Why you should sell Larsen and Toubro

HSBC Bank has cut the target price for infrastructure and construction major Larsen and Toubro (L&T) by almost 10 percent from Rs 2,135 to Rs 1,942. MF Global too initiated coverage on the company with a Sell rating and a target price of Rs 1,400. Currently the stock is trading at Rs 1,492.

And the basic premise of the negative stance on the company is same for both research houses. Though L&T is proxy to the India growth story, with capital expenditure and investments slowing down, L&T is bound to suffer from slowing execution and order book. It will also suffer as 90 percent of its orders are domestic. The company has guided for a 15-20 percent order book growth this financial year. But such a task might get almost impossible with the slow down. MF Global estimates a mid single digit growth in order book. HSBC after meeting the new CFO, Shakar Raman, says, the management maintains the guidance of 15 percent growth but is a bit cautious about the domestic front because of the delays in projects.

[caption id=“attachment_90398” align=“alignleft” width=“380” caption=“With high raw material costs and stiff competition the company is likely to see drop in margins. AFP”]  [/caption]

In terms of order book, sectors like roads, real estate, processes, power transmission and hydrocarbons in the Middle East continue to do well. But power equipment is suffering due to severe competition while defence and shipbuilding are suffering due to lack of policy action. L&T may not be able to double its order from the Middle East as it had recently cited since competition from Korean players is very high there. They are themselves trying to offset the sluggish growth in their own countries. As a result, HSBC says that the company recently undertook an internal review and will revise its current guidance of 15-18 percent growth for this year if necessary.

More from Investing

MSMEs are breaking the traditional convention. Look who’s funding them Scale-up your startup without an investor! Here’s how

Moreover, L&T’s margins might just be peaking out. The operating margins have improved tremendously from 2005 to 2011 by 6 percent. With high raw material costs and stiff competition the company is likely to see drop in margins. The management says margins could drop by half a percent. But MF Global puts the number at 70 basis points (100 bps=1 percent). HSBC is a little more optimistic as it says the margins will dop 40bps to 12.4 percent this year.

In terms of execution, management has guided to a 25 percent growth over last year. MF Global is negative on this front as well citing uncertain macro environment, coupled with difficulties being faced by real estate developers and predicts a slowdown in execution over the remaining quarters.

Excluding one of its power equipment orders which is facing land allocation issues, majority of the projects have been in line with expectations, with a manageable delay of two to three months. So HSBC says, “With 90 percent of its revenue target being contributed by financial year 2011 closing order book, the company is confident of achieving its FY12 revenue guidance.”

MF Global have a target price of Rs 1,400. They have taken the historical average and put the value of the core company at 15 times the expected 2013 earnings. They have added another Rs 366 as a value of its subsidiaries.

HSBC no doubt is far more optimistic as it expect the company’s earnings to grow by 20 percent over the next two years. They have put a multiple of 18 times, which is a bit too high, over 2013 earnings. They have valued the subsidiaries at Rs 404 and maintain a Buy rating. But going by the slowdown in power and infrastructure sectors, such valuations would be very difficult to come buy. And the Street would perhaps punish the stock for any execution delays that might come by.