Larsen & Toubro (L&T)'s share price has fallen 30% and has underperformed the BSE Sensex by 29% year-to-date. The under-performance seems acute if looked at over the past two years (down 33%), which suggests no return on investment as the downturn in the industrials business cycle hurt its valuation outlook. However, the sharp fall in the share price causes us to reconsider our not-so-positive outlook over the past two years.
Our analysis suggests that some of the key concerns over Larsen & Toubro's earnings growth are now receding. This, coupled with a potential improvement in business outlook post the Indian general elections in Q1FY15, suggests overlooking the near-term earnings weakness in FY14. Below we argue against key investment concerns on Larsen & Toubro.
What if the macro slows down even more?
Consensus GDP growth forecasts for India have been toned down to 4.5% for FY14 and to 5.5% for FY15. However, we believe the market is more concerned about the consistent downgrades than the low growth. Our interaction with investors suggests they are concerned about L&T on two counts: (i) How much will order inflow growth be impacted by the macro slowdown along with the elections; and (ii) What is the possibility of large-scale write-offs due to escalations/cancellations/defaults. We address both issues in detail.
Larsen & Toubro's order backlog is now less geared toward industrials capex: L&T’s track record of winning new projects during the year preceding a general election has been strong. There are only three instances in the past 18 years (analysis period) when Larsen & Toubro's new orders growth fell below the nominal GDP growth rate and only once in the past five election years did L&T report order inflow growth of less than 5% (FY00). This time around, market concerns stem from the fact that the elections have been accompanied by declining macro growth resulting in private sector orders falling off a cliff.
Can order inflow growth slow down if macro weakens?: Yes. However, looking at the announced orders trend during Q2FY14 (R194 bn announced to date) Larsen & Toubro could report 20% y-o-y growth after posting 28% in Q1FY14. We have raised our order inflow estimate for FY14 to 12% from 8% factoring in only modest 2% growth in H2FY14.
Infrastructure now bigger than industrials: In the past Larsen & Toubro's exposure to the industrials capex segment (e.g., domestic power, oil & gas, metals),