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Action: Retain Reduce rating on challenging macro conditions
L&T has announced INR289bn of orders YTD (35% of FY13 guidance)
despite challenging macro conditions. We think the momentum is likely
to slow in 2HFY13 to ~INR150bn/quarter.
Further, our meetings with peers/consultants confirm negative
margin/ROE outlook from Middle East orders. We also note rising
challenges in the roads sector, and despite good inflow in the buildings
segment, we see risk of an elongated execution and payment cycle.
Our analysis of foreign and other manufacturing subsidiaries’ financials
suggests subpar ROE generation at their level even as capital
employed continues to increase, suggesting consolidated ROE is not
hampered only by investments in developmental projects.
Catalysts: Macro worsening, orders and margins
We believe worsening macro conditions, disappointment on order inflow
guidance and margin squeeze will be key triggers for the stock’s de-rating.
Valuation: Raising estimates to factor in higher dividend from
subsidiaries, while TP benefits from roll-over and switch to DCF
We switch our valuation methodology to DCF with 13.5% Ke, terminal
year margin and growth assumptions of 10.5% and 6% respectively, to
arrive at INR782/share value for the standalone entity. The implied FY14F
P/E on adjusted EPS is thus 12.5x, which we see as reasonable. Our
terminal year assumptions imply a 10.5% CAGR in orders over FY13-20 to
reach USD25bn in FY20. We value the subsidiaries and other investments
at INR318 and thus arrive at our revised TP of INR1100/share.
4
Meetings with industry bodies and peers in the roads and
hydrocarbon verticals reconfirm negative outlook
We recently interacted with an industry representative for road developers, a
hydrocarbon sector project consultant and a couple of competitors in the hydrocarbon
and realty space. Below are the key takeaways from these meetings.
Takeaways from our interaction with industry representative for road developers:
• INR150bn worth of bills are pending as of Mar-12 with National Highway Authority of
India (compared with INR110-120bn as of Mar-11) to be paid to various BOT and EPC
companies. Much of this payment is disputed due to cost overrun issues, and some of
these claims are as old as 10-15 years.
• Poor award activity in other infrastructure segments such as power, water etc.
continues to drive an influx of new players in the road segment even now.
• In the last fiscal year, 53 projects were bid out by NHAI, of which 30 projects were bid
at heavy premium by developers.
• In contrast, the last 10-15 projects haven’t attracted many bidders.
• Out of these 53 projects awarded last year, not a single project has completed the
mandatory 80% land acquisition by NHAI (in fact, the average is as low as 30-40%).
• 43 projects are still pending environment clearance.
• States such as UP, West Bengal and Kerala haven’t seen even a single square
kilometre of land acquisition in last several years.
• Do not expect any respite from the proposed land acquisition bill and the industry
representative thinks it will only add to the cost burden for the developers.
• On a positive note, despite the poor balance sheet health of most companies in the
sector, financial institutions prefer road developers and contractors as a sector over
many other infrastructure segments such as even power because to date no road
developer or contractor has ever defaulted on a bank loan.
• Several developers are looking to monetize pre-2009 projects which are potentially
better IRR generating projects (and were bid at average grant received of 30%).
Interaction with a project consultant and a competitor in the hydrocarbon vertical:
Our discussion centred on the opportunity in the Middle East hydrocarbon sector and
whether Indian companies including L&T could compete against the Koreans in that
space.
• As per the representative, Korean companies enjoy strong support from their vendors
and that is their key edge for winning projects in the Middle East. Further, the Korean
and Japanese vendor bases regularly feature among the approved vendor list for
projects in the ME, while the Indian vendor base is almost non-existent in the approved
list.
• Managing and expediting supplies from the vendor base is a key skill and can be easily
managed by Korean companies, as most of their vendors are local.
• Korean companies also enjoy price discounts with their local vendor base and
scheduling preference. Similar benefits are also enjoyed by Japanese companies from
their vendor base. However, Indian companies cannot enjoy these benefits as the
Indian vendor base is non-existent, while vendors in Korea and Japan prefer to
prioritize orders from local companies over orders from companies in other
geographies.
• Offshore projects are less complicated and primarily require fabrication and
manufacturing jobs, while refinery and petchem projects are much more engineering
design oriented. Companies with a manufacturing and fabrication base can target
offshore projects, but penetrating petchem and refinery projects will be difficult for
Indian companies.
Feedback from this meeting corroborated with feedback from our Korean E&C analyst
(please refer to the following link: Engineering & Construction - Read across from
Korean E&C experience in ME).
Interaction with a competitor in the realty (buildings and factories) vertical:
• No signs of pick-up in activity from either residential or government sector projects.
• DLF and Jaiprakash Associates have been giving out projects to 3rd party contractors
vs. in-house construction earlier.
• While metro cities are definitely slowing, Tier-2 cities are no exception – though the
pace of slowdown is comparatively lower.
• L&T has probably been gaining market share, and that possibly explains the rise in
orders from buildings segment.
• Almost all orders in the segment are likely to be affected by slow execution and
payment cycle as the sector continues to be in distress.
INR289bn of orders announced YTD, but we think momentum
will slow
L&T has announced INR93bn worth of order inflows quarter-till-date, thus taking the
YTD inflow total to INR289bn. This is 42% of our full-year FY13F forecast and ~35% of
company guidance.
We think that the company is on track so far to meet our estimate of ~INR700bn order
inflow in FY13F (company guidance is higher at INR800-840bn).
How big are these manufacturing subsidiaries anyways?
PAT from the manufacturing (excluding the power equipment JVs, developmental
projects, Finance and IT subs) and foreign subsidiaries is ~6.7% of FY12 PAT reported
by the parent. Similarly, total equity invested in the analysed subs is ~INR17bn as of
Mar-12, which is ~7% of FY12 standalone book value. Additionally there might be loans
and advances/intercorporate deposits in these subs/JVs from the parent which have not
been analysed.
However, these subsidiaries together generated ~INR60bn of revenues in FY12, which
is 11% of standalone revenues.
Further, consolidated sales for L&T International FZE was ~INR30bn in FY12 (almost
half the size of standalone reported export revenues in FY12). If one takes a complete
picture of export revenue i.e. summation of revenue booked in the parent entity and in
the foreign subsidiaries, then the margins/ROE in this business appear much lower than
what is reported in the standalone numbers.
As highlighted in the tables above, L&T International FZE ROIE is just 11-14%,
compared with standalone adjusted ROE above 20%.
How big can L&T become vs. how big are
construction/engineering companies globally?
L&T’s FY12 standalone revenues from the E&C segment were ~USD8.5bn, while order
inflow over FY10-12 has been ~USD12bn. Of this, USD7.5bn of revenues and USD11bn
of order inflow was from the domestic E&C segment alone.
These numbers compare very favourably against some of the other similarly or larger
sized global construction/engineering giants such as Samsung Engineering, Hyundai,
Vinci, Fluor, Technip, Alstom, ABB, Siemens, Linde, Saipem, Skanska and Areva, as
most of these global giants have a large international market compared to the
domestic/home market.
With the Indian market facing headwinds, we think L&T has been making the right
choices in the form of geographical diversification. However, in addition to our concerns
on margins and ROE, we are unsure of how big L&T can grow given that the global
players have revenues of USD3-15bn, while L&T is already approaching this size. The
only companies that exceed this revenue amount materially are the ones that are backed
by strong technology differentiation such as Siemens, ABB and Areva.
Meanwhile, the leading global players are operating in more than 100 countries and with
strong market share in their areas of focus. Compared to this, L&T is already the market
leader in India but present in just 30 other countries and not a market leader in most of
these countries outside India.
While opportunities are definitely present for L&T to try to take market share from
incumbents, in a construction business we see an inherent increase in management
bandwidth needed to handle the increased business.
In the Indian domestic market, we note that L&T has constantly been gaining market
share over the past few years and this is evident in the following chart where L&T’s
domestic sales as a share of GDP, GCF and GFCF have all risen consistently over the
past few years.
However, if we were to assume that L&T’s share of Gross Fixed Capital Formation were
to remain constant at FY12 levels in the 12th Five-Year Plan period, it would imply that on
our estimated sales numbers for L&T, India would add USD2tn in GFCF in the 12th Five-
Year Plan period compared to ~USD1.45tn in the 11th Five-Year Plan Period, implying a
40% growth in the fixed capital formation in the country in the next 5 years. Given the
current macro conditions, we do not see significant upside to our numbers.
Valuation
We revise our target price to INR1,100 from INR992. With ~20% potential downside to
our revised target price, we retain our Reduce rating.
Our change in target price is driven by a change in valuation methodology for the
company as we now shift to DCF method for valuing the standalone business using a
cost of equity of 13.5% and terminal EBITDA margin and FCF growth rate of 10.5% and
6% respectively beyond FY20. Based on this, we arrive at a INR782/share value for the
standalone entity, which implies a P/E multiple of 12.5x on adjusted FY14F EPS (net of
dividend and interest income from subsidiaries).
The implied orderbook and order inflow numbers for the terminal year (i.e. FY20) of our
DCF forecast is ~US$53bn and ~US$25bn respectively, suggesting a 10-11% CAGR
over FY13-20. We also undertake a comprehensive review of the subsidiaries and
associates and now value each of these investments individually to arrive at
INR318/share value.
Action: Retain Reduce rating on challenging macro conditions
L&T has announced INR289bn of orders YTD (35% of FY13 guidance)
despite challenging macro conditions. We think the momentum is likely
to slow in 2HFY13 to ~INR150bn/quarter.
Further, our meetings with peers/consultants confirm negative
margin/ROE outlook from Middle East orders. We also note rising
challenges in the roads sector, and despite good inflow in the buildings
segment, we see risk of an elongated execution and payment cycle.
Our analysis of foreign and other manufacturing subsidiaries’ financials
suggests subpar ROE generation at their level even as capital
employed continues to increase, suggesting consolidated ROE is not
hampered only by investments in developmental projects.
Catalysts: Macro worsening, orders and margins
We believe worsening macro conditions, disappointment on order inflow
guidance and margin squeeze will be key triggers for the stock’s de-rating.
Valuation: Raising estimates to factor in higher dividend from
subsidiaries, while TP benefits from roll-over and switch to DCF
We switch our valuation methodology to DCF with 13.5% Ke, terminal
year margin and growth assumptions of 10.5% and 6% respectively, to
arrive at INR782/share value for the standalone entity. The implied FY14F
P/E on adjusted EPS is thus 12.5x, which we see as reasonable. Our
terminal year assumptions imply a 10.5% CAGR in orders over FY13-20 to
reach USD25bn in FY20. We value the subsidiaries and other investments
at INR318 and thus arrive at our revised TP of INR1100/share.
4
Meetings with industry bodies and peers in the roads and
hydrocarbon verticals reconfirm negative outlook
We recently interacted with an industry representative for road developers, a
hydrocarbon sector project consultant and a couple of competitors in the hydrocarbon
and realty space. Below are the key takeaways from these meetings.
Takeaways from our interaction with industry representative for road developers:
• INR150bn worth of bills are pending as of Mar-12 with National Highway Authority of
India (compared with INR110-120bn as of Mar-11) to be paid to various BOT and EPC
companies. Much of this payment is disputed due to cost overrun issues, and some of
these claims are as old as 10-15 years.
• Poor award activity in other infrastructure segments such as power, water etc.
continues to drive an influx of new players in the road segment even now.
• In the last fiscal year, 53 projects were bid out by NHAI, of which 30 projects were bid
at heavy premium by developers.
• In contrast, the last 10-15 projects haven’t attracted many bidders.
• Out of these 53 projects awarded last year, not a single project has completed the
mandatory 80% land acquisition by NHAI (in fact, the average is as low as 30-40%).
• 43 projects are still pending environment clearance.
• States such as UP, West Bengal and Kerala haven’t seen even a single square
kilometre of land acquisition in last several years.
• Do not expect any respite from the proposed land acquisition bill and the industry
representative thinks it will only add to the cost burden for the developers.
• On a positive note, despite the poor balance sheet health of most companies in the
sector, financial institutions prefer road developers and contractors as a sector over
many other infrastructure segments such as even power because to date no road
developer or contractor has ever defaulted on a bank loan.
• Several developers are looking to monetize pre-2009 projects which are potentially
better IRR generating projects (and were bid at average grant received of 30%).
Interaction with a project consultant and a competitor in the hydrocarbon vertical:
Our discussion centred on the opportunity in the Middle East hydrocarbon sector and
whether Indian companies including L&T could compete against the Koreans in that
space.
• As per the representative, Korean companies enjoy strong support from their vendors
and that is their key edge for winning projects in the Middle East. Further, the Korean
and Japanese vendor bases regularly feature among the approved vendor list for
projects in the ME, while the Indian vendor base is almost non-existent in the approved
list.
• Managing and expediting supplies from the vendor base is a key skill and can be easily
managed by Korean companies, as most of their vendors are local.
• Korean companies also enjoy price discounts with their local vendor base and
scheduling preference. Similar benefits are also enjoyed by Japanese companies from
their vendor base. However, Indian companies cannot enjoy these benefits as the
Indian vendor base is non-existent, while vendors in Korea and Japan prefer to
prioritize orders from local companies over orders from companies in other
geographies.
• Offshore projects are less complicated and primarily require fabrication and
manufacturing jobs, while refinery and petchem projects are much more engineering
design oriented. Companies with a manufacturing and fabrication base can target
offshore projects, but penetrating petchem and refinery projects will be difficult for
Indian companies.
Feedback from this meeting corroborated with feedback from our Korean E&C analyst
(please refer to the following link: Engineering & Construction - Read across from
Korean E&C experience in ME).
Interaction with a competitor in the realty (buildings and factories) vertical:
• No signs of pick-up in activity from either residential or government sector projects.
• DLF and Jaiprakash Associates have been giving out projects to 3rd party contractors
vs. in-house construction earlier.
• While metro cities are definitely slowing, Tier-2 cities are no exception – though the
pace of slowdown is comparatively lower.
• L&T has probably been gaining market share, and that possibly explains the rise in
orders from buildings segment.
• Almost all orders in the segment are likely to be affected by slow execution and
payment cycle as the sector continues to be in distress.
INR289bn of orders announced YTD, but we think momentum
will slow
L&T has announced INR93bn worth of order inflows quarter-till-date, thus taking the
YTD inflow total to INR289bn. This is 42% of our full-year FY13F forecast and ~35% of
company guidance.
We think that the company is on track so far to meet our estimate of ~INR700bn order
inflow in FY13F (company guidance is higher at INR800-840bn).
How big are these manufacturing subsidiaries anyways?
PAT from the manufacturing (excluding the power equipment JVs, developmental
projects, Finance and IT subs) and foreign subsidiaries is ~6.7% of FY12 PAT reported
by the parent. Similarly, total equity invested in the analysed subs is ~INR17bn as of
Mar-12, which is ~7% of FY12 standalone book value. Additionally there might be loans
and advances/intercorporate deposits in these subs/JVs from the parent which have not
been analysed.
However, these subsidiaries together generated ~INR60bn of revenues in FY12, which
is 11% of standalone revenues.
Further, consolidated sales for L&T International FZE was ~INR30bn in FY12 (almost
half the size of standalone reported export revenues in FY12). If one takes a complete
picture of export revenue i.e. summation of revenue booked in the parent entity and in
the foreign subsidiaries, then the margins/ROE in this business appear much lower than
what is reported in the standalone numbers.
As highlighted in the tables above, L&T International FZE ROIE is just 11-14%,
compared with standalone adjusted ROE above 20%.
How big can L&T become vs. how big are
construction/engineering companies globally?
L&T’s FY12 standalone revenues from the E&C segment were ~USD8.5bn, while order
inflow over FY10-12 has been ~USD12bn. Of this, USD7.5bn of revenues and USD11bn
of order inflow was from the domestic E&C segment alone.
These numbers compare very favourably against some of the other similarly or larger
sized global construction/engineering giants such as Samsung Engineering, Hyundai,
Vinci, Fluor, Technip, Alstom, ABB, Siemens, Linde, Saipem, Skanska and Areva, as
most of these global giants have a large international market compared to the
domestic/home market.
With the Indian market facing headwinds, we think L&T has been making the right
choices in the form of geographical diversification. However, in addition to our concerns
on margins and ROE, we are unsure of how big L&T can grow given that the global
players have revenues of USD3-15bn, while L&T is already approaching this size. The
only companies that exceed this revenue amount materially are the ones that are backed
by strong technology differentiation such as Siemens, ABB and Areva.
Meanwhile, the leading global players are operating in more than 100 countries and with
strong market share in their areas of focus. Compared to this, L&T is already the market
leader in India but present in just 30 other countries and not a market leader in most of
these countries outside India.
While opportunities are definitely present for L&T to try to take market share from
incumbents, in a construction business we see an inherent increase in management
bandwidth needed to handle the increased business.
In the Indian domestic market, we note that L&T has constantly been gaining market
share over the past few years and this is evident in the following chart where L&T’s
domestic sales as a share of GDP, GCF and GFCF have all risen consistently over the
past few years.
However, if we were to assume that L&T’s share of Gross Fixed Capital Formation were
to remain constant at FY12 levels in the 12th Five-Year Plan period, it would imply that on
our estimated sales numbers for L&T, India would add USD2tn in GFCF in the 12th Five-
Year Plan period compared to ~USD1.45tn in the 11th Five-Year Plan Period, implying a
40% growth in the fixed capital formation in the country in the next 5 years. Given the
current macro conditions, we do not see significant upside to our numbers.
Valuation
We revise our target price to INR1,100 from INR992. With ~20% potential downside to
our revised target price, we retain our Reduce rating.
Our change in target price is driven by a change in valuation methodology for the
company as we now shift to DCF method for valuing the standalone business using a
cost of equity of 13.5% and terminal EBITDA margin and FCF growth rate of 10.5% and
6% respectively beyond FY20. Based on this, we arrive at a INR782/share value for the
standalone entity, which implies a P/E multiple of 12.5x on adjusted FY14F EPS (net of
dividend and interest income from subsidiaries).
The implied orderbook and order inflow numbers for the terminal year (i.e. FY20) of our
DCF forecast is ~US$53bn and ~US$25bn respectively, suggesting a 10-11% CAGR
over FY13-20. We also undertake a comprehensive review of the subsidiaries and
associates and now value each of these investments individually to arrive at
INR318/share value.
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