Let’s keep it simple and straightforward.
After reading the title, you may directly read the last sentence and you wouldn’t lose the core message. Or you may spend a few more minutes to get the 360 degree view of one of India’s oldest engineering conglomerates.
Some companies may show a depressed stock market performance but their track-record and the integrated value of their businesses tells you an entirely different story. Larsen & Toubro (L&T) is one such company. Three of its subsidiaries in the technology segment have been painting the town red with their envious run, at a time when L&T is stuck in the red.
On a 1-year timeframe, L&T has fallen by a massive 37% while Nifty 50 has managed to post modest gains of 5%. The stock has grossly underperformed Nifty in the recent past. From the March lows, Nifty 50 has shot up ~59% while L&T has generated a mediocre ~35% return.
Value of Rs 10,000 invested simultaneously in Nifty 50 and L&T
Data as on October 13, 2020
(Source: NSE)
For decades, investors have considered L&T as a proxy for India’s infrastructure story. However, the glamour around the country’s infrastructure development faded away in the past few years—with balance sheet constraints of the state and central government, high-NPAs of banks, slacking consumption demand, and a paradigm shift in the approach of the government in awarding contracts. The private capex has remained in the slow lane as well.
Revenue from operations represents revenues from continuing operations in FY20 and FY19
RoE is calculated on PAT excluding extraordinary and exceptional items
(Source: Annual Report FY20)
On the heels of virus-inflicted slowdown in the economy, the engineering behemoth lost some crucial days in the Q4FY21. Construction orders reach their peak in March under normal circumstances. If that wasn’t enough, the coronavirus pandemic has delivered a mighty blow to the Hyderabad Metro project which is proving to be an Achilles’ heel for L&T.
According to media reports, the company has incurred a massive loss of Rs 400 crore on the Hyderabad Metro during lockdowns, which might push its break-even from 4-5 years to about 7 years. Nonetheless, the Telangana state government has been considering providing subsidies and financial relief to L&T based on the number of days of business lost.
Working capital management has been another pain point for L&T. According to the company’s Annual Report for FY20, net working capital as a percentage of sales rose to 23.7% in FY20 as against 18.1% reported a year ago. A massive change in the working capital position denotes delays in collections and financial support provided to vendors and sub-contractors under difficult financial circumstances.
Investors have been anxious about L&T’s rising debt. The decision to buyout Mindtree in a hostile takeover for the value of Rs 10,700 didn’t go down well with investors.
As a result, the stock market sentiment about L&T has been weak, especially since the outbreak out of the coronavirus pandemic.
During the Q1FY21 post-earnings call, Mr SN Subrahmanyan, MD&CEO of L&T had briefed the media about the situation at the grassroots level. Order inflows of L&T fell 39% in Q1FY21. Despite that, the company was sitting on a healthy order book of Rs 3.05 lakh crore. Mr Subramanyan also opined that there could be project execution delays in the range of 6-12 months as compared to the pre-pandemic deadlines. He also sounded hopeful about multilateral agencies such as World Bank, Asian Development Bank and Japan International Cooperation Agency stepping in to fund some projects.
Mr Subramanyan remarked, I see various projects and tenders that are visible across sectors and I do see multilateral agencies or other funding agencies looking at projects across India. I am positive that these projects will happen.
In its Annual Report for FY20, the company has highlighted a few areas wherein it sees good prospects. They include government buildings, data centres, healthcare infrastructure, airports, metro rail projects, water projects including waste water treatment, irrigation projects and expressways among others. But it has refrained from making any comment on the expected timeframe for the orders in the aforesaid areas to gather pace.
On a standalone basis, L&T has the Net-debt-to-EBITDA of 2.3 times on FY20 earnings. The company enjoys the highest credit rating of “AAA” on its long term securities and A1+ on papers with shorter maturities. Strong parentage, dominant position in the EPC business and conservative financial policy are often cited as reasons for its high creditworthiness. In the current environment of low interest rates for protracted times, strong companies such as L&T have managed to raise money at extremely competitive rates.
4-point growth strategy of L&T
Bring down exposure to capital intensive businesses and achieve a perfect blend of mature businesses and growth-stage businesses. The company also aims to cut back its exposure to businesses such as financial services which need capital infusion form time-to-time.
Attain geographic diversification by focusing on high-growth potential countries. At present, overseas revenue contributes ~35% to the company’s revenues.
Increase the contribution of Services business to deal with the cyclicity of EPC business.
Entering strategic partnerships to supplement standalone offerings and effectively deal with project concentration risk.
Parallelly, the company continues to scout for asset-light businesses that are backed by megatrends such as urbanization, digitalization and sustainability among others. If services start contributing more to the consolidated earnings of L&T, its margins may improve.
The management of L&T has been emphasizing on making the company’s operations more focused and lean by divesting from a variety of businesses—ports, insurance, road concessions, etc. It recently raised Rs 14,000 crore by selling off its Electrical and Automation (E&A) business to Schneider Electric. This strategic deal was initiated in 2018.
Company management has also clarified that focus of L&T’s digital initiatives will now turn from just transforming operations to developing digital solutions in the areas of connected products, services and customer experience.
We thought of quickly evaluating L&T’s various business segments to ascertain their contribution to the group’s business.
Valuations based on FY22 earnings in case of L&T core business and L&T Hydrocarbon;
*Core business reflects the performance of infrastructure segment, power, heavy engineering, defence engineering, and realty, construction & mining machinery and rubber processing machinery;
L&T Finance, L&T Infotech, Mindtree, and LTTS are the listed subsidiaries of L&T;
#Holding company discount of 50% applied on the L&T’s holdings in listed subsidiaries at their respective current market value
@Assuming 30% discount on L&T’s stake in listed subsidiaries
Sum of the Parts (SOTP) valuation shown above is on conservative estimates and hence assumes the contribution of Hyderabad Metro as zero since it is yet to break-even. L&T has also been keen to divest from Hyderabad Metro for the reason that it isn’t a metro operator. In case it finds a strategic buyer, this may not only improve the company’s balance sheet but it can help the engineering behemoth to invest in future businesses.
There’s almost unanimity amongst business leaders that technology is the way forward post pandemic.
L&T has been sitting on both the sides of the table—a consumer as well as a supplier of IT solutions. The years of understanding of construction, manufacturing and engineering businesses may help it not only intelligently use the technology for higher productivity, but may help it gain mileage in its technology business. Conservative-back-of-the-envelope SOTP calculations suggest that, the stock at the current market capitalization of Rs ~1.25 lakh crore might be reflecting major negatives.
Unless, there’s a second-wave of infections in India which thwarts infrastructure development and construction activities or an unforeseen slack in the international businesses, L&T’s cash flows may improve. If it can raise cash by selling non-core businesses and reduce exposure to those with high cyclicity and high capital requirements, the market sentiment about the company may improve substantially. The investors would do well to watch future capital allocations, margin improvements and return ratios.
If you believe in India’s long term economic growth story, its success will depend on how companies such as L&T fare—irrespective of their recent stock market performance.
Please Note (read as a disclaimer): None of the stocks discussed in the article are recommendations to buy, hold or sell. This could just be the starting point for deeper analysis that you might want to carry out on your own. You may also take professional help as you feel appropriate.
You may also like to read: Be bold with fashion not with valuation!
Disclaimer
We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:
Consult your financial advisor before taking any investment decision.
We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflicts of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.
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