Building blocks in place for L&T stock to outperform

Improving balance sheet, likely rise in order flows and attractive valuations are among key positives

Larsen & Toubro (L&T) has been a steady outperformer through this bull-run. The Nifty has risen by 44 per cent in the past 12 months, by 19 per cent since January, and by 9 per cent in the past three months. In comparison, L&T has returned 65 per cent (12 months), 26.5 per cent (YTD), and 11 per cent (3 months), respectively.

Many traders would consider this an obvious momentum trade. But there are also fundamental reasons for believing that the stock could continue to outperform. The infrastructure focus in the Union Budget should benefit its engineering and construction (E&C) business. Any improvement in the GDP growth rate should lead to some acceleration in top line growth.

The company has done a good job in deleveraging, monetising assets and improving liquidity on the balance sheet. It could continue to generate impressive free cash flows from the engineering business. Moreover, a recent report from Motilal Oswal Securities suggests that the market may be underestimating the likely order flow as the economy normalises. Further asset monetisation, such as in the Hyderabad Metro, could take place.

The second wave led to multiple award deferments. This clearly shows when results of the first quarter of financial year 2021-22 (Q1FY22) are compared with Q4FY21 (QoQ) and Q1FY21 (YoY). Consolidated revenues of Rs 29,982 crore, were down versus Rs 49,116 crore (Q4) and up versus Rs 22,037 crore (Q1FY21). Ebitda was Rs 3,819.5 crore, versus Rs 7,417 crore (Q4) and Rs 2,397.9 crore (Q1FY21). Net profits were Rs 1,531.6 crore, versus Rs 3,820.2 crore (Q4) and Rs 536.9 crore (Q1FY21).

Segment-wise only the IT and tech services division did better sequentially because of the second wave. The order book stands at Rs 3.24 trillion, versus Rs 3.05 trillion (last year) with about Rs 26,600 crore in orders booked during Q1FY22. The standalone Ebitda margin is around 11 per cent. Lower interest rates should lead to significant savings especially in the financial leasing and services segment. Motilal Oswal Securities estimates that the core E&C division will generate up to $2 billion (roughly Rs 15,000 crore) of free cash flow per annum. The exit from the roads sector should lead to improved liquidity on the balance sheet.

We can anticipate an improvement in order flows over the next two years, and a stronger working capital cycle. The capex requirements for L&T is relatively low, and free cash flow generation could result in higher payouts to shareholders.

A sum-of-the-parts valuation, which includes the valuation of its many listed subsidiaries, is estimated at around Rs 1,950 per share. The stock is trading well below that level so the upside could be 15-20 per cent purely on that basis. Adjusting valuations for the value of the stakes held in subsidiaries, L&T seems to have a one-year forward PE of about 14x. This is again well below the long-term average PE of about 22x and also just half of the average Nifty PE of 27.

There are few apparent downside risks apart from a bad third wave. Upsides could include strong private sector capex trends, as well as sustained order flow from the government.