L&T analysis: Earlier carrot, now stick

After significant outperformance in 2012 over Sensex, dark clouds to engulf Larsen and Toubro?s stock

Larsen and Toubro’s stock was the fourth best performer among Sensex companies in 2012 with gains of 61% compared to latter’s 26%. However year to date in 2013, the stock has significantly underperformed Sensex as it has declined 6% while Sensex has remained flat mainly due to concerns of cancellation of road projects by GMR and GVK. Besides, market is also nervous about its ability to meet order inflow guidance in FY13. Though analysts believe that the company will be the largest beneficiary of reforms, rate cuts and uptick in investment cycle, it is too early to rejoice and hence the stock could face a range bound movement or selling pressure. While Citi Research and Barclays have recently downgraded the stock, ICICI Securities maintains its SELL rating.

Says Venkatesh Balasubramaniam, analyst, Citi Research, in January 7 report, “After maintaining buy and top India Industrial pick for the whole of 2012, we downgrade to neutral and cut our target price by 7% due to significant outperformance, slow moving orders, net working capital deterioration, domestic slowdown and lower international margins.”  Adds Venugopal Garre, analyst, Barclays Equity Research, in Jaunary 8 report “L&T was our top sector pick for CY12, given favourable valuations and low consensus expectations. Given limited returns over the next 12 months, we downgrade our rating to equalweight and lower our target price by 5.5%.” Prakash Gaurav Goel continues to maintain his negative stance as negatives still outweigh the positives arising in the wake of slew of policy measures initiated by the government.

Cancellation of road projects

Recently GMR and GVK opted out of Kishangarh-Udaipur-Ahmedabad and Shipuri-Dewas highway BOT projects respectively. The construction orders for both the projects are with L&T and analysts estimate them to be worth Rs 4800-5200 crore, which is around 3% of the company’s order backlog of Rs 1,60,000 crore as on September 2012 quarter (Q2). Says Garre of  Barclays, “Cancellation of these orders negatively impacts our estimate.” Adds Balasubramaniam of  Citi, “Even if the orders donot get cancelled, there is a likelihood of they becoming slow moving orders (already 10% of order backlog).” Awarding of EPC road contracts has already been sluggish.
Q3FY13: Nervousness over order inflows

Despite the busy season of Q3, L&T’s revenue growth of 14.5% is expected to be lower than past three quarters’ average of 21%. But operating profit margins is expected to be maintained at 9.6%. Net profit margin is likely to slip by 50 basis points to 6.6% on account of lower other income. However, overall, there is unlikely to be any negative surprise on the company’s financial performance but market is nervous about the order inflows due to macro woes.

The company has announced order inflows worth Rs 11,200 crore in Q3. Accounting for unannounced orders, the same could be in the range of Rs 18,000-19,000crore. If this is added to the first half order intake of Rs 40,600 crore, the same comes to roughly Rs 60,000 crore, which is 71% of targetted order inflows in FY13. Achieving the balance does not seem to be a tall task for the company given March quarter is the busiest for infrastructure sector. Nevertheless, management retaining its guidance of 15-20% would be keenly watched.

Outlook for FY14 cloudy

While the government has recently announced many policy measures like approval of urea investment policy, formation of cabinet committee on investment and interest rates are widely expected to be softening, concerns still prevail about the effective implementation of the reforms, hurdles for investment cycle revival amid myriad of unsolved operational issues and impact of a diesel price hike on inflation and interest rates. This will continue to affect ordering scenario in FY14. Says Garre of Barclays, “Our bottom-up analysis suggests continued weakness in the investment cycle in FY14. We expect power BTG and industrial capex to remain weak and T&D order growth to slow. We expect L&T to now report only 10% growth in order inflows in FY14 (vs. prior estimate of 14.5%).” Adds Balasubramaniam of Citi, “The collapse of new project announcements is bound to impact domestic prospects with a lag in FY14. Further, one should remember that six months before general elections in CY14, Government ordering would slow down to a trickle.” Though the company is trying to compensate slow domestic orders by going overseas, international margins are significantly lower than India.