L&T walks a tightrope as new orders dwindle

Company braces for a lacklustre order inflow scenario in FY18

Larsen and Toubro (L&T), reckoned as India’s best proxy to play the domestic capital expansion (capex) market, now seems to be walking a tightrope. While the Street gave a thumbs up to its September quarter (Q2) results, the big disappointment was the cut in FY18 order inflow guidance to flat growth (zero per cent growth) as against a 12-14 per cent increase guided earlier. L&T’s order book (pending orders) grew by a mere two per cent to Rs 2,57,500 crore in Q2. This was after removing Rs 6,500 crore of slow or non-moving projects. The current order book offers reasonable revenue outlook. Yet, for the size, magnitude and diversity of L&T’s business, a strong order book is critical to keep its operating profit margins and working capital position intact. Analysts at JP Morgan note the tender-to-award cycle remains elongated and the deferment of lumpy orders could weigh on L&T’s core business growth in FY19 as well.

Just when fundamentals are looking better than what was a year ago, the scenario of thinning order inflows doesn’t offer comfort to investors. In fact, working capital ratio is on the mend from 25 per cent a year ago to 21 per cent in Q2. Much of the improvement is coming from faster or better order execution. Yet, while revenue growth is looking up and the quarterly run-rate has been in the 8–12 per cent range in the past few quarters, operating profit margins, particularly for its core infrastructure segment, hasn’t gained similar traction. They have been stuck in the seven-nine per cent range in the past two fiscal years.

Far fewer big-ticket projects being bid and intense competition from relatively small- and mid-sized contractors are weighing on L&T’s profitability. Even as there are green shoots of revival in India’s capex because of public spending, meaty orders from power and construction sectors remain evasive. Therefore, whether L&T foregoes margins to keep its order inflows buoyant or vice versa will be closely watched. Either alternatives may not be to the fullest advantage of L&T.

Also, the order book mix after course correction is now in favour of domestic projects (74 per cent of total order book). But, international projects tend to have better realisations as well as execution risk. Whether L&T will tinker its domestic and overseas order proportion to keep its act together on the order book front is also a key monitorable. Having burnt its fingers with overseas projects in the past, investors may not be happy if the order book mix changes significantly in favour of foreign projects.

In all, it’s a tough balancing act for L&T. Whether it chooses to focus on order inflows growth, profitability or working capital utilisation needs to be seen as a holistic improvement remains distant; a marked improvement in domestic infrastructure spends, though, could improve things for L&T. The current scenario perhaps justifies the discount attributed to L&T stock. Trading at 25x FY19 earnings, L&T is one of the undervalued large-cap stocks. Yet, analysts at IDFC who have a ‘neutral’ view on L&T believe that valuations do not offer margin of safety against risk to earnings from weak order inflow and execution.