Hopes of improved profitability driving up L&T's stock

Shift from owning assets to functioning as an EPC, annuity contractor supports its long-term plans

The Larsen and Toubro (L&T) stock has been a surprise winner, gaining 22 per cent year-to-date, much higher than the Sensex’s 12.5 per cent. This is despite a lacklustre December quarter showing. But, the Street is willing to put all the disappointment behind. “L&T today has reached a certain scale that it would be unfair to see the company expand its order book by 12-15 per cent over a year hereon, given its base effect and the operating conditions which haven’t turned totally favourable yet,” a fund manager invested in the stock said.

Therefore, he said that what analysts would closely monitor is whether L&T is taking the right steps to reduce its working capital ratio and monetise its non-core assets. Analysts at Jefferies, who recently upped their 12-month target price on L&T to ~2,000 (20 per cent upside), say the company has begun the process of improving its return ratios from the FY16 bottom. “The management focus on reducing working capital and asset monetisation should yield results in 12-36 months. L&T will see additional benefits from macro tailwinds of industrial capex announcements in FY18,” the analysts add. 

Another foreign brokerage Nomura says over the past 15 months, there have been visible efforts by L&T to focus on profitability along with growth against its earlier skewed focus on order inflows. “The company is walking the talk on its five-year strategy,” the analysts point out. For Nomura, L&T is among the top picks in the industrial space in India.

These moves on divestment and the recent reduction in working capital ratio prompt analysts to say that it is on a proper course correction path. In FY16, the initial public offerings of L&T Technologies and L&T Infotech, and a few smaller stake sales should boost the return on equity (RoE), from about 10 per cent in FY16 to 11.5-12 per cent in FY17. Nomura feels sustained efforts to reduce non-core assets exposure may further elevate the RoE to 14 per cent by FY19. The working capital ratio has also declined from 24 per cent in FY16 to 22 per cent so far in FY17. 

On the whole, L&T’s deliberate shift from owning assets to functioning as an EPC (engineering, procurement and construction) and annuity contractor supports its long-term plans. The sore point in the near-term is the capital tied up in the Hyderabad metro rail project. However, improved order flows from hydrocarbon projects, smart cities and a gradual recovery in heavy engineering projects should compensate. For now, 10-15 per cent annual revenue growth is 

the target the Street has for L&T. But, whether the company keeps up with it will be known in a few weeks.