Retain ‘buy’ on Larsen and Toubro, decrease TP to Rs 1,160 from Rs 1,200

By HSBC Global Research

Despite Covid-19, the government has continued capital spend close to last year’s run rate, which should bode well for collections. Capex outlook has improved on the back of demand recovery and will likely improve government finances. Retain ‘buy’, decrease target price (TP) to Rs 1,160 from Rs 1,200 to factor in slower-than-expected revival as Covid-19 hurts government finances.

Marked underperformance makes valuation even more attractive. Shares of L&T are down 30% YTD and have underperformed the Sensex and the BSE capital goods index by 29% and 14%, respectively. This underperformance is significant particularly given combined per share contribution of L&T’s four listed subsidiaries has gone up to 52% of the stock price from 28% (assuming 10% holding company discount) since the start of the year. The stock now trades at c13x FY22e EPS, which we think is very attractive given it has traded in the range of 15x-31x over 2015-2020. Adjusted for subsidiary valuation, core business now trades at only 7.7x FY22e PE despite being much diversified, decent growth (c8-10%) and strong ROCE business (c17-18%).

Capex outlook improving though at slower pace: With most of the economic indicators returning to normal and government finances as indicated by GST collection also reaching the pre-Covid-levels, we believe capex will follow soon. In this report, we highlight that despite significant financial constraints, the Centre has almost maintained expenditure on capital account and several ministries have reaffirmed capex. We think capex from Public Sector Undertakings (PSUs) is unlikely to be affected by Covid-19. State finances driven by GST, petroleum products tax and real estate revenue should also see improvement. Further, lower interest rate, government-led incentives and demand recovery should pave the way for selective private capex recovery on a benign base.

FY21 Q2 preview. L&T’s order announcement trend has been weak in Q2. We forecast L&T to report Rs 340 billion of orders – down 30% YoY. Despite 4% higher order backlog at the start of the quarter, we build in a 9% y-o-y drop in revenue due to slower execution and 110bp ebitda margin compression. We expect Q2 recurring PAT to drop by 40%, to Rs 15.1 billion, though exceptional gains (Rs 93 billion, E&A divestment) should result in strong growth in reported PAT.

Buy; trim TP. We have cut earnings by 6-9% to factor in higher finance costs, losses in development business and lower profitability in real estate business. While we have rolled over valuation and contribution from listed shares has sharply increased, this has been offset by a cut in earnings and lower target P/E multiple for core business (15.0x vs. 18.5x earlier, to factor slower pace of recovery) resulting in 3% reduction in TP to Rs 1160. Downside risks, slower pickup in the corporate capex cycle; slower-than-expected recovery in execution; cancellation of orders.