Time to book profits in BHEL, L&T

With a recovery some time away and given the steep run in share prices, valuations have become less compelling

There could be many reasons to continue holding on to BHEL and Larsen & Toubro (L&T) at current prices as long-term investments. Yet, a section of the Street believes it is a good time to sell and book profits in these two counters, as they have run up significantly in the recent past. To put this in perspective because of the spurt in prices, BHEL is currently trading at almost 25 per cent premium to the Bloomberg consensus analyst target price. In the case of L&T, the premium stands at six per cent.

“I do not think fundamentally much has changed. I would advise to sell BHEL entirely. In the case of L&T, one can think of booking some profits. If not that, I will at least not add any fresh position at current prices (in L&T). This is also to do with the fact that the valuations in both cases have gone up in the recent past,” said Misal Singh, who tracks engineering companies at Religare Capital Markets.

A slew of government initiatives such as increasing the availability of coal, power rate settlements, SEB (state electricity board) debt restructuring, faster clearance of large projects and improvement in project awarding has led to renewed optimism about capital goods companies. Though analysts consider these developments positive for the sector, they fear that near-term issues of working capital, execution, funding and availability of fuel, among others, could play spoilsport for the sector. Additionally, the valuations at current market prices leave limited room on the upside.

L&T’s share price has recovered by almost 58 per cent from the lows of Rs 677 a share and BHEL has seen gains of 65 per cent from its recent lows of about Rs 100 a share. As a result, valuations have become less compelling. At current market prices, both L&T and BHEL are trading at 17-18 times their expected earnings in FY15.

To justify these valuations, it is necessary that the companies see a significant improvement in their earnings outlook, unlikely to happen soon in the light of a dismal recovery in the capex cycle and subdued public and private sector spending. Further, given the general elections next year, analysts believe it would be better to first let the scenario of a sustainable recovery play out. This is expected only in FY15.

On the business front, BHEL’s prospects are considered to be much more fragile vis-à-vis L&T given the latter’s diversified business portfolio (in terms of segments and geographies) and growing order book (aided by international orders). On the other hand, in spite of its huge order book of Rs 102,300 crore, BHEL could hardly convert it into revenues due to client-side issues. Over the last four quarters, the company’s revenues have remained flat. And if analyst estimates are any indication, revenues for the current financial year are expected to remain flat as well, with some even expecting a marginal decline. This is because projects on the client side are facing challenges due to a lack of fuel and policy clarity. Though some measures have been taken, analysts remain sceptical on any immediate recovery.

“The BHEL management indicated the sentiment in the power sector is improving post the Cabinet Committee on Investment clearing stalled projects, debt restructuring of SEBs, 6,000 Mw of fuel supply agreements signed by Coal India, coal block allocation to PSUs and pass-through of fuel cost. However, we remain sceptical on improvement in order inflows in FY14 and FY15, due to over-leveraged balance sheets of private generation companies and some critical reforms (fuel cost pass-through and SEB debt restructuring) are yet to be implemented," said Bhavin Vithlani of Axis Capital in a note on the company. Because of these issues, the company is expected to see its earnings per share decline from Rs 27 in FY13 to about Rs 9 in FY15.

L&T, too, is facing its share of worries. However, considering its diversification, it is in a better position. About a quarter of L&T’s order book comes from the power sector, as against about 80 per cent (the rest 20 per cent is from the industrial sector) in the case of BHEL. That apart, L&T has a better mix of public and private sector clients along with a relatively higher proportion coming from the export markets. This has helped the company report a decent performance in the recent past. For instance, for FY13, its revenues and profits grew by 16 per cent and two per cent, respectively, to Rs 74,498 crore and Rs 4,613.49 crore, respectively. The company’s earnings are expected to decline marginally by five-seven per cent in FY14, but analysts expect 14-15 per cent growth in FY15.