Buy rating on Larsen & Toubro: Better days lie ahead for L&T

The earnings and orders miss in 1HFY16 might suggest that nothing is going right for L&T; however, we believe that after a weak FY16F, L&T is well placed for an earnings recovery and improving RoE on the back of:

Management’s decision to change the company’s focus to asset light businesses and unlocking value from its subsidiaries/JVs over the past two years and going forward (real-estate, Dhamra & Kattupalli ports, L&T Finance, L&T Infotech).

A pick-up in execution in long-gestation projects to drive 20% revenue CAGR over FY16-18F in the core E&C business, in our view. Unlike orders in the power equipment sector, we think L&T’s order backlog is only ‘slow-moving’ or even ‘slow to start’ rather than ‘non-moving’ as in the case of BHEL (BHEL IN, Reduce, TP R123).

Margin recovery as several long-gestation orders reach margin recognition thresholds coupled with tailwinds from the decline in commodity prices.

With bulk of the problems now behind the company, we expect earnings pick up from FY17F and estimate 35% EPS CAGR for L&T over FY16F-18F.

Catalysts: Pick up in execution and margin recovery

Valuation: Trading at ~19.7x FY17F earnings, L&T is not inexpensive. However, the current order backlog provides strong growth visibility and will likely lead to a recovery in RoE and FCF metrics. We switch to consolidated earnings as they better reflect L&T’s new business segments and reduce TP to R1,663 as we now value L&T on SoTP of its individual business segments . Our new target price implies FY17F P/E of 25.6 and EV/Ebitda of 15.6. With expected growth in Ebitda from FY17F as more projects mature we believe our EV/Ebitda multiple of 15.6x is justified given the risks. Slower than expected recovery in the economy and investment cycle are key risks.

Weak near-term outlook; but long-term growth story remains intact

L&T’s recent correction is a reflection of past concerns and a weak economy. L&T’s share price has corrected by 12% in the last three months against a decline of 1.4% for the Sensex. In our view, this factors in the short-term weak outlook for orders as well as a slow execution cycle.

In our view, the current troubles are largely as a result of past decisions. However, we do not think the market is factoring in improvements that these investments will deliver once the execution cycle improves and projects under execution currently start to deliver cash flows.

Lessons from the past—L&T is now taking corrective action

Transition to asset heavy model has led to profitless growth and high gearing. L&T decided to embark on an asset heavy business model from an asset light model from FY11. This investment in assets was largely debt financed and envisioned as long-term cash generators. While the assets have so far delivered decent growth in revenues and operating profits, they have failed to deliver any bottom-line growth.