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Order inflows and thus earning disappointments likely vs guidance/estimates.
Highlight potential for disappointments in 4QFY11E order inflows vs implied asking rate
on guidance and/or full-year estimates. Downgrade L&T to REDUCE with earnings cut
(5%, 11% for FY12E, FY13E) on the back of likely lower inflows (FY12E) along with risk
to margin (commodity price, mix), execution (longer gestation book), RoCE dilution and
higher risk on increasing infrastructure investments. Reiterate BUY on CRG, Thermax.
Revise L&T estimates on lower order inflow assumptions; downgrade L&T to REDUCE
Besides FY2011E inflows estimates, we believe that FY2012E inflows (lowered to Rs820 bn from
Rs940 bn earlier) may also be adversely impacted based on competition, slowdown and other
clearance/ political issues. We have therefore revised our consolidated earnings estimates to Rs82
(from Rs86) and Rs96.4 (from Rs106.6) for FY2012E and FY2013E based on lower booking
assumptions. We have correspondingly revised SOTP-based TP to Rs1,775 from Rs1,850 earlier.
L&T has risks from lower-than-expected inflows, margins, execution, return dilutive infra investments
We believe that L&T has risks from (1) lower-than-expected order inflows – 9MFY11 external
orders have not grown, no third party order for power equipment and EPC apart from Karchana
and a small gas plant order from GSECL, rising competition and slow decision making across
clients such as NTPC, (2) margins – commodity prices (steel is up 35% versus FY2010 average),
change in mix may lead to lower margins such as power generation ,where outsourcing to JVs etc.
is likely to be high, (3) execution may remain sedate as order book execution cycle elongates,
3QFY11 execution supported by base effect as well, and (4) return dilutive and higher risk
infrastructure investments which may be necessary to keep pushing the growth envelope.
Risks are known but consensus expectations high and may have downside; valuation also not cheap
While acknowledging the recent stock correction, we highlight that consensus earnings
expectations still remain high and valuation is not cheap. We have standalone earnings estimates
of Rs70 and Rs82 in FY2012E and FY2013E based on 18-19% CAGR revenue growth, 12.3%
margins (marginal 30-40 bps decline), flattish other income and interest costs (cash gets utilized in
infra assets). We believe these estimates are not conservative and may not be exceeded materially.
We also value subsidiaries at Rs500 using optimistic multiples to respective valuation drivers of
each sub. Standalone valuation adj. for subs is about 18X and 15X for FY2012E and FY2013E.
Potential for disappointments in others as well; estimates/guidance imply high asking rate
Order inflow has remained weak in 9MFY11 and may lead to disappointment in 4QFY11E also,
particularly as 4QFY10 base is very high. Full-year order inflow estimates and/or management
guidance imply strong asking rate for 4QFY11E, e.g. (1) Thermax requires order inflow of Rs17.5
bn (vs Rs14 bn in 4Q10 and Rs10 bn in 3Q), (2) Voltas - inflow of Rs31 bn vs Rs21 bn in 9MFY11.
Marginally revise Thermax estimates; reiterate BUY on Thermax and CRG
We reduce our inflow estimates for Thermax based on slow traction in 9MFY11 and weak
coincidental indicators and earnings to Rs32.3 and Rs36 (from Rs.32.7 and Rs38.4) for FY2011E
and FY2012E, and TP to Rs760/share (from Rs805). Retain BUY based on expanding opportunity
set in large power plants, pollution control, boiler JV, strong balance sheet and corp. governance.
We note that Thermax is a deeply cyclical stock as it does not enjoy the benefit of large backlog
with long execution and stable infra. segment. Retain BUY on CRG (TP Rs310) based on diversified
presence across sectors and geography reducing near-term risk to estimates and strong execution.
Downgrade to REDUCE on risks to inflows, margins, execution, returns dilution
We downgrade our rating on L&T to REDUCE (from ADD earlier) based on limited upside to
our revised target price of Rs1,775/share. We believe that L&T’s estimates could face
potential risks related to (1) lower-than-expected order inflows, (2) margin pressure given
rising commodity prices and change in order inflows mix, (3) sedate execution as order book
execution cycle elongates, and (4) return dilutive and higher risk infrastructure investments
which may be necessary to keep pushing the growth envelope.
Needs Rs297 bn orders in 4Q to meet estimates; asking rate even higher for
guidance
L&T has guided for full-year order inflow growth of 25% yoy for FY2011E, implying a very
strong order inflow requirement of about Rs375 bn in 4QFY11E. This would be about 57%
higher than 4QFY10 reported order inflows of Rs238 bn. The management has cited that a
majority of the expected orders are likely to be booked in March 2012. We have marginally
revised our full-year FY2011E inflows estimate to Rs775 bn (from Rs790 bn) primarily on
lower process and hydrocarbon sector inflows which have remained relatively slow in
FY2011E so far. Our estimates imply additional order inflow requirement of about Rs280 bn
in 4QFY11E in order to meet our full-year estimate (yoy growth requirement of 17.8%).
FY2012E inflows may also face several challenges
We note potential risks to meeting our FY2012E inflows estimates as well on account of
increased competition, sectoral slowdowns, clearance/allocation issues (land acquisitions,
environmental clearances, gas/coal allocations etc.) and political issues. Based on these risks,
we have reduced our FY2012E inflows estimate to Rs824 bn (up 6% yoy) from Rs940 bn
earlier. The inflows are likely to be led by the power (Rs300 bn, 36% of total inflows) and
infrastructure (Rs280 bn, 34% of total inflows) segments. We expect process and oil & gas
segments each to contribute about 10-12% to the total inflows.
FY2011E inflows were adversely impacted due to several reasons 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 that some of these reasons may also impact future
execution of the company.
The exhibit below demonstrates exposure of L&T’s business segments to these various
factors.
Power EPC/BTG - no major external order apart from Karchana in FY2011E
We note that L&T has bagged no major external order in the power EPC/equipment sector
apart from the Rs28 bn order from Jaiprakash Group for the 3X660 MW Karchana power
plant.
L&T would have to improve traction in winning third party orders to meet our FY2012E
order inflow estimates.
EPC business: Our assumption of Rs80 bn EPC orders in FY2012E implies about 2 GW of
orders. This would partly be driven by potential in-house orders from L&T’s joint venture
with KPCL and the remaining from third party vendors.
Equipment business: We build in Rs100 bn of equipment order (about 3.5-4 GW of BTG
orders) likely to be primarily led by the NTPC bulk tender (8X900 MW). The remaining
would have to be met by third party orders.
Orders from third parties (excl. in-house development projects) have in fact declined
by 11% yoy
Of the total order inflows of Rs361 bn reported in 1HFY11, share of in-house development
projects has increased to 28% versus just 5% in 1HFY10. These include Rajpura power
project and Krishnagiri-Walajahpet road construction order. We also note that order inflows
from third-party vendors (public + private) have in fact recorded a yoy decline on an absolute
basis. L&T reported third-party orders to the tune of about Rs260 bn in 1HFY11 versus
Rs265 bn reported in 1HFY10.
Margins may face pressure related to rising commodity prices and segment mix
We currently build in relatively flat EBITDA margin on a yoy basis of about 12-12.5% over
the next few years (FY2011E-13E). L&T reported EBITDA margin of about 11.5% in
9MFY11E. We believe that the company may face headwinds of margin pressure related to:
Rising commodity prices: L&T margins are likely to remain under pressure given the
rising commodity price environment. Almost 30% of L&T’s existing backlog is based on
fixed-price contracts and therefore vulnerable to commodity price fluctuations. Part of this
rise was already reflected in 3QFY11 results—EBITDA margin declined by 160 bps yoy.
Prices of key commodities such as steel, copper, aluminium etc. have recorded sharp
increase since 2QFY11. For instance, China domestic hot-rolled steel is currently trading at
about US$745/ton, about 35% higher than FY2010 average.
Change in revenue mix: We also note that share of inflows (and hence revenues) of
power segment to total inflows has increased significantly over the past few years. Power
segment contributed to about 43% of 9MFY11 inflows versus an average of about 10-
15% over FY2006-08. This was primarily led by inflows in the power EPC and BTG
segments (negligible in FY2008 versus almost 30% of 9MFY11 inflows). Note that this
segment is likely to have a higher proportion of outsourcing (to JVs etc.) and hence may
potentially have lower margins.
Rise in average execution cycle, but 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 over FY2008-9MFY11.
Increasing investments in emerging/infra business may dilute near-term returns
L&T’s asset base recorded a very strong growth in FY2010—47% yoy increase in net worth,
23% yoy increase in net fixed assets and 32% increase in capital employed. This is versus
revenue growth of about 9% and net profit growth of 13.5% for the same period. The
relatively sedate business/execution in FY2010 versus a very strong capital growth led to the
reduction in returns. Adjusted for the sharp increase in current investments, L&T’s returns
(RoCE) have continued to remain at historical high levels of about 30-31%.
However, L&T would have to increase its investments in several infrastructure projects such
as Hyderabad metro, Rajpura power project etc. The returns on these investments are likely
to come in only over a longer period of time and may lead to a reduction in the returns of
L&T for the near term.
Revise earnings estimates and target price to Rs1,775/share
We have revised our standalone earnings estimates to Rs63 and Rs70.1 from Rs63.6 and
Rs73.7 earlier for FY2011E and FY2012E, respectively and our consolidated earnings
estimates to Rs74.3 and Rs82 from Rs74.9 and Rs86 earlier based on lower order inflow
assumptions.
Risks are known but consensus expectations high and may have downside
While acknowledging the recent stock correction, we highlight that consensus earnings
expectations still remain high and valuation are not cheap. We have standalone earnings
estimates of Rs70 and Rs82 in FY2012E and FY2013E based on 18-19% CAGR revenue
growth, 12.3% margins (marginal 30-40 bps decline), flattish other income and interest
costs (cash gets utilized in infra assets). We believe these estimates are not conservative and
may not be exceeded materially. We also value subsidiaries at Rs500/share using optimistic
multiples to respective valuation drivers of each subsidiary. Standalone valuation adjusted for
subsidiaries is about 18X FY2012E and 15X FY2013E earnings.
Consensus estimates (as per Bloomberg consensus) is currently about 7-10% above our
estimates—standalone estimates of Rs75-76 in FY2012E and Rs90-92 in FY2013E and
consolidated estimates of Rs88-90 in FY2012E and Rs106 in FY2013E.
Revised target price of Rs1,775/share
We correspondingly revise SOTP-based target price to Rs1,775 from Rs1,850 earlier. Our
target price is comprised of (1) Rs1,268/share from the core construction business based on
18X FY2012E expected earnings, (2) Rs225/share from L&T’s service subsidiaries, (3)
Rs76/share from the manufacturing subsidiaries, (4) Rs107/share from the infrastructure
SPVs and (5) Rs94/share from other subsidiaries and investments.
Weak order inflow traction may lead to disappointments in 4Q as well
Order inflow traction has remained relatively weak in 9MFY11 which may lead to
disappointment in 4QFY11E as well. Our full-year order inflow estimates for capital goods
companies imply strong asking rate for remaining 4QFY11E (management guidance implies
even higher asking rates for 4Q) viz. (1) BHEL required a strong inflow about Rs210-215 bn
in 4QFY11E to meet its FY2011E guidance of Rs600 bn (16 GW), and (2) our full-year
estimates for L&T imply a strong 18% inflow growth requirement in 4Q (company guidance
even higher). Even companies such as Thermax and Voltas have a high asking rate of about
30-40% growth in inflows in 4Q based on management guidance levels.
Thermax: Cautious on order inflow cycle; deeply cyclical stock
Management remains cautious on order inflow cycle and recently reduced its full-year
inflows guidance to flat yoy inflows (versus expectation of a double digit growth earlier).
Even flat yoy inflows imply a strong requirement of about Rs17 bn, 27% higher than
4QFY10 inflows.
We note that Thermax is a deeply cyclical stock as it does not enjoy the benefit of large
backlog with long execution cycle orders and stable infrastructure segment. We have
therefore reduced our inflows estimate to Rs55 bn in FY2011E (a yoy decline of 5%). Our
estimate implies order inflow requirement of Rs14.6 bn in 4QFY11E—a growth of 6% over
4QFY10 inflows (versus 9% inflows decline in 9MFY11). We have revised our earnings
estimates to Rs32.3 and Rs36 from Rs.32.7 and Rs38.4 for FY2011E and FY2012E,
respectively. We have correspondingly revised our target price to Rs760/share (from Rs805)
comprised of (1) Rs685/ share for the core business (implying 19X P/E on FY2012E EPS -
historical average P/E) and (2) Rs75/share for 51% stake in a supercritical JV with B&W.
4Q asking rate high for other capital goods companies as well
BHEL: The company has guided for order inflows of about Rs600 bn (about 16,000 MW)
for FY2011E (broadly in line with our estimates) implying a strong inflow requirement of
about Rs210-215 bn in 4QFY11E. The inflow guidance likely includes assumptions of
NTPC 660 MW bulk tender—management expects both the boiler as well as turbine
component of this tender to be awarded in this fiscal.
Voltas: Voltas has reported order inflows to the tune of just about Rs22 bn in 9MFY11
versus our full-year estimate of Rs31 bn in FY2011E. This implies 4QFY11E inflow
requirement of Rs9.3 bn, a growth of 46% over 4QFY10 inflows and about 28% over
quarterly average inflows in FY2011E.
BGR Energy: BGR Energy requires additional Rs40 bn of orders in 4QFY11E to meet our
full-year estimate of Rs64 bn. This implies win of at least 1-2 large EPC/BoP orders in 4Q
(yoy comparison is not valid as orders are very lumpy in nature). Note that our order
inflow estimate is significantly lower than management’s guidance of about Rs150-200
bn.
Weak order inflow momentum witnessed in 3Q across most companies
Several companies reported relatively moderate-weak inflows potentially reducing visibility
for a pick-up in execution in the near term. Several companies reported sharp decline in
order inflows to the tune of about 25-30%—for instance, Thermax and Voltas reported a
28-29% yoy decline in inflows, L&T also reported a sharp decline of 25% yoy. The strong
growth in Siemens order inflows was primarily on account of a single large order from
Torrent power (quantum unknown). Total order inflows (for the six capital goods companies,
excluding Siemens) recorded a yoy decline of 19.4%.
We note that this trend was significantly in contrast to that witnessed in the first half of the
year where total inflows recorded about 34% yoy growth. However, the growth in the first
half is likely to have been also aided by low based effect—1HFY10 recorded a 13.5%
decline in order inflows.
High 4QFY10 base likely to adversely impact yoy growth in 4Q
Order inflows in 4QFY10 recorded a very strong growth of over 60% yoy primarily led by
strong order inflows in L&T. Even the other capital goods companies recorded strong yoy
inflow growth of 35-45%.
Stock calls—top picks remain Crompton and Thermax
We prefer companies with expanding opportunity set, diversified business exposure, positive
long-term outlook and relatively cheaper valuations. Our top picks in the industrial sector
include Crompton (diversified presence) and Thermax (wary of capex cycle risks).
Crompton: BUY (TP: Rs310) on diversified business and overseas business recovery
We retain our BUY rating on Crompton with a target price of Rs310 based on (1) diversified
business profile across geographies and segments, (4) strong cash flow generation
characteristics, (3) strong pick-up witnessed in overseas subsidiaries in the past quarters and
(4) strong balance sheet. Key risks to earnings relate to (1) aggressive competition may
pressure revenue growth and margins—already reflected in sharp decline in average
realizations in 9MFY11, and (2) slower-than-expected pick-up in domestic power segment.
Thermax: BUY (TP: Rs760) on expansion of business opportunity; but wary of capex
cycle related risks
Our BUY rating on Thermax is based on (1) strong expansion of business opportunity across
projects and products: scale-up in supercritical JV, potential JV with Siemens in HRSG, EPC of
small/medium sized utilities, (2) extremely strong balance sheet, negative working capital,
among the strongest corporate governance and (3) relatively attractive valuations—stock is
currently trading at a P/E of 15X FY2012E earnings (adjusted for Rs75/share for the
supercritical JV) versus historical trading levels of about 18-19X. Key risks include (1) capexcycle
related risks—deeply cyclical stock as it does not enjoy the benefit of large backlog
with long execution cycle orders and stable infrastructure segment, (2) potential margin
pressure and (3) delay in setting up supercritical JV facility and winning large utility orders.
BHEL: REDUCE (TP: Rs2,400) on sedate inflows leading to lower visibility in mid term
We expect BHEL’s future inflows to remain flattish in the medium term as (1) about 3/4th of
XIIth plan ordering may already be complete even assuming optimistic 120 GW execution,
(2) scale-up of competition with credible global partners, and (3) continuing strong Chinese
competition. Lower inflows traction would reduce visibility and revenue growth post
FY2012E despite assuming stronger execution as order book matures. Aggressive price
competition in boiler bulk tender may be a near-term negative catalyst. Order inflows have
primarily come from relatively smaller utilities (Adhunik, India Bulls etc.) potentially exposing
BHEL to higher execution risks.
Voltas: REDUCE (TP: Rs200) on sedate inflows and potential margin risks
Our REDUCE rating on the company is based on (1) sedate order inflows leading to
low revenue visibility , (2) limited upside to our FY2012E based target price, (3)
potential headwind of margins pressure and (4) slow pick-up in execution of new
projects. Key upside risks to our estimates could come from stronger-than expected
order inflows and execution pick-up in the EMP segment, particularly from
international markets.
BGR: REDUCE (TP: Rs600) on earnings risks, potential disappointment on near-term
opportunities
Our REDUCE rating is based on (1) potential disappointment on near-term
opportunities, (2) large dependence of near-term earnings on incremental order
inflows (1/4th and 3/4th of FY2012E and FY2013E revenues depend on incremental
orders), (3) large investment requirement in equipment venture pressing earnings,
(4) rising competition could adversely impact margins, (5) relatively concentrated
customer base and (6) dependence on large projects—any delay/deferral in any of
the projects could materially impact the earnings.
ABB (TP: Rs725, REDUCE)/Siemens (TP: Rs735, REDUCE)
Our negative stance on ABB and Siemens is primarily based on pricing pressures, company
specific issues, volatility in operating performance and very high valuations and growth
expectations.
India Equity Research Reports, IPO and Stock News
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Industrials
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Order inflows and thus earning disappointments likely vs guidance/estimates.
Highlight potential for disappointments in 4QFY11E order inflows vs implied asking rate
on guidance and/or full-year estimates. Downgrade L&T to REDUCE with earnings cut
(5%, 11% for FY12E, FY13E) on the back of likely lower inflows (FY12E) along with risk
to margin (commodity price, mix), execution (longer gestation book), RoCE dilution and
higher risk on increasing infrastructure investments. Reiterate BUY on CRG, Thermax.
Stock calls—top picks remain Crompton and Thermax
- Crompton: BUY (TP: Rs310) on diversified business and overseas business recovery
- Thermax: BUY (TP: Rs760) on expansion of business opportunity; but wary of capex cycle related risks
- BHEL: REDUCE (TP: Rs2,400) on sedate inflows leading to lower visibility in mid term
- Voltas: REDUCE (TP: Rs200) on sedate inflows and potential margin risks
- BGR: REDUCE (TP: Rs600) on earnings risks, potential disappointment on near-term opportunities
- ABB (TP: Rs725, REDUCE)/Siemens (TP: Rs735, REDUCE)
Revise L&T estimates on lower order inflow assumptions; downgrade L&T to REDUCE
Besides FY2011E inflows estimates, we believe that FY2012E inflows (lowered to Rs820 bn from
Rs940 bn earlier) may also be adversely impacted based on competition, slowdown and other
clearance/ political issues. We have therefore revised our consolidated earnings estimates to Rs82
(from Rs86) and Rs96.4 (from Rs106.6) for FY2012E and FY2013E based on lower booking
assumptions. We have correspondingly revised SOTP-based TP to Rs1,775 from Rs1,850 earlier.
L&T has risks from lower-than-expected inflows, margins, execution, return dilutive infra investments
We believe that L&T has risks from (1) lower-than-expected order inflows – 9MFY11 external
orders have not grown, no third party order for power equipment and EPC apart from Karchana
and a small gas plant order from GSECL, rising competition and slow decision making across
clients such as NTPC, (2) margins – commodity prices (steel is up 35% versus FY2010 average),
change in mix may lead to lower margins such as power generation ,where outsourcing to JVs etc.
is likely to be high, (3) execution may remain sedate as order book execution cycle elongates,
3QFY11 execution supported by base effect as well, and (4) return dilutive and higher risk
infrastructure investments which may be necessary to keep pushing the growth envelope.
Risks are known but consensus expectations high and may have downside; valuation also not cheap
While acknowledging the recent stock correction, we highlight that consensus earnings
expectations still remain high and valuation is not cheap. We have standalone earnings estimates
of Rs70 and Rs82 in FY2012E and FY2013E based on 18-19% CAGR revenue growth, 12.3%
margins (marginal 30-40 bps decline), flattish other income and interest costs (cash gets utilized in
infra assets). We believe these estimates are not conservative and may not be exceeded materially.
We also value subsidiaries at Rs500 using optimistic multiples to respective valuation drivers of
each sub. Standalone valuation adj. for subs is about 18X and 15X for FY2012E and FY2013E.
Potential for disappointments in others as well; estimates/guidance imply high asking rate
Order inflow has remained weak in 9MFY11 and may lead to disappointment in 4QFY11E also,
particularly as 4QFY10 base is very high. Full-year order inflow estimates and/or management
guidance imply strong asking rate for 4QFY11E, e.g. (1) Thermax requires order inflow of Rs17.5
bn (vs Rs14 bn in 4Q10 and Rs10 bn in 3Q), (2) Voltas - inflow of Rs31 bn vs Rs21 bn in 9MFY11.
Marginally revise Thermax estimates; reiterate BUY on Thermax and CRG
We reduce our inflow estimates for Thermax based on slow traction in 9MFY11 and weak
coincidental indicators and earnings to Rs32.3 and Rs36 (from Rs.32.7 and Rs38.4) for FY2011E
and FY2012E, and TP to Rs760/share (from Rs805). Retain BUY based on expanding opportunity
set in large power plants, pollution control, boiler JV, strong balance sheet and corp. governance.
We note that Thermax is a deeply cyclical stock as it does not enjoy the benefit of large backlog
with long execution and stable infra. segment. Retain BUY on CRG (TP Rs310) based on diversified
presence across sectors and geography reducing near-term risk to estimates and strong execution.
Downgrade to REDUCE on risks to inflows, margins, execution, returns dilution
We downgrade our rating on L&T to REDUCE (from ADD earlier) based on limited upside to
our revised target price of Rs1,775/share. We believe that L&T’s estimates could face
potential risks related to (1) lower-than-expected order inflows, (2) margin pressure given
rising commodity prices and change in order inflows mix, (3) sedate execution as order book
execution cycle elongates, and (4) return dilutive and higher risk infrastructure investments
which may be necessary to keep pushing the growth envelope.
Needs Rs297 bn orders in 4Q to meet estimates; asking rate even higher for
guidance
L&T has guided for full-year order inflow growth of 25% yoy for FY2011E, implying a very
strong order inflow requirement of about Rs375 bn in 4QFY11E. This would be about 57%
higher than 4QFY10 reported order inflows of Rs238 bn. The management has cited that a
majority of the expected orders are likely to be booked in March 2012. We have marginally
revised our full-year FY2011E inflows estimate to Rs775 bn (from Rs790 bn) primarily on
lower process and hydrocarbon sector inflows which have remained relatively slow in
FY2011E so far. Our estimates imply additional order inflow requirement of about Rs280 bn
in 4QFY11E in order to meet our full-year estimate (yoy growth requirement of 17.8%).
FY2012E inflows may also face several challenges
We note potential risks to meeting our FY2012E inflows estimates as well on account of
increased competition, sectoral slowdowns, clearance/allocation issues (land acquisitions,
environmental clearances, gas/coal allocations etc.) and political issues. Based on these risks,
we have reduced our FY2012E inflows estimate to Rs824 bn (up 6% yoy) from Rs940 bn
earlier. The inflows are likely to be led by the power (Rs300 bn, 36% of total inflows) and
infrastructure (Rs280 bn, 34% of total inflows) segments. We expect process and oil & gas
segments each to contribute about 10-12% to the total inflows.
FY2011E inflows were adversely impacted due to several reasons 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 that some of these reasons may also impact future
execution of the company.
The exhibit below demonstrates exposure of L&T’s business segments to these various
factors.
Power EPC/BTG - no major external order apart from Karchana in FY2011E
We note that L&T has bagged no major external order in the power EPC/equipment sector
apart from the Rs28 bn order from Jaiprakash Group for the 3X660 MW Karchana power
plant.
L&T would have to improve traction in winning third party orders to meet our FY2012E
order inflow estimates.
EPC business: Our assumption of Rs80 bn EPC orders in FY2012E implies about 2 GW of
orders. This would partly be driven by potential in-house orders from L&T’s joint venture
with KPCL and the remaining from third party vendors.
Equipment business: We build in Rs100 bn of equipment order (about 3.5-4 GW of BTG
orders) likely to be primarily led by the NTPC bulk tender (8X900 MW). The remaining
would have to be met by third party orders.
Orders from third parties (excl. in-house development projects) have in fact declined
by 11% yoy
Of the total order inflows of Rs361 bn reported in 1HFY11, share of in-house development
projects has increased to 28% versus just 5% in 1HFY10. These include Rajpura power
project and Krishnagiri-Walajahpet road construction order. We also note that order inflows
from third-party vendors (public + private) have in fact recorded a yoy decline on an absolute
basis. L&T reported third-party orders to the tune of about Rs260 bn in 1HFY11 versus
Rs265 bn reported in 1HFY10.
Margins may face pressure related to rising commodity prices and segment mix
We currently build in relatively flat EBITDA margin on a yoy basis of about 12-12.5% over
the next few years (FY2011E-13E). L&T reported EBITDA margin of about 11.5% in
9MFY11E. We believe that the company may face headwinds of margin pressure related to:
Rising commodity prices: L&T margins are likely to remain under pressure given the
rising commodity price environment. Almost 30% of L&T’s existing backlog is based on
fixed-price contracts and therefore vulnerable to commodity price fluctuations. Part of this
rise was already reflected in 3QFY11 results—EBITDA margin declined by 160 bps yoy.
Prices of key commodities such as steel, copper, aluminium etc. have recorded sharp
increase since 2QFY11. For instance, China domestic hot-rolled steel is currently trading at
about US$745/ton, about 35% higher than FY2010 average.
Change in revenue mix: We also note that share of inflows (and hence revenues) of
power segment to total inflows has increased significantly over the past few years. Power
segment contributed to about 43% of 9MFY11 inflows versus an average of about 10-
15% over FY2006-08. This was primarily led by inflows in the power EPC and BTG
segments (negligible in FY2008 versus almost 30% of 9MFY11 inflows). Note that this
segment is likely to have a higher proportion of outsourcing (to JVs etc.) and hence may
potentially have lower margins.
Rise in average execution cycle, but 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 over FY2008-9MFY11.
Increasing investments in emerging/infra business may dilute near-term returns
L&T’s asset base recorded a very strong growth in FY2010—47% yoy increase in net worth,
23% yoy increase in net fixed assets and 32% increase in capital employed. This is versus
revenue growth of about 9% and net profit growth of 13.5% for the same period. The
relatively sedate business/execution in FY2010 versus a very strong capital growth led to the
reduction in returns. Adjusted for the sharp increase in current investments, L&T’s returns
(RoCE) have continued to remain at historical high levels of about 30-31%.
However, L&T would have to increase its investments in several infrastructure projects such
as Hyderabad metro, Rajpura power project etc. The returns on these investments are likely
to come in only over a longer period of time and may lead to a reduction in the returns of
L&T for the near term.
Revise earnings estimates and target price to Rs1,775/share
We have revised our standalone earnings estimates to Rs63 and Rs70.1 from Rs63.6 and
Rs73.7 earlier for FY2011E and FY2012E, respectively and our consolidated earnings
estimates to Rs74.3 and Rs82 from Rs74.9 and Rs86 earlier based on lower order inflow
assumptions.
Risks are known but consensus expectations high and may have downside
While acknowledging the recent stock correction, we highlight that consensus earnings
expectations still remain high and valuation are not cheap. We have standalone earnings
estimates of Rs70 and Rs82 in FY2012E and FY2013E based on 18-19% CAGR revenue
growth, 12.3% margins (marginal 30-40 bps decline), flattish other income and interest
costs (cash gets utilized in infra assets). We believe these estimates are not conservative and
may not be exceeded materially. We also value subsidiaries at Rs500/share using optimistic
multiples to respective valuation drivers of each subsidiary. Standalone valuation adjusted for
subsidiaries is about 18X FY2012E and 15X FY2013E earnings.
Consensus estimates (as per Bloomberg consensus) is currently about 7-10% above our
estimates—standalone estimates of Rs75-76 in FY2012E and Rs90-92 in FY2013E and
consolidated estimates of Rs88-90 in FY2012E and Rs106 in FY2013E.
Revised target price of Rs1,775/share
We correspondingly revise SOTP-based target price to Rs1,775 from Rs1,850 earlier. Our
target price is comprised of (1) Rs1,268/share from the core construction business based on
18X FY2012E expected earnings, (2) Rs225/share from L&T’s service subsidiaries, (3)
Rs76/share from the manufacturing subsidiaries, (4) Rs107/share from the infrastructure
SPVs and (5) Rs94/share from other subsidiaries and investments.
Weak order inflow traction may lead to disappointments in 4Q as well
Order inflow traction has remained relatively weak in 9MFY11 which may lead to
disappointment in 4QFY11E as well. Our full-year order inflow estimates for capital goods
companies imply strong asking rate for remaining 4QFY11E (management guidance implies
even higher asking rates for 4Q) viz. (1) BHEL required a strong inflow about Rs210-215 bn
in 4QFY11E to meet its FY2011E guidance of Rs600 bn (16 GW), and (2) our full-year
estimates for L&T imply a strong 18% inflow growth requirement in 4Q (company guidance
even higher). Even companies such as Thermax and Voltas have a high asking rate of about
30-40% growth in inflows in 4Q based on management guidance levels.
Thermax: Cautious on order inflow cycle; deeply cyclical stock
Management remains cautious on order inflow cycle and recently reduced its full-year
inflows guidance to flat yoy inflows (versus expectation of a double digit growth earlier).
Even flat yoy inflows imply a strong requirement of about Rs17 bn, 27% higher than
4QFY10 inflows.
We note that Thermax is a deeply cyclical stock as it does not enjoy the benefit of large
backlog with long execution cycle orders and stable infrastructure segment. We have
therefore reduced our inflows estimate to Rs55 bn in FY2011E (a yoy decline of 5%). Our
estimate implies order inflow requirement of Rs14.6 bn in 4QFY11E—a growth of 6% over
4QFY10 inflows (versus 9% inflows decline in 9MFY11). We have revised our earnings
estimates to Rs32.3 and Rs36 from Rs.32.7 and Rs38.4 for FY2011E and FY2012E,
respectively. We have correspondingly revised our target price to Rs760/share (from Rs805)
comprised of (1) Rs685/ share for the core business (implying 19X P/E on FY2012E EPS -
historical average P/E) and (2) Rs75/share for 51% stake in a supercritical JV with B&W.
4Q asking rate high for other capital goods companies as well
BHEL: The company has guided for order inflows of about Rs600 bn (about 16,000 MW)
for FY2011E (broadly in line with our estimates) implying a strong inflow requirement of
about Rs210-215 bn in 4QFY11E. The inflow guidance likely includes assumptions of
NTPC 660 MW bulk tender—management expects both the boiler as well as turbine
component of this tender to be awarded in this fiscal.
Voltas: Voltas has reported order inflows to the tune of just about Rs22 bn in 9MFY11
versus our full-year estimate of Rs31 bn in FY2011E. This implies 4QFY11E inflow
requirement of Rs9.3 bn, a growth of 46% over 4QFY10 inflows and about 28% over
quarterly average inflows in FY2011E.
BGR Energy: BGR Energy requires additional Rs40 bn of orders in 4QFY11E to meet our
full-year estimate of Rs64 bn. This implies win of at least 1-2 large EPC/BoP orders in 4Q
(yoy comparison is not valid as orders are very lumpy in nature). Note that our order
inflow estimate is significantly lower than management’s guidance of about Rs150-200
bn.
Weak order inflow momentum witnessed in 3Q across most companies
Several companies reported relatively moderate-weak inflows potentially reducing visibility
for a pick-up in execution in the near term. Several companies reported sharp decline in
order inflows to the tune of about 25-30%—for instance, Thermax and Voltas reported a
28-29% yoy decline in inflows, L&T also reported a sharp decline of 25% yoy. The strong
growth in Siemens order inflows was primarily on account of a single large order from
Torrent power (quantum unknown). Total order inflows (for the six capital goods companies,
excluding Siemens) recorded a yoy decline of 19.4%.
We note that this trend was significantly in contrast to that witnessed in the first half of the
year where total inflows recorded about 34% yoy growth. However, the growth in the first
half is likely to have been also aided by low based effect—1HFY10 recorded a 13.5%
decline in order inflows.
High 4QFY10 base likely to adversely impact yoy growth in 4Q
Order inflows in 4QFY10 recorded a very strong growth of over 60% yoy primarily led by
strong order inflows in L&T. Even the other capital goods companies recorded strong yoy
inflow growth of 35-45%.
Stock calls—top picks remain Crompton and Thermax
We prefer companies with expanding opportunity set, diversified business exposure, positive
long-term outlook and relatively cheaper valuations. Our top picks in the industrial sector
include Crompton (diversified presence) and Thermax (wary of capex cycle risks).
Crompton: BUY (TP: Rs310) on diversified business and overseas business recovery
We retain our BUY rating on Crompton with a target price of Rs310 based on (1) diversified
business profile across geographies and segments, (4) strong cash flow generation
characteristics, (3) strong pick-up witnessed in overseas subsidiaries in the past quarters and
(4) strong balance sheet. Key risks to earnings relate to (1) aggressive competition may
pressure revenue growth and margins—already reflected in sharp decline in average
realizations in 9MFY11, and (2) slower-than-expected pick-up in domestic power segment.
Thermax: BUY (TP: Rs760) on expansion of business opportunity; but wary of capex
cycle related risks
Our BUY rating on Thermax is based on (1) strong expansion of business opportunity across
projects and products: scale-up in supercritical JV, potential JV with Siemens in HRSG, EPC of
small/medium sized utilities, (2) extremely strong balance sheet, negative working capital,
among the strongest corporate governance and (3) relatively attractive valuations—stock is
currently trading at a P/E of 15X FY2012E earnings (adjusted for Rs75/share for the
supercritical JV) versus historical trading levels of about 18-19X. Key risks include (1) capexcycle
related risks—deeply cyclical stock as it does not enjoy the benefit of large backlog
with long execution cycle orders and stable infrastructure segment, (2) potential margin
pressure and (3) delay in setting up supercritical JV facility and winning large utility orders.
BHEL: REDUCE (TP: Rs2,400) on sedate inflows leading to lower visibility in mid term
We expect BHEL’s future inflows to remain flattish in the medium term as (1) about 3/4th of
XIIth plan ordering may already be complete even assuming optimistic 120 GW execution,
(2) scale-up of competition with credible global partners, and (3) continuing strong Chinese
competition. Lower inflows traction would reduce visibility and revenue growth post
FY2012E despite assuming stronger execution as order book matures. Aggressive price
competition in boiler bulk tender may be a near-term negative catalyst. Order inflows have
primarily come from relatively smaller utilities (Adhunik, India Bulls etc.) potentially exposing
BHEL to higher execution risks.
Voltas: REDUCE (TP: Rs200) on sedate inflows and potential margin risks
Our REDUCE rating on the company is based on (1) sedate order inflows leading to
low revenue visibility , (2) limited upside to our FY2012E based target price, (3)
potential headwind of margins pressure and (4) slow pick-up in execution of new
projects. Key upside risks to our estimates could come from stronger-than expected
order inflows and execution pick-up in the EMP segment, particularly from
international markets.
BGR: REDUCE (TP: Rs600) on earnings risks, potential disappointment on near-term
opportunities
Our REDUCE rating is based on (1) potential disappointment on near-term
opportunities, (2) large dependence of near-term earnings on incremental order
inflows (1/4th and 3/4th of FY2012E and FY2013E revenues depend on incremental
orders), (3) large investment requirement in equipment venture pressing earnings,
(4) rising competition could adversely impact margins, (5) relatively concentrated
customer base and (6) dependence on large projects—any delay/deferral in any of
the projects could materially impact the earnings.
ABB (TP: Rs725, REDUCE)/Siemens (TP: Rs735, REDUCE)
Our negative stance on ABB and Siemens is primarily based on pricing pressures, company
specific issues, volatility in operating performance and very high valuations and growth
expectations.
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