After a cautious and calculated guidance on order inflows by India’s infrastructure behemoth Larsen and Toubro
(L&T) for FY20, the past few weeks seem to have pleasantly contrasted the projection. From the EPC (engineering, procurement and construction) contract for Navi Mumbai airport to a 1,320-megawatt boiler EPC order from THDC, worth about Rs 5,000 crore, the going has thus far been good for L&T
in terms of orders. The optimism, though, isn’t reflecting on its stock price, which has fallen by over 8 per cent year-to-date and down by over 17 per cent from the high clocked by L&T
stock at Rs 1,596 apiece on June 30.
Analysts at JP Morgan explain that part of the recent underperformance may be linked to weak the economic conditions. Given its scale and presence, L&T
is considered a barometer of India’s infrastructure growth story. Slowing growth has taken the sheen off the infrastructure major which, analysts at JP Morgan believe, could derail the expectations of a capex cycle recovery (especially private spending). They say a revival in capex could be pushed further. “Underperformance of L&T Finance Holdings
and Mindtree stocks (both accounting for nine per cent of L&T’s overall valuations) may also weigh on the L&T stock,” they add.
Macros apart, company-specific issues did not provide comfort to the Street in Q1. Despite it being a general election-affected period, certain factors, such as compression in margin in the core infrastructure business and an elongated working capital cycle, apart from order execution not meeting expectations, didn’t go down well with the Street, and explain for the de-rating that L&T stock has seen since then. Therefore, while the headline numbers were okay, a miss on these parameters prompted analyst to trim their FY20 earnings estimates by 4–8 per cent.
For a company of L&T’s size, quarter-on-quarter tracking of operating margins may not reveal a good picture; the number falling by 10 basis points (bps) to 9 per cent in Q1 is an indicator that while order inflows are picking up, pricing power may not have entirely returned to the sector and more importantly, there is still some amount of cost overruns in the system.
The fact that L&T wasn’t able to keep pace with the Street’s expectation of 16 per cent order execution in Q1 (actuals were about 10 per cent, based on Nomura’s workings), an estimate that is drawn up based on time typically taken to execute an order is another worry. Consequently, the working capital cycle stretched to 23 per cent from 18 per cent in FY19. According to the company, this stretch was largely to due to liquidity constraints in the system.
With the last two factors not materially changing from Q1 to now given that liquidity remains a pain point in the system, a full-blown recovery in the core infrastructure sector may remain elusive for L&T for the next few quarters. Also, while the order wins so far are about Rs 23,500 crore in the September quarter (Q2), it is still lower than FY19’s Q2 order wins of 32,400 crore.
“While L&T has put up a good show in the current market conditions, there is a possibility that the company reduced its order win and/or financial projections for FY20, should the environment remain tough,” says an analyst tracking the stock.
The silver lining is that, after a long pause, the management turned optimistic on demand from state-owned utilities, a factor that was reflected in Q1 and continues to do so even now. Further, unlike in the past, L&T has now moved on to an asset-light model. Therefore, even if there is a delay in execution, the return profile of the company may not deteriorate much as it did from FY14–mid FY17.
Perhaps, this explains why despite the medium-term headwinds, analysts are increasingly turning positive on L&T stock. From about 76 per cent analysts recommending buy on the counter two years ago, 90 per cent of analysts covering the stock and polled on Bloomberg have turned optimistic today. Valuations at 18 times FY20 earnings are affordable, given the pedigree of the company.