Risk-reward favourable for L&T

While the recent correction has made valuations attractive, order inflow has also been good, which has made analysts positive

Uncertainty over business prospects and sector-related issues have led to an opportunity in the form of the Larsen & Toubro (L&T) stock, India's largest engineering company, now trading at valuations last seen during the downturns of 2009 and 2003-2004. At current levels of Rs 816, analysts say the downside risk is very limited, and investors could consider from a one-two year perspective.

"The underperformance of 20 per cent over six months factors in most negatives, including weak domestic execution, margins and losses in new business. Our worst-case scenario (eight-year low margins, below historic average revenue growth) gives us only an eight per cent downside, while the best-case scenario gives us a 27 per cent upside," says Amit Mahawar, tracking the company at Edelweiss Securities.

Analysts say though the industry environment has not improved drastically, buying leaders like L&T during downturns would reap good returns in the long run. "Stocks like L&T should typically be evaluated during weak phases and, with valuation at a 10-year low, the downside risk is low," said Venugopal Garre of Barclays. Overall, analysts have a target price of Rs 950-1,100.

Though there are challenges operationally, the company is expected do well as some of the concerns, such as lower order inflows, pressure on margins and execution delays, are expected to ease. L&T has surprised the Street with over 20 per cent growth in order inflows in the first five months of the current financial year. Compared to the Rs 25,000 crore of orders it got in the June quarter (up 28 per cent yearly), the company has secured orders in excess of Rs 23,500 crore in the current quarter (considering only the major announcements made by L&T between July and September 2). Even as its peers are facing tough times with their order inflows down, compared with last year's order inflow growth of 24.7 per cent, L&T is expected to see a rise of over 15 per cent in order inflow in FY14. Its exposure to the global markets and diverse skills, specially in the hydrocarbon sector, has led to this optimism.

Analysts at Prabhudas Lilladher, in a report, India Strategy & Top Ideas, say, "With the recent news flow in terms of order intake being positive, L&T looks on a comfortable wicket and poised to end the year with a 20 per cent order inflow and 15 per cent revenue growth." The analysts say L&T has seen some revival in hydrocarbon, power and global orders (specially from West Asia) and given the impetus to Delhi-Mumbai Industrial Corridor, Dedicated Freight Corridor and other BOT (build-operate-transfer) projects in transportation (Budget 2013-14), along with a strong financial backing, they expect it to be able to secure sizeable orders.

Against this backdrop, the company is expected to close the current year with an outstanding order book (orders pending execution) of Rs 186,000 crore, equivalent to 2.7 times its FY13 standalone revenue, a 21 per cent growth compared to the order book at March-end.

As the order book remains healthy, the key trigger to watch is project execution. Some of its projects in the power, industrial and real estate are facing delays, which has led to pressure on the margins and working capital. However, analysts expect the environment to improve in the second half of FY14, which could allow it to speed its execution, leading to a positive impact on its revenues and earnings. Recently, the company's operating margins have also come under pressure and have fallen from 11.8 in FY12 to 10 per cent in the June quarter. While the project mix will have a bearing on the margins, analysts expect some improvement in margins in 12-18 months, which will help in better earnings growth and return ratios.

"We believe that the strength in order inflows, recovery in earnings from second half of the financial year 2014, ability to sell a stake in L&T IDPL subsidiary, Dhamra Port, should serve as key positive catalysts for the stock," says Garre of Barclays. L&T has invested Rs 7,280 crore as equity in IDPL, the infrastructure arm holding the BOT assets.

The key risk is if the domestic macro environment deteriorates further.