Pursuant to the sharp 15% rally since Q2 results, Larsen & Toubro (L&T) shares are trading slightly above our target price of Rs 970. We downgrade to neutral. At current levels, we believe the price adequately discounts near-term positives, including the healthy growth in order book, decent margin performance and success in international business, helping to tide over weak local macros.
But we remain wary of risks associated with deteriorating working capital of Larsen & Toubro, higher than expected margin drag on overseas orders and a potential increase in slow moving order book. Also, valuations at 18x one year forward earnings are not cheap. A decisive improvement in the investment cycle — not our base case at this point — would be a necessary trigger for further re-rating, in our view.
In our base case, we expect Larsen & Toubro liquidity environment to improve next fiscal, easing working capital pressures. However, if working capital intensity remains at FY14E level (18% of sales) over the medium term, there is 6% downside to our base case target price. Large unforeseen cost provisions in overseas orders booked by Larsen & Toubro (particularly in hydrocarbon segment where complexities are higher) is a key risk to our margin assumptions.