Analysis: Diversification helps L&T score over BHEL
L&T’s diversification has worked well in difficult times such as the current scenario whereas its peer like BHEL has been impacted due to its fortunes being strongly linked with the power sector. The sharp contrast in the performance of the two companies during the September 2012 quarter is evident and which also explains the wide divergence in the behaviour of their stocks. BHEL's share price is down 29% in last one year, whereas L&T is up 15%. Notably, and given that the trend in unlikely to change any time soon, most analysts believe L&T will continue to outperform and the stock remains their preferred pick in the capital goods space.
Diversification gains for L&T
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Both L&T and BHEL are well known for their strong execution capabilities. However, the woes of the power sector as well as slowing economic growth are reflecting visibly on BHEL’s performance. In spite of its huge order book, BHEL could hardly convert them into revenues due to client side issues. Over the last four quarters, the company’s revenues have remained flat. And if analyst estimates are any indication, revenues for the current financial year are expected to remain flat or could even decline marginally. This is possible as the projects at the client side are facing challenges due to lack of fuel and policy clarity.
L&T, too, is facing its share of problems, but it is still in a better position given the business diversification. About a quarter of L&T’s order book comes from power sector as against about 80% (rest 20% from industrial) in the case of BHEL. That apart, L&T has better mix of public/private sector clients along with relatively higher proportion coming from the export markets. “In our view, presence of L&T in diverse business opportunities ranging from heavy engineering, construction, power, machinery and industrial products, ship building, infrastructure, finance and information technology lends the company a great benefit of diversification. It de-risks L&T’s business model from slowdown in any particular industry, which makes it one of the best options in capital goods space to play the anticipated policy rate easing and consequent decline in cost of capital theme," says Misal Singh, director institutional research, Religare Capital Markets.
No wonder, on the one hand, BHEL which is largely in the power sector saw its new order inflow decline by 78% year-on-year in the September 2012 quarter, while on the other hand L&T did well with a 30.3% growth as a result of better inflows from construction, hydrocarbon and industrial sectors.
BHEL: Balance sheet issues emerging
The trend in new orders and progress of existing projects is bound to reflect on growth visibility. Currently, BHEL has an order book of Rs 122,000 crore or about two and a half time its current turnover. Whereas L&T has an order book of Rs 158,000 crore which is equal to three times its standalone turnover. Top of that if one deducts the orders that face the risk of delay/cancellation in the case of BHEL, there is a clear indication that L&T has got higher visibility.
Besides, analysts are also watching the balance-sheet issues that are cropping up for BHEL in the recent past. For instance, inventory levels are rising and clients are delaying their payments (debtor turnover ratio in FY12 at 264 days as against the 241 days in FY11), which has led to higher working capital requirements. BHEL’s management, too, has indicated that existing orders from the private sector could face execution delays at the customers end. In fact, analysts say that BHEL faces a significant risk of order cancellation.
In 2011-12, the additional working capital requirement (trade receivables plus inventory minus trade payables) more than doubled to about Rs 8,000 crore compared to 2010-11. In fact, for the first time in many years BHEL reported a negative cash flow from operating activities in FY12—Cash balance also fell 30% to Rs 6,700 crore in FY12.
“Due to slow down of order inflow and due to increasing exposure towards working capital intensive EPC (engineering, procurement and construction) business, BHEL’s working capital has come under pressure. But, for L&T the risk is different. It’s order inflow is growing but orders are not like BHEL orders, so advances from these orders are certainly supporting the increasing working capital requirements of L&T. Also, L&T has the cushion of monetising its SPVs (special purpose vehicles related to infrastructure assets) when time requires to meet its working capital requirements. This comfort BHEL hardly enjoys," says Rabindra Nath Nayak, who tracks the company at SBICAP Securities.
Overall, these also had an impact on the return and dividend pay-out ratios of BHEL, which were looking weak in 2011-12.