Published on 31/03/2020 4:11:17 PM | Source: Motilal Oswal Securities Ltd

Buy Larsen and Toubro Ltd For Target Rs. 1320 - Motilal Oswal

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Near-term execution impact imminent

Working capital stabilization to determine extent of growth revival in FY22

* In this report, we highlight some of the risks that have emerged for L&T’s (Larsen & Toubro) business in the near term and its impact on earnings/cash flow.

* We expect L&T to tide over these challenging times, thanks to multiple levers in its business, scale of operations and the re-emergence as a pure EPC company.

* However, on account of worsening working capital, growth post the lockdown in India may be spaced over the next few months, impacting our near-term earnings estimates and TP. We cut FY21/22E earnings by 20%/14% and TP to INR1,320.


* Execution halt in peak season to impact revenue growth: The Covid-19 lockdown in India has brought construction activities to a halt in the peak season. We note that March is a peak month for construction activities in India. Even post the lockdown, there might be some more delays in resuming construction activities in full swing as labor, machinery and materials would need to be re-mobilized. Thus, we see a clear risk to our revenue growth assumptions for 4QFY20 as well as FY21E estimates.


* Working capital likely to spike, recovery post lockdown may take time: Historically, the month of March is marked by superior execution and higher payments from government authorities, which brings down the year-ending closing working capital. However, 4QFY20 will see absence of both execution as well as payment push. Moreover, L&T would have to continue supporting its vendor base, including sub-contractors, in these tough times as it has been doing over the past many months. This is likely to increase its working capital further. Working capital as % of sales stood at 23.5% at end-3QFY20 v/s 18% at end-FY19. We fear that working capital can spike to 25% of sales in the near term, implying no FCF for FY20/FY21, despite revenue and EBITDA growth. Higher working capital is likely to weigh on the execution rate even after the lockdown is removed, thus implying that recovery may not be as swift as expected. Thus, we expect the focus to shift toward working capital management in the near term. Moreover, we believe that L&T will start showing improvement in FCF from FY22, thereby returning to the growth trajectory given its scale of operations and multiple operating levers.


* Oil price crash weakens prospects of hydrocarbon segment in near term: The hydrocarbon segment has been a key driver of execution and earnings since the last 4 years (from the lows witnessed in FY15 when oil prices saw a correction). Currently, the hydrocarbon segment enjoys the highest-ever order book of INR450b+ and margins in double-digit. Over FY14-20E, the hydrocarbon segment has witnessed an order inflow CAGR of 18%, driving EBITDA CAGR of 33% subsequently v/s overall E&C order inflow/EBITDA CAGR of 4% each. As international orders form ~50% of the order book for the hydrocarbon segment, there is risk of order inflow growth tapering in sync with the current level of oil prices.


* Re-emergence as a pure EPC company to help tide over challenging times: We draw comfort from the fact that since FY16, the company has taken multiple steps to emerge as a pure-play engineering, procurement and construction (EPC) company. We recall that post the Global Financial Crisis of FY08, capex growth was driven by the private sector and even L&T forayed into the development business. Thus, over FY10-16, while revenue/EBITDA growth stood at 15%/8%, adj. PAT declined at 4% CAGR as depreciation and interest expense surged. With no major capex planned except for maintenance, we believe that L&T would be able to tide over the current challenging times and would emerge stronger. However, we do see risk for some mid-cap contractors with high leverage; these companies may face the uphill task of mending their balance sheets post the current economic slowdown.


* Positive over L&T’s long-term prospects, but push growth further by a year: L&T remains the best play on India’s capex story. We note that without the capex cycle, it may be difficult for economic growth to achieve/sustain higher levels. However, with delays in the capex cycle, the vendor base including subcontractors are facing serious challenges to survive and L&T may have to support them in the near term. Once the situation improves, we believe L&T would be able to improve its working capital cycle as it has done in the past. For instance, L&T’s working capital improved from 25% in FY15 to 18% in FY19.


Valuation and view: We cut our core FY21/FY22E E&C earnings by 10.6%/8.3% factoring in lower execution, order inflow delays and worsening working capital over the next 12 months or so. While FY21E looks challenging from growth perspective, we do expect a bounce-back in FY22E, helped by a lower base and stabilization of working capital. Our consolidated earnings cut look higher at 20%/14% for FY21/FY22E on account of higher losses from Hyderabad Metro (fully operational now but real-estate monetization may be slower than expected) and lower growth expected in Financial Services and IT business. From valuation perspective, we reduce our TP to INR1,320 on account of (a) cut in core earnings as well as reduction of core business P/E multiple to 18x from 20x earlier, and (b) lower contribution from listed subsidiaries due to market cap erosion (we continue to value L&T’s stake in 4 listed subsidiaries after applying 30% holding company discount). Maintain Buy.


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