Why stocking up on L&T could offer fewer rewards in the short-term

A sign of Larsen and Toubro (L&T) is placed on a road divider in Mumbai, India May 25, 2016. REUTERS/Shailesh Andrade/File Photo - RTSGV4J

While India's engineering industry may not be painting a doomsday scenario, the best days are still yet to come as demand side concerns persist. While addressing a media conference post earnings, AM Naik, Executive Chairman of Larsen & Toubro, India's largest engineering company, spoke about challenges on ground and indicated that industrial capex cycle recovery could be slow, as a result of the leveraged balance sheets of corporates and risk-averse nature of banks. On top of that, the government's delay in finalising new orders or postponing some of them remains a key overhang on the industry.

L&T did not remain unscathed. During FY17, the company received orders worth Rs 1,43,000 crore showing a tepid growth of 5 percent. Order book, too, grew at meagre 5 percent to Rs 2,61,300 crore - executable over the next two years. This also had its impact on the financials of FY17 as revenue at Rs 1,10,000 crore saw 8 percent growth.

However, most segments reported strong improvement in margins. Except for infrastructure (accounting for 48 percent of the revenue), which saw 100 basis point decline in margins, power saw 80 basis points improvement. For heavy engineering segment margins spiked from 0.6 percent in FY16 to 19.9 percent in FY17. Electrical and automation segment and hydrocarbon segment reported 260 basis points and 620 basis points improvement in margin respectively. This is a good indication of execution gathering pace and cost being contained, which will continue to help in improving profitability.

In FY17, there were several one-offs like increase in sales and administrative cost by 22 percent as a result of higher provisioning by its financial services subsidiary and higher depreciation led by restatement of assets. But the company's net profit grew by 43 percent to Rs 6000 crore boosted by lower interest cost and 55 percent jump in other income mainly comprising treasury income.

Figures in Rs cr.

While the profitability was boosted by several one-offs in FY17, it is likely to remain equally challenging in FY18 as well. Even if the execution is on track, the company is facing challenges to deliver projects as clients are postponing the same to manage cash crunch at their end.

L&T is, therefore, focusing on putting its house in better order. The company has built a cash pile of almost Rs 10,000 crore, which it aims to use for the opportunities that come up in the sector like bidding for some large defense orders. It has also brought down its working capital to 19 percent of sales as against 24 percent a year ago. Its debt to equity at the standalone entity has now come down to 0.23 times, which is not only comfortable but also gives it an ability to tap the market as and when the cycle turn. That apart, it has removed the slow-moving order book of close to Rs 18,000 crore. L&T has consolidated its position in real estate space and it is getting selective in picking up orders from the international markets that are impacted because of falling crude oil prices.

L&T has guided for order inflow growth of 12-14 percent which prima facie looks aggressive given its own assessment of the macro environment. It is important to remember that in the last two years, the company has missed its own guidance. This is also a reason that Street remains cautiously optimistic about FY18 guidance. Moreover at current valuation of 20 times its FY19 earnings, the stock offers little margin of safety. Even on a sum of the part (SOTP) valuation basis, the value works out to Rs 1750-1850 per share. At current market price of Rs 1776, the stock offers very little reward.

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