L&T: Course correction yielding results

Better returns profile, reduction in working capital dependence positives

Larsen & Toubro is among the few stocks which reacts positively to good quarterly results. The March quarter results, published about a fortnight ago, satisfied the key performance yardsticks on most fronts. While revenues and net profit came ahead of estimates, the engineering giant posted five per cent growth in order flows for FY17 — a welcome change as the past two years have been tough. L&T’s management has raised its benchmark for a few parameters. It expects revenue to grow by 12 per cent in FY18 and the order book to improve by 12-14 per cent. 

While the Street was initially happy with this forecast, it doesn’t seem to reflect on L&T’s stock price — down over two per cent since May 29, when results were announced. The reasons are apparent and the Street would closely monitor L&T’s progress on improving profitability and return ratios. In other words, with L&T gaining confidence after revenue growth of eight per cent and net profit growth of 43 per cent in FY17, the focus shifts to qualitative aspects. 

Changing composition of the order book may help L&T achieve its target. From being dependent on foreign orders, particularly West Asia, the order book (Rs 2.61 lakh crore) composition is in favour of domestic orders. The share of domestic orders has risen to 73 per cent in FY17 versus 71 per cent in FY16. This is a positive as a diversified domestic order book removes the uncertainties on currency fluctuation and global demand. Higher contribution by the core infrastructure segment (74 per cent to the order book) is also good. But, the fluctuating profitability of the segment is a concern. Overall operating margins have been flat at 10.3 per cent, due to a fall in the infrastructure segment’s profitability at 10.2 per cent in FY17 versus 11.2 per cent in FY16. This scenario may prevail until significant operating levers kick in. Execution, too, remains wobbly as is the case with most Indian infrastructure companies. 

The other positive is the moderation in the dependence on working capital. Working capital as a ratio of sales has reduced from 23 per cent in FY16 to 19 per cent in FY17. However, a further reduction could be challenging as most orders are from the government, where payments tend to be unpredictable. An improvement in return profile is equally noteworthy. After touching a low of 6.4 per cent in FY16, return on capital employed is on a mend (9 per cent in FY17). Analysts expect the it to increase to 11-12 per cent by FY19. L&T’s intentions not to own assets going ahead reiterates its commitments to achieve profitable growth and superior capital allocation. This is why despite a sharp year-to-date run-up in its stock price, L&T remains a preferred pick in the capital goods space.