At the crossroads, stock appears more like a market performer: The latest annual report shows management efforts for cash preservation are yielding results. However, due to our expectation of a demand pushback, we cut our estimates by 2%/16% for FY16/17 and our 12m target price to Rs 1560/share. Our estimates are 9/23% below Bloomberg consensus for FY16/17 and highlight the risk that consensus estimates may be pushed back by a year. Our valuation framework on twelve different scenarios shows that unless L&T manages to release capital by value unlocking and/or cuts NWC/sales sharply, the stock may suffer 4-55% value erosion from demand pushback or margin compression. We prefer Shree/Cummins India.
Annual report data show that, by and large, risk management is good: The annual report shows good risk management as: (a) NWC/sales shrank by 650 bps to 24% (vs. 31%); (b) debtors over six months are 7% of the total; (c) net un-hedged forex exposure is <9% of total net worth (vs. 17% in FY14).
However, performance/corporate guarantees for subsidiaries are at 48% of parent company net-worth (vs. 28% in FY14), which may limit medium-term upside, unless the subsidiaries turn around.
But management efforts are being stymied by the weak demand environment: New orders are being deferred/pushed back in both India and the Middle East – barring a few state segments such as Andhra.
Consequently, with rising competitive intensity and estimating the company to be selective in bidding, we cut our order inflow (core E&C) FY16E/17E EPS by 20/18%, leading to earnings cuts of 2%/16%. Our estimates build in a slow ramp-up in project execution in the infra segment and a higher margin from weak input cost.
Capital release could be a differentiator, at times of weak demand: Our valuation methodology remains the same—i.e., SOTP, with E&C business valued in line with the SP Capital Goods index and other divisions in line with their peers. With a 12m TP of INR1560, we downgrade the stock to Hold. Our scenario analysis suggests that demand uptick/value unlocking can have an upside risk of 6-13%. However, the stock could suffer value erosion of
4-45% from demand pushback/ weak execution and margin dip.
* We cut estimates on weak demand.
* Ordering growth showing signs of weakness.
* We agree that government has made good progress in approvals.
Experts suggest that the government has done well in providing approvals for projects. This is visible in sectors such as railways/DFC, where ordering has begun. On the water infrastructure, the government has set in motion an integrated Ganga conservation plan (Naman Ganga) as the DPR stage is over and ~18 projects have been submitted for approval. Also, the government is working on expediting the water linking projects, and order awards in projects such as Godawari (Andhra Pradesh) could become a reality. Even in Indian Railways, DPRs have been made for a large portion of 11000 kms of additional rail lines, but they await cabinet approval. The DFC awards for the western and eastern corridors are also likely to come in late Q4 or early Q1FY17.
So at the current pace there is risk of large orders likely spilling over to FY17 and beyond
However, we see a few of the large orders in the following areas as likely to get deferred:
Nuclear: This includes projects such as 9.9GW Jaitapur (Areva) and 6GW Mithivirdi (Gujarat), Gorakhpur (2*700MW) and Kudankulam expansion.
Defence: Although the government has renewed its emphasis on the domestic manufacturing of defence equipment, major defence orders are likely to spill over to next year and beyond, including Corvettes (worth Rs 120 bn), submarine orders (Rs 400 bn), gun orders (Rs 300 bn), and battlefield management systems (Rs 130 bn) which are in the pipeline.
The coastal roads project award worth Rs 130 bn in Maharashtra is likely to be delayed until next year given the recent suggestion by the Maharashtra environment department to build elevated roads through areas where mangroves are located.
Competitive intensity has also gone up
On the power side, its competitor (BHEL) appears to have bid aggressively. As a result, L&T lost a few of its power orders and BHEL is L1 in many contracts. On the railway business too, during Q2FY16 L&T lost a civil contract order pertaining to DFC (Western) worth Rs 42bn to a consortium of Mitsui, Ircon and Tata. Meanwhile, on the road front, recent bids show intense competition as even the smaller players bagged orders.
MEED data suggests export orders, especially in Saudi, could be deferred
The plunge in oil prices is putting pressure on Middle East economies to maintain their fiscal balance. In countries such as Saudi Arabia, the government is working on cutting unnecessary expenses . The Saudi Arabian government’s plans to increase the size and scope of soccer stadiums have been scaled back, and a $201m contract to buy highspeed trains was also cancelled recently.
Our bottom-up data suggest overall all-India capex likely to pick up by 2HFY17 or early FY18
Our bottom-up analysis of key projects and important segments suggests capex spending from these could be $631bn over FY16-20—a 36% rise vs. FY11-15. A majority of the capex would be led by government spending, followed by state spending and PSUs. Private sector spending as of now is expected to remain muted at
$45 bn over the next five years vs. $153 bn in the last cycle (FY11-15). Excluding Reliance Industries/ auto companies, the amount from other private sector segments is 60-70% lower than in previous years. Overall, country capex spending as a whole could pick up in FY17 and will probably accelerate from FY18 onwards.
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