The Larsen & Toubro (L&T) stock, which underperformed the broader market between July and December 2011, has delivered significantly higher returns (up 30 per cent) in 2012, compared to 11-13 per cent by the Sensex and Bharat Heavy Electricals Ltd. The gains are consequent to hopes that the higher interest rate cycle will reverse at some point in time, leading to better economic activity.
While valuations of around 16 times 2012-13 estimated earnings are not expensive, sustaining the outperformance on bourses looks difficult. Though the interest rate cycle is expected to turn in 2012, most analysts haven’t turned bullish yet. They continue to give their short-term views on the stock, as competition (both in India and globally) has significantly changed L&T’s long-term outlook and the macro environment hasn’t changed for the better.
Akshay Soni, analyst at Morgan Stanley, said in a recent report, “L&T is facing the trinity of slowing order environment, elongating execution cycle and margin pressures.” Prakash Gaurav Goel, analyst at ICICI Securities, said, “Shrinking returns, rising competitive pressures, uncertainty about order book growth and exposure to asset-heavy businesses are the overhangs on L&T.”
| MUTED PROFIT GROWTH | |||
| In Rs crore | 9M' FY12 | FY12E | FY13E |
| Revenues | 34,727 | 53,899 | 62,559 |
| % change | 21.4 | 22.8 | 16.1 |
| Operating profit | 3,645 | 6,375 | 7,349 |
| % change | 12.5 | 13.4 | 15.3 |
| Net profit | 2,536 | 4,124 | 4,565 |
| % change | 17.1 | 13.8 | 10.7 |
| Standalone financial performance; E : Estimates Source: Company, Analyst reports | |||
Missing target
Based on a five per cent order inflow growth guidance, L&T needs to report growth of 13 per cent (or Rs 34,383 crore) for the March quarter. However, it has so far announced Rs 12,593 crore worth of order intake. The balance, Rs 21,790 crore, looks difficult even after including the unannounced orders. Though the previous corresponding quarter gives a higher base (order inflow was up 27 per cent), the consensus estimate is that L&T is likely to report a decline of five per cent in order inflows in 2011-12.
Gopal Ritolia and Anupam Gupta, analysts at IIFL, said in their March 27 note (Increasing risk to medium-term growth): “With order announcements remaining subdued so far in the fourth quarter of 2011-12, order inflow may negatively surprise the muted expectations.”
Rising competition
Apart from high interest rates, land acquisition and environmental clearance issues have led to weakness in both public and private capex. L&T’s order inflow growth of 29 per cent in FY09-FY10 came down to 15 per cent in 2010-11 and was flat year-on-year in the nine months to December 2011. Amid a sluggish demand environment, competition has heightened in India since the past few years. Goel said, “New players, domestic as well as foreign, are mushrooming in almost all sectors that have traditionally given business to L&T (power, hydrocarbons and infrastructure — roads, metro and rail).” While L&T has started looking at the foreign market (15 per cent of order book) and aims to achieve 25-30 per cent of inflows, there are many competitors even there, amid subdued economic conditions.
Missing on order inflows, however, may be a blessing in disguise for margins, as it indicates the company is not compromising and undercutting to win orders. In the nine months to December 2011, L&T maintained its operating profit margin, which slipped only 83 basis points. But Goel has a different opinion. “As L&T executes the order backlog and pipelines start to dry, the company, too, may have to resort to price aggression,” Goel said. According to him, increasing competition in a weak macro environment, rising proportion of in-house infrastructure orders, rising dependence on overseas business for growth and a firm raw material price scenario will keep margins subdued.
In short, sales growth and margins are at risk. Analysts don’t expect an improvement in FY13-FY14 due to the absence of a revival in short-cycle orders (precursor to revival in the capex cycle), unresolved issues in core sectors (power, hydrocarbon and process, which form half of its order inflows) and good activity only in few segments (dedicated freight corridor, urban infrastructure and highways).
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Shares in L&T rose five per cent immediately after the announcement of the much-awaited succession plan on March 9. Soni said, “With the experienced A M Naik (executive chairman) and K Venkataramanan (chief executive and managing director) at the helm for the next 3.5 years, the risk of a deviation from the current course is significantly reduced, and creates an opportunity for a more orderly transition, as L&T looks to appoint a new CEO by January 1, 2015.”
However, given the stock’s recent performance and the unchanged macro environment, most analysts are wary of medium-term prospects. Soni prefers to stay on the sidelines until some clarity emerges on the capex cycle. Bharat Parekh, analyst, Bank of America Merrill Lynch, has a neutral rating on the stock on risks of a de-rating in its core business, led by losses of big-ticket orders in power, metal and infra, weak earnings growth and decline in return on equity due to a shift in the business model — from asset-light engineering, procurement and construction business to an infra developer. Goel believes higher growth is required to defend the valuation, which is higher compared to Indian and global peers.
IIFL analysts, who have an ‘add’ rating on L&T, with a price target of Rs 1,296, said, “With traction unlikely to improve in 2012-13, medium-term revenue estimates are at risk.” They said risk to medium-term margins increased with protracted sluggishness, and they had cut their below-consensus 2013-14 earnings per share estimate by five per cent.
However, a few like Venkatesh Balasubramaniam, analyst at Citigroup Global Markets, believe there is unnecessary pessimism, and its huge backlog (Rs 145,800 crore) and strong balance sheet would enable it to withstand the slowdown. “Inflow guidance slippages are already factored into the stock price, margin contraction fears are overplayed and consensus earnings downgrades have bottomed,” he said.
On the whole, until the rate cut cycle reverses or economic outlook improves significantly, the upside at best looks limited, based on the average 12-month target price of Rs 1,400.