L&T walks a tightrope as new orders dwindle

Company braces for a lacklustre order inflow scenario in FY18

Larsen and Toubro (L&T), reckoned as India’s best proxy to play the domestic capital expansion (capex) market, seems to be walking a tightrope. While the Street gave a thumbs up to its September quarter (Q2) results, the big disappointment was the cut in FY18 order inflow guidance to flat growth (zero per cent growth) against a 12-14 per cent increase guided earlier. L&T’s order book (pending orders) grew just two per cent to ~2,57,500 crore in Q2. This was after removing ~6,500 crore of slow or non-moving projects. The current order book offers reasonable revenue outlook. Yet, for the size, magnitude and diversity of L&T’s business, a strong order book is critical to keep its operating profit margins and working capital position intact. Analysts at JP Morgan note the tender-to-award cycle remains elongated and the deferment of lumpy orders could weigh on L&T’s core business growth in FY19 as well.

Just when fundamentals were looking better than last year’s, thinning order inflows don’t offer comfort to investors. While working capital ratio is on the mend from 25 per cent a year ago to 21 per cent in Q2, much of the improvement is coming from faster or better order execution. Yet, while revenue growth is looking up and the quarterly run-rate has been in the 8–12 per cent range in the past few quarters, operating profit margins (stuck at seven-nine per cent for the past two fiscal years), particularly for its core infrastructure segment, hasn’t gained similar traction.

Far fewer big-ticket projects being bid and intense competition from relatively small- and mid-sized contractors are weighing on L&T’s profitability. Even as there are signs of revival in India’s capex because of public spending, meaty orders from power and construction sectors remain elusive. Therefore, whether L&T foregoes margins to keep its order inflows buoyant or vice versa will be closely watched.

Also, the order book mix after course correction is now in favour of domestic projects (74 per cent of total order book). But, international projects tend to have better realisations as well as execution risk. Whether L&T will tinker with its domestic and overseas order proportion to keep its act together is also a key monitorable. Having burnt its fingers with overseas projects in the past, investors may not be happy if the order book mix changes significantly in favour of foreign projects.

In all, it’s a tough balancing act for L&T. Whether it chooses to focus on order inflows growth, profitability or working capital utilisation needs to be seen as a holistic improvement remains distant; a marked improvement in domestic infrastructure spends, though, could improve things. The current scenario, perhaps, justifies the discount attributed to L&T stock. Trading at 25x FY19 earnings, L&T is one of the undervalued large-cap stocks. Yet, analysts at IDFC who have a ‘neutral’ view on L&T believe valuations do not offer margin of safety against risk to earnings from weak order inflow and execution.