includes exceptional profit of INR300 mn (post-tax) on account of a gain on
the divestment of a part-stake in subsidiary and associate companies. Excluding this,
recurring profit was INR8,105 mn, 13% above our estimate. This was mainly on
account of higher-than-expected operating profit and lower-than-expected interest
expenses.
Segment overview: E&C drives revenue growth, margins lower
across segments
L&T reported strong revenue growth in the engineering and construction (E&C)
business. In the E&C segment, domestic revenues delivered a 45% rise y-y and 25%
q-q as execution picked up in infrastructure orders and BTG orders. Margins were
lower in this segment on account of higher commodity prices, particularly steel and a
change in job-mix.
The electrical & electronics (E&E) division reported 10% revenue growth y-y as
industrial and agricultural demand showed some improvement. Here, margins were
lower due to a sharp spike in input costs (mainly silver and copper), a drop in exports
and increased competition. According to management, efforts are ongoing for better
cost pass-through to customers.
In machinery & industrial products (MIP), growth in sales was led by increased offtake
in industrial valves and mining & construction equipment business. Again, margins
were lower as input prices increased.
Performance of key subsidiaries
L&T Infotech — Growing in line with industry
In L&T Infotech, revenues grew by 18% y-y to INR6.04bn in 3Q FY11 from INR5.12bn
in 3Q FY10. The growth is in line with IT industry growth. Net profit, though was flat at
INR0.73bn.
Finance subsidiaries — IPO expected in 4QFY11F
L&T did not give any details on its financial services subsidiaries as the holding
unit has filed the prospectus for an IPO. Management expects the IPO to be
completed in the current quarter if market conditions stabilise.
Infrastructure development subsidiaries – On the growth path
L&T currently has an infrastructure development portfolio of 15 road projects, one
metro project, three port projects, five power projects and 14 urban infrastructure
projects. The total cost of the project portfolio is INR613bn up from INR570bn at
end-2Q FY11 as L&T has added two hydropower projects to its portfolio. Total
equity invested in these projects at the end of 3Q FY11 was INR38bn versus
INR34n at the end of the previous quarter.
Order inflow guidance unlikely to be met
for FY11
Order inflows for the quarter were below our expectations. Order booking at
INR133.7bn was below our INR150bn estimate. Excluding the BTG and development
project orders, order intake momentum has stagnated since Dec 2007, in our view
(see below). During the quarter, the company didn’t book any BTG and development
project orders. The company ascribes the failure of order inflows to pick up in FY11 to:
1) a deferment of orders from private clients; 2) lack of policy action by the government;
3) issues surrounding land acquisition, environmental clearance, coal block allocation
and 4) market-share loss to competition, particularly in the hydrocarbon sector.
Management commentary post 3QFY11 results suggests potential slippage in order
inflow guidance for FY11. To meet the stated guidance of INR870bn, the company
would need to book orders worth INR375bn in 4QFY11F. Even assuming the
Hyderabad Metro development order of INR120bn (financial closure targeted by 4 Mar
2011) and boiler order related to NTPC bulk tender of INR40bn; L&T would have to
book INR215bn worth of orders which is much higher than the current run rate of nonBTG, non-development orders.
Sequential dip in backlog ratio
Order backlog at the end of the quarter stood at INR1,149bn implying an order bookto-sales ratio of 2.72. There is a marginal sequential dip in backlog ratio as execution
picked up and order inflow slowed down. In addition, the company has also taken out
orders worth ~INR20bn related to commercial real estate projects where there has
been no progress. We expect the backlog ratio to pick up in the near future with the
booking of the Hyderabad metro order and NTPC BTG orders.
Earnings estimates and valuation
We revise FY11/FY12 ests; introduce FY13 estimates
We make the following changes to our earnings model:
a) We reduce FY11 and FY12 order inflow est by 5% and 9% respectively. The
cut is to build in a delay of awards of key infrastructure projects and slowdown
in corporate capex.
b) Revenue estimates are marginally adjusted
c) We reduce our EBITDA margin estimate for FY11, FY12 by 50bps to 13%.
This is to account for higher input prices and uncertainty over margins in BTG
and development projects. Note that we expect BTG and development
revenues to contribute 16% of total revenues in FY12F vs 6% in FY11F.
d) Our net profit estimates are reduced by 3-6%.
With the current order book and order accretion rate, we expect L&T to sustain its
growth rate at ~20% over the next two years. We introduce our FY13 estimates with a
20% YoY growth rate and 13% EBITDA margin.
The stock has corrected 23% since its recent peak on 9 November 2010,
underperforming the broader market by 13%. The key concerns on the stock are: 1) a
slowdown in order accretion thereby impacting long-term growth potential and 2) a fall
in margins and profitability. We believe the stock correction factors in these concerns
and we see value emerging from a long-term perspective. The stock currently trades at
16.85x FY12F adjusted earnings, which we believe is attractive.
We believe, excluding periodic aberrations, the stable trading range for L&T has been
15-25x one-year forward earnings. We were valuing L&T at 22.5x one-year forward
EPS assuming a fair value range of 20-25x. This assumes a favourable macro
environment with an acceleration in the investment cycle. However, with the recent
slowdown in ordering activity, increase in interest rates and tightening liquidity, the
stock is most likely to trade in the range of 15-20x one-year forward earnings.
Therefore, we reset our parent business valuation at 17.5x FY13F to arrive at a oneyear forward value of INR1,517/sh. We retain a subsidiary valuation at INR449/sh. Our
price target is INR1,966/sh which presents potential upside of 17% over the next 12
months from current levels. Maintain BUY.
Risks to our investment view
Higher-than-expected slowdown in order inflows, rising interest rates, lower-thanexpected execution, a substantial increase in raw material prices and a higher risk
premium are the key risks to our price target
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