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Larsen & Toubro (LT)
Industrials
Strong execution, would watch for margin recovery and order inflow pick-up.
Strong 3QFY11 revenue growth of 40.5% is likely led by power and infrastructure
segments. We believe margins may recover partially as the 160 bps decline may have
been led by the execution of several projects which had not yet reached threshold level.
Full-year inflow guidance of 25% maintained though with caveats of slippage in
FY2012E. We retain ADD for now and would watch for margin recovery and order
inflow traction picking up.
Strong revenue growth on execution pick-up likely led by power and infrastructure
L&T reported very strong revenue growth of 40.5% yoy to Rs114 bn in 3QFY11, about 12%
higher than our estimate of Rs101.7 bn led by a pick-up in execution of the strong backlog. The
strong revenue growth is likely to be led by the power and infrastructure segments. Lower-thanexpected
margin (10.8% versus estimate of 12.3%) led to in line PAT of Rs8.05 bn, up 15.6% yoy.
Margin decline attributed to several projects not yet reaching threshold and higher material costs
The 160 bps yoy EBITDA margin decline was primarily attributed to (1) some orders for which
execution has started recently but have not entered the margin recognition phase and (2) increase
in raw material costs (about 1/3rd backlog comprises of fixed price orders). We believe the power
segment is likely to have contributed to more than 30% of 3QFY11 revenues. Assuming about
30% of this revenue line is from orders that have not achieved the margin recognition threshold
that would contribute a difference of 200-250 bps at the contribution-margin level. Note that
contribution margins have declined by 340 bps on a yoy basis.
Deferrals lead to sedate inflows in 3Q; maintains FY2011E guidance, with several caveats though
L&T management cited changes in ordering patterns for several projects leading to the lower-thanexpected
inflows in 3QFY11 (reported inflows of Rs113 bn – down 25% yoy). L&T management
has maintained its full-year order inflow guidance growth of 25% yoy for FY2011E, however, with
several caveats as orders may slip into FY2012E. The management has cited a majority of the
expected orders are likely to be booked in the month of March 2012. We estimate order inflows
of about Rs790 bn (up 14% yoy) for the full-year FY2011E.
Marginal changes and retain ADD as we watch for margins and order inflow traction recovery
We retain our ADD rating with a revised TP of Rs2,050 (from Rs2,125) based on (1) recent sharp
correction, (2) incrementally positive on strong execution, (3) legible explanation on lower margins
in 3QFY11, (4) lower-than-expected order inflows likely to be already factored in and (5) relatively
reasonable valuations of 16-17X FY2012E standalone earnings. We marginally revise our
consolidated estimates to Rs74.9 and Rs86 for FY2011E and FY2012E, respectively, from Rs76.3
and Rs87.6.
Strong revenue growth likely led by power and infrastructure segments
L&T reported very strong revenue growth of 40.5% yoy to Rs114 bn in 3QFY11, about 12%
higher than our estimate of Rs101.7 bn. This is likely a reflection of a pick-up in execution of
the strong order backlog of the company. The company cited that several projects which
were won in the second half of FY2010 moved from the initial engineering phase to the
procurement and construction phase leading to the strong revenue growth for the quarter.
Margin declines on increase in material costs and several orders not reaching margin
recognition threshold levels
The strong revenue growth was, however, partially offset by lower-than-expected EBITDA
margin. L&T reported EBITDA margin of 10.8% in 3QFY11, about 160 bps down on a yoy
basis led by lower contribution margins. We had expected margins to remain broadly flat on
a yoy basis. Operating leverage has partially cushioned the margin decline, as contribution
margins have declined sharply on a yoy basis by 340 bps. The lower-than-expected EBITDA
margin led to a reported EBITDA of Rs12.4 bn - inline with our estimates.
The yoy margin decline was primarily attributed to (1) increase in raw material costs – about
1/3rd of L&T’s order backlog comprises of fixed priced orders and (2) some orders for which
execution has started recently but have not entered the margin recognition phase. We
believe that power itself may have contributed more than 30% to the revenues in this
quarter. If 30% of this revenue line is from orders that have not achieved the margin
recognition threshold, then that would contribute a difference of 200-250 bps at
contribution level.
L&T reported a PAT (before extraordinary items) of Rs8.05 bn, in line with our estimates and
up 15.6% yoy from Rs6.96 bn. For the nine months ending December 31, 2010, the
company has reported revenues of Rs286 bn, up 22% yoy. EBITDA margin of 11.4% was
flat on a yoy basis leading to a net PAT growth of 18.5% to Rs21.7 bn in 9MFY11 versus
Rs18.3 bn in 9MFY10.
Strong revenue growth led by core E&C segment; product segments report relatively
sedate quarter
Revenue growth in 3QFY11 was primarily led by the core E&C segment which recorded
42% yoy revenue growth. The product segments of L&T reported relatively weak results
likely reflecting relatively slow pick-up in domestic capex activity. Machinery and Industrial
products segment has reported a sedate growth of 15% for the quarter while Electrical and
Electronics segment reported only a 10% growth on a yoy basis.
Revenue pick-up likely to be led by power and infrastructure
L&T’s strong revenue growth in 3QFY11 (up 40.5%) yoy is likely to be led by (1) power
segment – start of execution of several BTG orders and (2) infrastructure segment – pick-up
in execution of infrastructure orders under construction. Power segment is likely to have
contributed to about 32% of the total sales of L&T in 3QFY11 – this is versus about 21% of
total sales in FY2010 and 1HFY11.
Maintains guidance of 25% inflow growth – we build inflow growth of 14%
L&T management has maintained its full-year order inflow guidance growth of 25% yoy for
FY2011E. This implies an order inflow requirement of about Rs375 bn in 4QFY11E (reported
order inflows of about Rs495 bn in 9MFY11). The management has cited that a majority of
the expected orders are likely to be booked in the month of March 2012. We believe that
several of these orders may slip into FY2012E. We estimate order inflows of about Rs790 bn
(about 14% yoy growth) for the full-year FY2011E implying an order inflow requirement of
Rs297 bn in 4QFY11E.
Deferment of order inflows leads to lower-than-expected inflows
L&T management cited changes in ordering patterns for several projects leading to the
lower-than-expected inflows in 3QFY11 (reported inflows of Rs113 bn – down 25% yoy)
such as (1) organization inertia, (2) delays in gas/coal allocations, land acquisition,
environmental clearances etc., (3) splitting up of large EPC projects in smaller components,
(4) scam and corruption related issues, (5) political issues etc. We believe some of these
reasons may also impact future execution of the company.
No contribution of in-house projects to Rs133 bn of inflows in 3QFY11 may be
positive
In-house development projects did not contribute to the total Rs133 bn of order inflows in
3QFY11 versus a contribution of about 28% in 1HFY11
Rise in average execution cycle matched by increasing visibility
Our tracking suggests that average execution time of inflows has gone up to 2.8 years in
9MFY11 from 2.4 in FY2008. However, this is more than matched up by increasing visibility.
The order backlog visibility has increased from an average of about 1.5 years (on forward
four quarter revenues) in FY2008 to about 2.3 years at end-9MFY11.
Note that our study is based on estimated execution periods for order announcements of
L&T over FY2008-9MFY11.
Steep competition witnessed in Hydrocarbons segment
Order inflows hydrocarbon segment remained weak in this quarter (contributed to 6% of
inflows in 9MFY11 versus 17% in 9MFY10). Management cited very steep competition in
this segment leading to loss of several orders (witnessed price difference of an average of
25% between L&T’s bid and the winning bid).
Balance sheet remains strong with no deterioration in working capital
L&T reported a strong balance sheet at end-9MFY11 with no deterioration in working
capital levels (remained at about 7.5% of sales versus end-FY2010 levels) and gross debt to
equity of 0.37X. L&T increased its investments in its subsidiaries and associates (in the form
of equity investments, ICDs, loans & advances) by Rs24 bn to Rs100.9 bn at end-9MFY11
from FY2010-end level of Rs77 bn. This was primarily led by (1) buy-out of PE stake in L&T
IDPL for Rs7.1 bn (increased stake to 97.5%), (2) increase in investment in L&T Finance and
L&T Infra. Finance by Rs4.7 bn and (3) increase in investment in L&T Power Development to
the tune of about Rs4.6 bn.
L&T IDPL buyback of 13.2% stake for Rs7.1 bn implies value of Rs54 bn; but does not
include all projects
L&T recently completed a buyback of about 13.2% stake in L&T IDPL from private equity
investors for a value of Rs7.1 bn. This implies a value of Rs54 bn for 100% of L&T IDPL. This
value for IDPL is likely to not include several development projects (such as Hyderabad metro
project, Gujarat road projects etc.) which are presently not within L&T IDPL. We currently
value all the infrastructure SPVs of L&T (IDPL + other development projects) at Rs85 bn.
Retain ADD as we watch for margins and order inflow traction recovery
We retain our ADD rating with a revised target price of Rs2,050 based on (1) recent sharp
correction provides about 18% upside to our target price (stock has corrected by about
15% on an absolute basis and 10% relative to SENSEX in the past month), (2) incrementally
positive on strong execution, (3) legible explanation on lower margins in 3QFY11, (4) lowerthan-
expected order inflows likely to be already factored into the price and (5) relatively
reasonable valuations of 16-17X FY2012E standalone earnings.
We have marginally revised our standalone earnings estimates to Rs63.6 and Rs73.7 from
Rs65.1 and Rs75.3 for FY2011E and FY2012E, respectively. Our earnings revisions are based
on marginally lower order inflow and EBITDA margin assumptions for FY2011E and FY2012E.
We have correspondingly revised our estimates for the consolidated entity to Rs74.9 and
Rs86 from Rs76.3 and Rs87.6 for FY2011E and FY2012E, respectively.
We revise our SOTP-based target price to Rs2,050/share (from Rs2,125/share earlier)
comprised of (1) Rs1,647/share from the core construction business based on 21X FY2012E
expected earnings, (2) Rs238/share from L&T’s service subsidiaries, (3) Rs76/share from the
manufacturing subsidiaries, (4) Rs119/share from the infrastructure SPVs and (5) Rs94/share
from other subsidiaries and investments. The target price revision is primarily due to
increased value from the finance subsidiaries (L&T Finance, L&T Infra Finance) as additional
capital would aid growth and reduce pressure on the parent’s balance sheet.
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