BackWhy Larsen and Toubro missed estimates
Its June quarter results clearly saw the adverse impact of falling crude oil prices and the glut in global commodity markets along with weak commodity prices on corporate activity
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When a company is a corporate proxy for the economy, major macroeconomic developments would certainly have a bearing on its performance, notwithstanding its internal efficiencies. Take the case of engineering conglomerate Larsen and Toubro Ltd (L&T). Its June quarter results clearly saw the adverse impact of falling crude oil prices and the glut in global commodity markets along with weak commodity prices on corporate activity. It also mirrors the sluggish demand environment and underutilization of existing capacities in core sectors. The firm disappointed the Street on most counts.
The biggest impact was seen in the 21% year-on-year fall in order inflows to ₹ 26,376 crore, the first drop in six quarters. The management said that international orders fell by almost half to ₹ 8,000 crore. With a large chunk accruing from the Middle Eastern region, this seems logical, given that plunging crude oil prices have jeopardized economic activity in the area. On the other hand, L&T’s prowess in the domestic markets is seen in the fact that it bagged most of the road projects tendered out. It was also able to maintain domestic order inflows at the year-ago level.
Also, the June quarter operating performance shows that the company slipped most in segments such as metallurgical and material handling, and heavy engineering. Revenues for these two businesses declined 47% and 22%, respectively, while the material handling segment posted losses. These divisions are linked to oil and gas and large engineering projects, where progress is slow, given the state of the economy. Barring the infrastructure segment, which fortunately comprises most of the stand-alone revenue and clocked a marginal 70 basis points (bps) rise in margins, the other segments’ profit margins fell from a year back. A basis point is one-hundredth of a percentage point.
With these challenges, the consolidated operating margin fell by 193 bps year-on-year, also a tad lower than forecasts. Stand-alone operating margin at 9.1% disappointed the Street and was lower than a year ago by about 142 bps.
So L&T’s huge 37% fall in reported net profit, which includes one-off items in the year-ago period, is not surprising. But what is worrisome are the prospects. While the management has not altered its guidance of 15% growth in revenue and order inflows along with a 100 bps expansion in profit margin for the current fiscal year, the global economic gloom may thwart a strong ramp-up in earnings.
L&T’s chief financial officer outlined concerns of soft oil prices and weakness in the euro zone, which have put many large international projects on hold. Softer commodities could have a cascading effect on the economy in delaying the capex cycle. Meanwhile, strained credit lines impact cash flows. A peek into this is seen in the huge rise in working capital as a percentage to sales, which has more than doubled to heady levels of 25-30% over the last four years. Meanwhile, the company would find it hard to cut back fixed costs based on quarterly performance, but would likely do so if the pain is prolonged.
For now, given that commodity prices and crude oil are showing no signs of an uptrend, the investment outlook may remain weak. If and when the domestic budgetary outlay towards infrastructure fructifies into orders, L&T would be a big beneficiary.
That said, the one big relief is its gigantic order book of around ₹ 2,38,973 crore, which the firm could feed on to sustain profits until good times roll. Perhaps that is why L&T’s stock trades at premium valuation to its peers.
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The writer does not have positions in the companies discussed here.
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