Most analysts’ price targets for Larsen and Toubro Ltd shares have been breached. Bloomberg data shows that the average price target was Rs3,325.
On Friday, L&T shares closed at Rs3,873, more than 16% higher. But that doesn’t necessarily mean that analysts will change their recommendations to ‘sell/underweight’ or even ‘hold’.
Like in the past, price targets are likely to be raised, on the back of earnings upgrades.
One catalyst would be the robust growth in earnings for the first half this fiscal. The other simply is that one can’t possibly be underweight on a company that is growing its order backlog by over 40% year-on-year (The end-September order backlog of Rs44,000 crore amounts to nearly two years’ revenues), and enjoying pricing strength as it can be choosy about the projects it takes up, thanks to high demand.
The company’s performance in the six months to September demonstrates the result of this wonderful combination.
While operating revenues grew by 38.7% to Rs10,008 crore, core profit before tax and non-operating income has jumped 143% to Rs892 crore. Margins have improved nearly 400 basis points, thanks to pricing strength, on the one hand, and operating efficiencies, on the other. The company has reduced the number of sites it works in, and the increased concentration of work in fewer locations helps in terms of benefits of scale.
But the company has also pointed out that margins were much higher this year (especially in the September quarter) as a number of its projects reached the threshold level of completion. Based on the accounting norms followed by the company, this translates into a jump in revenue and profit booking. For this reason, it doesn’t make sense to read much into the company’s quarterly numbers.
What’s more important is the trend in order inflows, which is growing at a healthy pace of 26%. Also, the first half results suggest that profit growth will be higher than revenue growth in the near to medium term. The company, however, has maintained that margins for the 12 months till March 2008 will be at the same levels as FY07.
This is probably because of cost escalation owing to a rise in commodity prices and due to rupee appreciation can eat into the company’s margins.
Only 20% of the company’s order book is priced on a cost-plus basis, besides which about 5-10% have cost escalation clauses tied into them. Note that the cost escalation accounts for only pre-defined increases in commodity prices, and does not compensate for currency fluctuation.
Such projects accounted for only about 10% of the order book a year ago, and the proportion has been rising given the pricing strength the company is currently enjoying. But since a majority of the projects are still ‘fixed-price’ in nature, rising material prices could eat into margins.
But the company points out that even if it maintains margins at last year’s levels of about 11%, it would be content since these are high margins by global standards for engineering and construction companies.
In any case, analysts aren’t worried about this having a large impact on earnings growth. Some estimates of the company’s FY09 earnings per share are in the region of Rs120, which represents an annual average growth of about 55% from FY07 levels. This values the core business at about 28 times FY09 earnings, which is steep, but then as long as the growth story is intact, no one is complaining.
Dr Reddy’s Laboratories
Dr Reddy’s Laboratories Ltd’s shares have underperformed NSE’s Nifty by 46% since January owing to a host of reasons. The betapharm acquisition has nearly backfired as a change in regulation forced the company to cut product prices in Germany.
Also, as Credit Suisse points out, there is a lack of immediate catalysts in the company’s US pipeline.
This is acting as a cap on the stock, especially since in the past it has been driven by one-off gains from launches in the US market. To make things worse, the company’s shares will be replaced by realty major DLF in the Sensex, which will act as a technical overhang since some index funds will sell the stock to adjust their portfolios.
The upshot is that the stock is available cheap—it trades at about 17 times estimated FY08 earnings. The company’s September quarter results confirmed the concerns about betapharm – for most analysts, the results of the German company were worse than expected. But, on the other hand, the company’s other business segments have done well. Despite the downtrend in betapharm and pressure owing to an appreciating rupee, the company has managed to maintain its gross margin at 51%, similar to what it achieved in the June quarter. Selling, general and administrative expenses, however, jumped by 36% over the June quarter, leading to a sharp drop in operating margin. Operating profit was 35% lower compared to the June quarter.
But note that SG&A expenses include some exceptional items related to legal charges and some one-time payments made by betapharm.
Analysts point out that there could be cost savings in betapharm as the firm is increasingly shifting work to India. The September quarter demonstrated that the rest of the business had no negative surprises. And with the stock having underperformed massively in the recent past, analysts say that the downside is limited.
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