No near-term respite for L&T

Worries began for L&T on estimates that there will be decline in order inflows for Q3 FY16

After rewarding its investors with nearly a 25 per cent gain in 2015, the new year has seen engineering giant Larsen & Toubro's stock price having reversed around 10 per cent.

Worries began on estimates of a decline in order inflow for the December quarter, estimated at Rs 6,200 crore, versus the Rs 14,400 crore in the same quarter of 2014-15. The worry got compounded as global equity brokerage CLSA replaced L&T with Reliance Industries in its Asia ex-Japan long-only portfolio.

Analysts believe that while the Street has partially factored in a dismal order flow position, any earnings miss in the quarter or a further downgrade on this or order inflow estimates could result in more de-rating of the stock. On the back of weak order intake, concerns on the company’s business diversification since 2010 have resurfaced. Rohit Natarajan of IDBI Capital notes that from a miniscule component of total business, L&T has increased its exposure to non-core business to around 45 per cent of assets. “This (latter) business, barring few, fetches appallingly low return on equity,” he adds.

Analysts believe the diverse businesses might limit its opportunity to ride on any significant economic turnaround. Sanjeev Zarbade, vice-president, PCG Research, Kotak Securities, highlights that despite worries in L&T due to investments in forgings, power generation equipment and shipbuilding, prevalent over the past three years, order inflow was never an issue even in a tough economic situation. “Now, with the order intake momentum also slowing, investors have become concerned on the growth outlook,” he says.

Over the past five years (FY10-15), L&T has increased its total capital employed from Rs 24,780 crore to Rs 82,137 crore. While, key valuation parameters such as return on capital employed (ROCE) have failed to keep pace. From an ROCE of 24 per cent in FY10, it was five per cent as on end-September 2015. A closer look at the number indicates that returns for its core infrastructure business has also declined from 41 per cent to nine per cent in this period.

A Nomura report notes working capital had more than doubled over the five years ending FY15, due to loans and advances for financial activities and increasing receivables and current assets. Analysts feel this situation could stay for a while, despite the order book being strong at Rs 232,649 crore. According to Zarbade, “if clients are not in a position to provide timely clearances and payments, then L&T’s execution momentum might be impacted, leading to muted revenue growth.”

Meanwhile, issues with its hydrocarbon business (L&T has deployed Rs 2,300 crore), which yielded profit for the first time in the September 2015 quarter, is likely to worsen. For, countries in West Asia and North Africa (60 per cent of the segment’s business) are expected to trim their capital expenditure, after crude oil plunging to $32.8 a barrel. Zarbade warns that if business continues to slow down here, recovering of overhead cost might become a challenge.

As for the infrastructure business, experts are hopeful of traction in order flow (albeit at a slow pace of order awards), given the increasing tendering activity of the government, particularly in the roads, power transmission, railways and defence segments. That said, operating margins (at 7.5 per cent in the first half of FY16 versus eight per cent in the same period a year before) might remain stressed, due the fragmentation of these business segments. “Given the competition and systemic risks in these themes, margins are anybody’s guess,” says Natarajan.

Analysts, however, believe that at the current valuation of 18.2 times the FY17 price to earnings estimate, the stock trades at an inexpensive valuation and any further correction could be a buying opportunity. Going forward, L&T’s divestment plans and pick-up in order flows could be key triggers.