L&T will witness pressure on profitability both in core and non-core businesses such as IT and financial services
Highlights
- June quarter severely impacted by Covid-19
- Stress could continue in September quarter,
albeit at a slower pace
- Strong balance sheet and order book to
support in the interim
- Expect flat or marginal growth this year
- Valuation offers little margins of
safety
If Larsen & Toubro’s (CMP: Rs 916, Mcap:
Rs 1,28,654 crore) June quarter results are any indication, it is
clear that the stress in the engineering and construction space is much more
than what the Street had initially expected. The pain because of the nationwide
lockdown and the subsequent slowing of industrial activity was acute during the
reporting quarter. It is likely to continue in the second quarter of the
current financial year as well, albeit to a lesser degree.
“With the partial lifting of the lockdown and the
graded resumption of business operations, the domestic economy is expected to
improve incrementally over the next few quarters. Ordering activity in roads,
urban infra particularly health care, railways, water distribution and
waste-water treatment and irrigation sub-segments is expected to pick up in the
later part of the fiscal year,” the L&T management has observed while
giving out an outlook for the next few months.
No wonder the company skipped its revenue and
profitability guidance, citing uncertainty. While its operations have resumed
and offices are functioning, L&T expects the recovery to be gradual. In all
probability, the current year would be one of consolidation and investors
should keep expectations low.
Results at a glance
In the June quarter, the execution of orders has
suffered because of the lockdown and most of L&T’s business segments have
seen lower revenues. The company’s consolidated revenue dropped by 28 per cent
on a year-on-year (YoY) basis.
The pain was largely reflected in
L&T’s core business (excluding IT and financial services business), which
saw a steep decline of 47 per cent on a YoY basis. The infrastructure business,
which is close to 50 per cent of its core business, saw revenues dropping by
more than 53 per cent. This segment suffered mostly because of non-availability
of labour and disruption in the supply chain during the lockdown.
Segments such as heavy engineering, defence,
electrical and automation also faced similar challenges. Client side issues and
supply chain disruption led to a drop in revenues in these segments as well.
On the other hand, IT and financial services, which
together account for 42 per cent of L&T’s total revenues, performed
relatively better and helped in somewhat offsetting the pressure on the core
business.
Operating performance
The profitability of L&T took a
hit as the core business earned lower margins because of high operating costs
and lower utilisations. During the June quarter, the group EBITDA (earnings
before interest, tax, depreciation and amortisation) dropped 47 per cent and
the EBITDA margin fell to 7.6 per cent as against 10.4 per cent in the
corresponding period last year.
L&T’s largest segment, infrastructure, reported
a 127.5-basis-point drop in EBIT to 3.8 per cent. The other notable contributor
to the decline was the financial services business, whose EBITDA margins
dropped to a piffling 3.6 per cent in the June quarter as against 22 per cent
in the last fiscal. Though L&T has divested its wealth management business,
the increased provisioning had put a pressure on profitability, dragging sharply
down the reported profits of the overall group by 79 per cent on a YoY basis.
Earnings outlook
While L&T has not given any guidance, the
stress in its core business will continue and contribution from other
businesses such as financial services will remain lower. As a result, the first
half of the year will be negative in terms of growth.
Though a recovery in the second half is likely, it
may not be enough to recoup the loss in revenues during the first half. Thus we
have estimated that this year the company will see a marginal 1-2 per cent
revenue growth on a YoY basis. Pressure on profitability will remain both in
the core business as well as noncore businesses such as IT and financial
services. Hence, operating margins could drop marginally.
This also means pressure on return ratios and
working capital this year. The company’s return on equity has already dropped
to 12.7 per cent in Q1FY21 from 15.4 per cent in the corresponding quarter. Net
working capital increased to 26.8 per cent of revenues as against 23.7 per cent
in fiscal 2020 and 18.1 per cent in fiscal 2019. This means L&T would
require additional cash for its business. This will drag down the overall
treasury income earned on surplus cash and lower the return on capital. The
only respite is that the balance sheet is strong and the company has a good
amount of cash in its books, which should help in mitigating the stress.
Thankfully, the order book remains healthy. During
the reporting quarter, order inflows dropped 39 per cent on a YoY basis.
However, it still continues to have good orders in hand of close to Rs 305100
crore, which is up by about 4 per cent on a YoY basis. As various issues
triggered by the lockdown get sorted out towards the end of the current fiscal,
execution should gather pace. This should lead to a better performance in
fiscal 2022, when we are expecting L&T’s overall revenues to grow to the
tune of 18-20 per cent.
Valuation
The company is sitting on a good amount of cash and
leverage is under control, enabling it to navigate this crisis well. Because of
a lack of growth this year, investors, in the interim, will have to live with
low expectations particularly in the light of the valuations. The stock is now
trading about 15 times its FY21 and 12 times FY22 estimated consolidated
earnings. At the current price, valuations offer little margins of safety as
some of the interim risks may not be adequately getting reflected in the price.
Source - Moneycontrol.com
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