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 We address both issues in detail. Larsen & Toubro's order backlog is now less geared toward industrials capex: L&Ts 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),which has been impacted by the macro slowdown,was high. But over the past four years,L&T has diversified into new segments like urban infrastructure,helping it to reduce the impact of a slowdown (67% of order backlog now). Also,its strong balance sheet has allowed Larsen & Toubro to gain market share in the domestic business. A worsening of the macro scenario would make matters worse for L&Ts domestic competitors. While growth would slow,it is unlikely to be flat or meaningfully lower as implied by current market expectations. Larsen & Toubro's order inflow growth implies a GDP multiplier of 2x during FY00-13. Assuming L&T achieves only a 1x multiplier over the next two years,then even at 5% GDP growth (and 5% inflation) L&T should be able to capture a 10% order inflow CAGR over FY14-16e (we are building in an 11% CAGR in our estimates) What about order cancellations? The Indian corporate sector seldom cancels projects but rather chooses to delay them indefinitely,which is tantamount to a cancellation in the near to medium term. During FY13,Larsen & Toubro removed R190 bn of orders from its order book,the highest level in 15 years. We forecast R160 bn more orders to be slow-moving,though of these R37 bn are from Larsen & Toubro's road development projects that could come back on track during FY14-15. Our current forecasts factor in R100 bn of order cancellations during FY14 and R60 bn during FY15. On our estimates,order cancellations will fall to less than 3% by FY15,similar to past mid-cycle levels. Investors are concerned that L&Ts earnings growth gets impacted similar to its large peer Bhel. We argue that Larsen & Toubro's customers are spread across diverse business segments unlike Bhel (single segment focus on power equipment),which has been hit hard owing to poor power equipment demand due to fuel supply concerns. L&T has consistently brought down its inventory and receivables reducing the impact of any write-off flare-ups from orders under execution. Quality of new orders remains stable: We note that the share of government orders among new orders has been steadily rising. Most of the new orders received during H1FY14 are also from quality customers. Although public orders carry higher working capital intensity,they have limited probability of cancellations,which increases our comfort level. This bodes well for the company as a revival in macro growth would remove the private sector orders from the slow-moving list,while existing government orders lend stability in the current weak environment. Falling Korean competition in the Middle East should ease margin concerns: In the Middle East we see early signs of Korean competition moderating (Korean market share fell to 24% in H1FY13 from 30% in 2012). This should reduce investors key concerns on L&Ts order inflow growth outlook and margins. Current share price factors in decade-long slowdown: Larsen & Toubro's share price has corrected 30% and underperformed the market by 29% YTD on concerns of a sustained macro slowdown. However,our reverse DCF (discounted cash flow) analysis suggests the share price now factors in only a 6% revenue CAGR over the next decade at Ebitda margin of 9% (100bp below current) and working capital to sales of 16% (currently 18%) at a low terminal growth rate of 3%. Upgrade to OW with a target price of R947 (R1,015 earlier): We continue to value L&T using sum-of-the-parts. Our target price implies that 12 months from now,L&T will trade at 14.3x one-year forward consolidated EPS vs. 13.5x currently. The share price (adjusted for subsidiary value) implies Larsen & Toubro's standalone E&C (engineering & construction) business is trading at 10.2x one-year forward EPS,while our target price assumes it will trade at 12.5x. HSBC
