Is the rally in L&T's stock justified?

The stock has risen 20% after results but analysts call it an over-reaction to positive forecasts by the company

When the Street was bracing for dull March quarter results from Larsen & Toubro (L&T), the company surprised everyone, with 11 per cent revenue growth and 23 per cent profit growth. Cheerful forecasts for FY17 — revenue growth of 12 per cent and order inflow growth of 15 per cent — caught the fancy of analysts. Some brokerages including Jefferies and Citi recommended buying the L&T stock, which has run up over 20 per cent after results. But other analysts say this rally is not justified.

“The run-up is not justified as it draws strength from only a quarter of good performance and forecast,” says Misal Singh of Religare Securities.

  Singh’s view is not without reason: L&T has a history of tweaking its forecast mid-year. In FY12, L&T reduced the target for order inflow growth to five per cent from 15-20 per cent. Forecast was changed in FY16, too. Target for revenue growth was lowered to 10 from 15 per cent in FY15. In fact, a report by Jefferies indicates that L&T has missed its order forecast in five out of 10 years since FY07, while in eight out of 10 years it missed the revenue target. “Credibility of L&T’s order forecast is yet to return, especially with the FY16 miss,” the report noted, adding execution is key for the current leg of re-rating.  Defence is seen as a promising area after the government announced new FDI rules, but it accounts for a small part of L&T's order book; hence, the new rules are unlikely to move the needle for L&T in the near term.

While this is one part, fast-tracking the divestment process is equally important for L&T. Even as L&T sold its general insurance business at less-than-invested value, the Street did not react negatively to this. Sanjeev Zarbade, vice-president, private client group research, Kotak Securities, says, “Now the group’s business interests have become very complex and capital-intensive and it makes sense for L&T to exit such business.”

Sale of non-core assets assumes importance for two reasons. First, consolidated return on equity (ROE) entered into a dismal zone, 6.6 per cent in FY16 as against 20 per cent in FY10, due to diversification of capital. Second, the need for debt has increased substantially. Gross debt-equity ratio has inched up from 2.12 per cent in FY14 to 2.3 per cent in FY16, while recovery period from debtors has gone up to 125 days in FY16 from 115 days in FY14. Given the stock target price of Rs 1,527, going by a poll of analysts by Bloomberg, the current upside for the stock is capped.