BackChanging business mix to impact L&T’s margins
The key concern is whether the changing profile of business will hurt profitability of the firm
Premium(Priyanka Parashar/Mint)
Larsen and Toubro Ltd’s (L&T’s) stock has lifted the overall performance of the BSE capital goods index in the past one year. Excluding L&T, which has a huge ₹ 98,000 crore market capitalization, the capital goods index underperformed the Sensex by 23%. In fact, the company’s weightage in the capital goods index expanded to 60% from 46% three years ago, driven by fundamental earnings growth at a time when most capital goods manufacturers have been struggling with poor order inflows and project execution.
But, even as L&T’s weightage in the capital goods index is increasing by virtue of its market capitalization and almost 90% free float in the market, its business is less reflective of the capital goods sector. A recent analysts’ presentation by the company says that portfolio diversification has partially mitigated the cyclicality of the business. The key concern is whether the changing profile of business will hurt profitability.
Note that 53% of L&T’s order inflows and 49% of its order book for the nine months ended December 2012 accrued from infrastructure, which also includes construction of roads, bridges, buildings and factories. This is more than twice the share of infrastructure a decade back. The share of process, power and hydrocarbons has reduced as the opportunities have dwindled given the economic slowdown and competition in these segments is increasingly eroding margins through pricing pressure.
“The buildings and factories segment accounts for 37% of its order inflows year-till-date, versus 5-10% in the previous years," said a report by Nomura Equity Research. And, more than half of these orders are from large residential (civil construction) projects, where growth rates could be lower in the medium term as builders are striving to pull out of the cash crunch.
That apart, fresh infrastructure ordering could stall six months prior to elections scheduled in 2014, even as orders from industries remain weak as the country’s capex cycle is in the doldrums. A Citi Research report says that to offset this, L&T is bidding aggressively in international markets, but at a 100-150 basis points lower margin than earlier.
Obviously these changes in order book profile, along with deteriorating working capital cycle in the near term, could have an impact on profit margins. Little wonder then that the management watered down its forecast for fiscal 2013, from + or – 50 basis points operating margin from last year’s 11.8% (in the beginning of the year) to a contraction of 50-100 basis points, in the recent post-December quarter analysts’ conference call. The Nomura report also adds that L&T may manage order inflows, but may have to sacrifice margins.
These factors explain the steady decline in the stock performance from January till date. In a sense, it implies that the risks are being factored into the stock price.
Analysts’ confidence in the management’s ability to steer the firm through tough times is reflected in their reaction to the World Bank debarment of L&T from participating in projects funded by it for six months, on grounds of forgery indulged by a company executive in 2008. Analysts reckon that since then corrective steps have been taken and the development does not entail any business risks, brushing aside any temporary slide in the stock price on this count.
What would alter earnings estimates for the next two years is any significant drop in fiscal 2013 profitability. L&T’s shares trade at ₹ 1,496—at a one-year forward price-to-earnings multiple of around 13. Business diversification makes it a strong defensive play on infrastructure, which could rebound faster than all other peers as the investment cycle turns. But there could well be some pain in the interim period.
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