Upgrade to Buy from Neutral — L&T has fallen nearly 20% in just three months and now trades below its historical mean, over-reacting to the faster-than-expected negative news of tepid inflows in Q1, fewer announced orders in Q2, defaults by two road subsidiaries, and delays in Riyadh Metro. The stock has underperformed the Sensex by 13% and trades at 17.5x FY17e adjusted standalone P/E (price-to-earnings ratio). We consider L&T as the best play on India’s infra development and economic growth, and a major beneficiary of the $245 bn defence and $140 bn railway upcoming opportunities. A likely post-Q2 guidance cut is largely priced in, we think.
* Target price cut to Rs 1,746 from Rs 1,845 — We factor in: (i) 10-11% standalone EPS (earnings per share) cuts and 13-15% lower consolidated EPS. For our standalone numbers, we have assumed inflow growth of 5.0% for FY16e, sales growth of 7.5%, 15.0% and 15.0% for FY16e, FY17e and FY18e respectively, and a 40bp margin contraction for FY16e.
* Focus on sales growth, not order inflows—L&T has won enough orders in the past two years to secure decent sales growth over the next three years (with flattish inflows in FY16e). Investors should therefore focus on execution pick-up in 2H FY16 and beyond. Aggressive competition has undoubtedly led to order losses in power, roads, hydrocarbons and DFC in 1H FY16, but L&T’s strong backlog gives the company the luxury to avoid aggressive bidding.
* Rationalising the business and unlocking value — Management’s focus on making the business leaner is evident from the Dhamra port sale; efforts to sell the Kattupalli port; sale of Chandigarh realty assets; value unlocking of legacy landbank in Mumbai, Chennai and Bangalore; and potential listing of subsidiaries.
We upgrade L&T to Buy (from Neutral):
After its 19% decline in the past three months, the stock looks cheap below its historical mean on an adjusted standalone P/E; L&T is a proxy for India’s infra development and economic growth with its unparalleled/diversified skill sets. We think likely guidance cut (order inflows/sales) post Q2 is largely factored in. We cut our target price to R1,746 (from R1,845) to factor in 10-11% standalone EPS cuts and 13-15% lower consolidated EPS. Our top India industrial picks now are L&T, Bharat Electronics, Cummins, Voltas and Crompton Greaves.
Less Expensive Than What Most Believe
* Is L&T stock expensive? L&T is trading 1sd above its historical average consolidated P/E. Some believe these valuations are expensive. We however think the stock is not extremely expensive.
* Some subsidiaries pulling down consolidated recurring PAT (profit after tax): Over FY12-15 some of the developmental subsidiaries, shipbuilding and nuclear forging entities were commissioned and are incurring losses, negating the positive contributions of other subsidiaries to consolidated PAT.
* Don’t look at just cons P/E: We do not believe in attributing negative or zero value to the developmental subsidiaries, shipbuilding and nuclear forging entities just because they are incurring losses currently. These assets have long gestation. Last but not least, in our view, extreme reduction of the subsidiary fair value as the stock corrects is not reasonable.
EPS revisions
We cut our standalone numbers by 10-11% for FY16E-17e (estimates) to factor in slower execution of the Mideast backlog and lower order inflows on account of competition. Further, we factor in smaller margins, extrapolating from trends in Q1FY16. Our consolidated numbers are down 13-15% as we factor in larger losses in shipbuilding and nuclear forgings than earlier. Our standalone and consolidated EPS estimates are 7-18% and 17-30% below consensus respectively.
Defence Opportunity: All Set to Take Off
Defence manufacturing in India is at an inflection point with a capex opportunity of $245 bn over the next decade.
Defence Acquisition Council (DAC) is the apex body of GoI for the capital acquisition. Hence, we believe, GoI’s intent and actions can be/should be judged on the work done by DAC. From July 2014 to July 2015, DAC approved projects worth more than Rs 2,350bn ($36 bn) to kick-start the revival of the defence manufacturing sector for the modernisation of the armed forces. Our interaction with the L&T management suggests the following opportunities are on the horizon:
* Landing Platform Docks (LPD): Four multipurpose ships to ferry tanks, landing craft, and helicopters and to transport troops. In the fray: L&T with Navantia of Spain, Pipavav Defence with DCNS, France and ABG Shipyard with Alion, US.
* Submarines: DAC on October 25, 2014 approved the proposal to build six diesel-electric submarines indigenously at a cost of R500-600 bn. In the fray: L&T, Mazgaon Docks, Pipavav and Hindustan Shipyard.
* Tracked Self Propelled Gun: 100 guns to be procured for R40-50bn. In the fray: L&T with Samsung Techwin and Rosoboronexport.
* Towed Gun: This is a R120-150 bn opportunity. In the fray: L&T with Nexter, France and Elbit, Israel with Bharat Forge.
* Tactical Communication System: R80-100 bn opportunity. Both players in the fray will develop prototype system with 80% funding from the Government. After trials, the winner will get a major share of subsequent production. In the fray: L&T with Tata Power and HCL Infosystems and Bharat Electronics.
Set to get Rs 50 bn artillery 155mm gun order
According to Economic Times, L&T has emerged as the finalist for the $750m (~Rs50 bn) contract to supply 100 self-propelled artillery 155mm guns to the Indian Army.
Two Road Subsidiaries of L&T IDPL Default
ICRA has revised the rating on: (i) Rs 4.75 bn term loans of L&T Chennai Tada Tollway from BBB- with a stable outlook to D and (ii) R10.1 bn long term loan of L&T Halol Shamlaji Tollway from BB+ with a stable outlook to D.
How many roads does L&T IDPL have?
* L&T IDPL had 19 roads. But two of those, Amravati-Jalgaon and Jalgaon-Gujarat border, were terminated by L&T IDPL with mutual consent (with forfeiture of bids security equivalent to 1% of project cost). L&T IDPL had fulfilled a majority of its conditions, but NHAI could not procure 80% of land after 380 days of signing of the concession agreement.
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