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Larsen & Toubro
No Longer "Waiting for
Godot," Downgrading to EW
What's Changed
Rating Overweight to Equal-weight
Price Target Rs2,010.00 to Rs1,763.00
Industry View Attractive to In-Line
EPS F12e/F13e -11.9% / - 18%
Best Idea list Removed
We think L&T remains the best-managed and
lowest-risk company in the industry. Yet given the
premium valuations and weak growth coming up,
we await a better entry point. Our estimate and price
target cuts reflect likely weakness in capex inflows
and expansion in the execution cycle.
Corporate confidence and hence capex unlikely to
return in a hurry: Capacity utilization is high in
corporate India, but we believe that the private sector’s
confidence to invest in capacity creation remains low.
Interest rates are hitting a decade’s highs as the RBI
seeks to contain inflation, and our economics team
expects them to “remain at levels that will stifle growth.”
AlphaWise evidence also corroborates this view:
See India Corporate Survey: Capex Caution but Hiring
Hail, August 19, by our strategy team for details.
Market share gains are useful for a while… In F2011,
L&T’s net order inflows (ex cancellations) grew only 10%,
a massive drop from the 35% CAGR in F05-10, despite
its tendency to gain market share in slowdowns. A
sanguine market and we absorbed this in anticipation of
the return of capex in F2H12e.
…but revival is needed now to stave off margin
pain: A similar story in F12e is likely to end differently.
Another rising risk is the increase in orders from the
competitive Middle East market. Coupled with rising
material costs and comparatively lower margins BTG
orders, we see a net 200 bps compression in margins
over F12-14e from the lifetime high achieved in F11e.
Downgrading L&T to Equal-weight; No Longer a Best Idea
Inflows, Execution Cycle & Margins = Perfect Storm
We believe that L&T will have to weather a perfect storm out
there. Neither the public nor the private sector is stepping up
capex, even relative to weak bases.
√ No longer “Waiting for Godot” – inflow growth
unlikely to get stronger despite weak F11 base: We
remain confident that L&T will gain market share as in
previous crises – but we believe that it might no longer be
enough. We expect the company to register an 18%
CAGR in order inflows over F2011-13e – strong in the
current environment, but a far cry from the 35% CAGR
achieved in F2005-10.
√ Execution cycle increase to lead to slower revenue
growth: Given the uncertain macro environment as well
as India-specific problems such as land acquisition and
environment clearances, we believe that project delays
will continue, hence lengthening the execution cycle
further (12% over F2010-13e). We project that this
coupled with the lower inflows will lead to revenue CAGR
of just 23% over F11-13e.
√ High margin base also likely to make it difficult to
compensate on that front this time: L&T has in the past
(F06-07 and F10-11) weathered such weak revenue
periods through growth in margins. However, we believe
that given the high base, the company’s increased
percentage of revenues from the lower-margin (MENA
and BTG) orders, and rising material costs, L&T is likely to
see weakness on this front too. We build in a 150 bps
decline over the next 24 months in EBITDA margins from
the lifetime high of 12.8% achieved in F2011.
High premium justified in weak environment, but difficult
to see outperformance from here
Despite the negatives, the stock is trading at a 51% premium to
the market on a 12-month forward PE basis (using
consolidated EPS) vs. its five-year median premium of 43%.
We think many investors will continue to take refuge in the
name, thanks to best-in-class management quality (helping the
company still deliver a 15% earnings CAGR even in the difficult
environment) and the strong long-term growth story (especially
when the survival of some peers is now under question).
However, we believe that it will be difficult for the stock to
expand its premium, and hence deliver outperformance.
We think L&T remains the best-managed and lowest-risk
company in the industry. Yet given the premium valuations,
macro headwinds, and weak growth coming up, we downgrade
our rating to and Equal Weight and await a better entry point.
Given L&T’s status as the best-quality company in the industry,
and our view that both public and private capex are likely to
take longer to recover than previously anticipated, we are
downgrading our industry view to In-Line from Attractive.
Why Not Underweight?
If so much is going wrong, why are we not going whole hog?
√ L&T retains a natural monopoly in India: In revenue
terms, L&T is equal to the next six companies put together
in India. We believe that this creates a natural monopoly of
scale for the company, with its Indian peers finding it
difficult to compete in larger contract size (upwards of
US$300 mn).
√ Implied growth indicates greater risk to upside on top
line: After accounting for the 17% CAGR in earnings we
project for F2011-14e, we estimate that L&T’s stock price
implies 15% growth for F2014-21e. This is based on the
assumption that the stock’s P/E will converge to a market
P/E over the next 10 years as earnings growth slows down
to market-average levels by F2021e. However, revenue
growth for the company (after splitting out cement
revenues) over any 10-year period since F1999 (using
F1989 as a base) has never moved below 15% levels.
This indicates to us that risk to top-line growth, while finely
balanced, is still more to the upside than the downside.
√ Materials could be the joker in the pack: For a peek at
what could be, we look at our Metals & Mining analyst,
Vipul Prasad’s bear case on pricing. He assumes that
steel prices in India could fall 14% over F11-13e.
Assuming that this is applicable across all materials, it
could lead to an increase in margins of 185 bps for L&T vs.
the 150 bps downtick we have built in. L&T would in that
case deliver an earnings CAGR of 29% over F11-13e vs.
the 15% we now assume.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Larsen & Toubro
No Longer "Waiting for
Godot," Downgrading to EW
What's Changed
Rating Overweight to Equal-weight
Price Target Rs2,010.00 to Rs1,763.00
Industry View Attractive to In-Line
EPS F12e/F13e -11.9% / - 18%
Best Idea list Removed
We think L&T remains the best-managed and
lowest-risk company in the industry. Yet given the
premium valuations and weak growth coming up,
we await a better entry point. Our estimate and price
target cuts reflect likely weakness in capex inflows
and expansion in the execution cycle.
Corporate confidence and hence capex unlikely to
return in a hurry: Capacity utilization is high in
corporate India, but we believe that the private sector’s
confidence to invest in capacity creation remains low.
Interest rates are hitting a decade’s highs as the RBI
seeks to contain inflation, and our economics team
expects them to “remain at levels that will stifle growth.”
AlphaWise evidence also corroborates this view:
See India Corporate Survey: Capex Caution but Hiring
Hail, August 19, by our strategy team for details.
Market share gains are useful for a while… In F2011,
L&T’s net order inflows (ex cancellations) grew only 10%,
a massive drop from the 35% CAGR in F05-10, despite
its tendency to gain market share in slowdowns. A
sanguine market and we absorbed this in anticipation of
the return of capex in F2H12e.
…but revival is needed now to stave off margin
pain: A similar story in F12e is likely to end differently.
Another rising risk is the increase in orders from the
competitive Middle East market. Coupled with rising
material costs and comparatively lower margins BTG
orders, we see a net 200 bps compression in margins
over F12-14e from the lifetime high achieved in F11e.
Downgrading L&T to Equal-weight; No Longer a Best Idea
Inflows, Execution Cycle & Margins = Perfect Storm
We believe that L&T will have to weather a perfect storm out
there. Neither the public nor the private sector is stepping up
capex, even relative to weak bases.
√ No longer “Waiting for Godot” – inflow growth
unlikely to get stronger despite weak F11 base: We
remain confident that L&T will gain market share as in
previous crises – but we believe that it might no longer be
enough. We expect the company to register an 18%
CAGR in order inflows over F2011-13e – strong in the
current environment, but a far cry from the 35% CAGR
achieved in F2005-10.
√ Execution cycle increase to lead to slower revenue
growth: Given the uncertain macro environment as well
as India-specific problems such as land acquisition and
environment clearances, we believe that project delays
will continue, hence lengthening the execution cycle
further (12% over F2010-13e). We project that this
coupled with the lower inflows will lead to revenue CAGR
of just 23% over F11-13e.
√ High margin base also likely to make it difficult to
compensate on that front this time: L&T has in the past
(F06-07 and F10-11) weathered such weak revenue
periods through growth in margins. However, we believe
that given the high base, the company’s increased
percentage of revenues from the lower-margin (MENA
and BTG) orders, and rising material costs, L&T is likely to
see weakness on this front too. We build in a 150 bps
decline over the next 24 months in EBITDA margins from
the lifetime high of 12.8% achieved in F2011.
High premium justified in weak environment, but difficult
to see outperformance from here
Despite the negatives, the stock is trading at a 51% premium to
the market on a 12-month forward PE basis (using
consolidated EPS) vs. its five-year median premium of 43%.
We think many investors will continue to take refuge in the
name, thanks to best-in-class management quality (helping the
company still deliver a 15% earnings CAGR even in the difficult
environment) and the strong long-term growth story (especially
when the survival of some peers is now under question).
However, we believe that it will be difficult for the stock to
expand its premium, and hence deliver outperformance.
We think L&T remains the best-managed and lowest-risk
company in the industry. Yet given the premium valuations,
macro headwinds, and weak growth coming up, we downgrade
our rating to and Equal Weight and await a better entry point.
Given L&T’s status as the best-quality company in the industry,
and our view that both public and private capex are likely to
take longer to recover than previously anticipated, we are
downgrading our industry view to In-Line from Attractive.
Why Not Underweight?
If so much is going wrong, why are we not going whole hog?
√ L&T retains a natural monopoly in India: In revenue
terms, L&T is equal to the next six companies put together
in India. We believe that this creates a natural monopoly of
scale for the company, with its Indian peers finding it
difficult to compete in larger contract size (upwards of
US$300 mn).
√ Implied growth indicates greater risk to upside on top
line: After accounting for the 17% CAGR in earnings we
project for F2011-14e, we estimate that L&T’s stock price
implies 15% growth for F2014-21e. This is based on the
assumption that the stock’s P/E will converge to a market
P/E over the next 10 years as earnings growth slows down
to market-average levels by F2021e. However, revenue
growth for the company (after splitting out cement
revenues) over any 10-year period since F1999 (using
F1989 as a base) has never moved below 15% levels.
This indicates to us that risk to top-line growth, while finely
balanced, is still more to the upside than the downside.
√ Materials could be the joker in the pack: For a peek at
what could be, we look at our Metals & Mining analyst,
Vipul Prasad’s bear case on pricing. He assumes that
steel prices in India could fall 14% over F11-13e.
Assuming that this is applicable across all materials, it
could lead to an increase in margins of 185 bps for L&T vs.
the 150 bps downtick we have built in. L&T would in that
case deliver an earnings CAGR of 29% over F11-13e vs.
the 15% we now assume.
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