India’s new government is expected to ramp up infrastructure spending, so investors are looking for companies that will benefit from a potential boom in engineering and construction. (see this AlphaNow article). However, here’s a big yellow “caution” sign — some companies in this sector may already be overvalued as the markets hit new highs. Larsen & Toubro (LART.NS) is one of the largest engineering and construction companies in India. We look at some of the valuation measures that indicate L&T may be expensive.
The StarMine Relative Valuation model industry rank leads us to believe that L&T is richly valued compared to others in the industry. It scores a poor 12 on this measure, which puts it close to the bottom decile of all companies, and it scores poorly compared to most of its peers. The current F12M P/E ratio is 25.6. That’s much higher than the historical five-year median of 18.2. As you can see in the chart below, periods where the red line is higher than the five-year median tend to indicate overvaluation.
Source: Eikon/StarMine
Sliding margins
Management may need to improve efficiency to boost earnings. Gross margins seem to be improving and the chart below shows that gross margins are at a ten year high at a healthy 28.1%. Unfortunately, operating margins and net margin measures have been falling over the last three years; both measures are at five-year lows. Falling operating margins despite improving gross margins could be an indicator of falling efficiency. In fact, net margins at 5.8% are at the lowest level in more than 10 years.
Source: Eikon/StarMine
L&T needs concrete results
In an environment of falling operating margins, L&T has continued to ramp up its investment in capital expenditures. As you can see in the chart below, capital expenditures have exceeded 60 billion rupees, or $1 billion, in each of the last four years, when cash flow from operations has been negative. Strong cash flows are a key component of strong earnings quality, and increasing capital expenditures that are not funded from operations is a sign of poor earnings quality, which means earnings may not be sustainable. The fact that L&T has over $15 billion in total debt does not help.
Source: Eikon/StarMine
Bridging the gaps
While the infrastructure boom in India will likely benefit L&T, the company will need to work on improving operating efficiency. Since it is one of the largest infrastructure players in the country, it has a long leash in terms of the balance sheet, but eventually, it will have to see some of its high investment projects come to completion and start generating cash flows. The company does not seem cheap, but it could justify those valuations if it can fire on all cylinders and finish its projects on time without delays. Analyst confidence does not seem terribly optimistic though, with full year earnings estimates reduced by more than 10% in the last 90 days and next year’s earnings estimates also being taken lower. Perhaps L&T needs to build some bridges to the investment community.
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