L&T surprises the Street but not yet out of the woods

With 10% growth in revenues in the September quarter, L&T has delivered eight per cent growth in revenue for the first half of the current financial year

Larsen & Toubro, India’s largest engineering company, might have surprised the Street with its better than expected results for the quarter ended September, but analysts are still hesitant in calling it a recovery.

Helped by its overseas business, L&T’s revenues and order intake grew ahead of estimates. However, the significant pressure on margins and a worsening working capital situation show that there are more challenges in the near term.

“We believe deteriorating working capital and cash flows will remain an overhang on the stock and cap near term upside. However, medium to long term catalysts like asset sales, higher growth in domestic revenue, and reduction in working capital exists,” said Bhavin Vithlani, who is tracking the company at Axis Capital.  

That apart, a part of the recovery in business is already built in valuations. L&T’s share price has appreciated almost 30 per cent from its recent low of Rs 678 a share in August to Rs 872 a share.

The stock is currently valued 15-17 times the street's consolidated estimated earnings and 2.2-2.5 times its book value in FY15.

“We believe our valuation at 11 times FY15 standalone PE is not conservative. During the FY97-03 downcycle, L&T traded at an average PE of just 8.8 times and stayed flat. Also, further risk to earnings or return on equity from an increase in the working capital cycle and a potential increase in slow moving orders exist. Trading at two times consolidated FY15 estimated book value for just a 13.5 per cent return on equity, we find L&T expensive,” said Amish Shah who is tracking the company at Credit Suisse.

With 10 per cent growth in revenues in the September quarter, L&T has delivered eight per cent growth in revenue for the first half of the current financial year.

However, to achieve its guidance (15 per cent growth) for the entire year, the company will have to grow its revenues by another 20 per cent in the second half of the financial year, which analysts believe is difficult, given the impending elections and execution issues for some of its large projects.

Thankfully, L&T has been able to tackle the domestic slowdown with the help of overseas projects resulting in improved order inflows in the recent quarters, resulting in a strong order book of Rs 1,76,000 crore, which is almost three times its revenues.

Against this backdrop, a section of the Street believes L&T could achieve its guided growth. The operating margins remain a worry. The operating margins remain a worry. “We remain concerned as margin at 9.7 per cent was down 100 basis points in Q2 due to a muted growth of four per cent in domestic revenue and 52 per cent year on year  increase in staff cost on higher increments and international deputations,” said Bhavin Vithlani of Axis Capital.

L&T has guided a possible contraction of 50 basis points in operating margins. However, the street believes that contraction in the margins could be in the range of 80-100 basis points led by low-margin international projects and slowdown in domestic revenues. Besides, pressure could also come from the subsidiaries where large capital is employed but the contribution to overall profitability has been poor. “We cut our FY14 consolidated EPS by four per cent to model higher losses of Rs 400 crore in ship building,” said Satyam Agarwal, analyst, Motilal Oswal Securities.