Red Sea crisis a storm for L&T?

If concerns about the impact of the Red Sea conflict on Larsen and Toubro Ltd. (L&T) are on investors' minds, the company's stock performance suggests a different story. Shares of L&T flirted with the fresh 52 week high of 3,605.7, hit on Monday. On Tuesday, L&T said that its construction arm has bagged a “mega" order, valued between 10,000 crore and 15,000 crore for constructing a high speed electrification system for the Mumbai Ahmedabad bullet train project.

This significant domestic contract is expected to bolster L&T’s order book and revenue stream. While this bodes well, L&T's operations in West Asia, especially in light of the Red Sea crisis, could raise concerns over margins and execution. The impact, though, is likely to be minimal.

Analyst Priyankar Biswas of BNP Paribas notes that L&T’s Middle East (West Asia) exposure by revenue (FY23) are largely to Saudi Arabia, the United Arab Emirates and Qatar. The company does not have any material exposure to either Israel or Yemen, which means there is no exposure to direct conflict zones.

Nearly 84% of L&T’s international order book comes from Saudi Arabia. Ankita Shah, vice president, research institutional equities, Elara Securities (India) highlighted that projects in Saudi Arabia are executed locally, mitigating risks associated with execution or supply chain disruptions.

As such, order inflows are unlikely to be affected by the regional conflicts. Analysts pointed out there has been no negative news flow on execution disruptions. In the half year ended September (H1FY24), L&T saw a 148% year on year growth in international order flows, leading to a 65% jump in total order inflow to 1,54,700 crore.

Of this, 41% of order inflows came from West Asia, contributing to 18% of revenues. Having said that, higher freight costs could marginally hurt profitability. “Red Sea conflict has led to sharp rise in ocean freight almost like 2 3 times in the last one month. This can impact Ebitda margins as L&T ships modules from India to Middle East (West Asia)," said Biswas.

Though, he added, rates are still significantly below the peaks seen in FY22 and could be offset by the recent corrections in prices of solar modules and other commodities. Ebitda is earnings before interest, tax, depreciation and amortization. In H1, L&T’s Ebitda margin for core business (projects and manufacturing) stood at 7.4%.

In Q3FY24, L&T’s Ebitda margin is largely expected to be flat year on year at 8.6%. Recall that in Q2 earnings call, L&T had said that several new projects in the ramp up stage may not reach the valuation threshold by the end of FY24, leading to a delay in margin recognition for the year. Consequently, L&T expects core business margin to be in the range of 8.5 9% for FY24 as against the initial guidance of 9%.

Prabhudas Lilladher highlighted L&T's strong order intake during Q3, in the range of 53,500 82,000 crore, driven by a few major hydrocarbon projects in West Asia. This indicates resilience in the face of potential regional disruptions. L&T's management commentary on reducing exposure to non core assets will be crucial for the stock.

Shares have rallied about 67% in the past one year, building in the government’s push on infrastructure, the company’s sturdy order book, increased share of West Asia in revenue contribution, and expectation of better margins. “L&T (stock) has done well in the past two pre election periods and then gone on to underperform the rest of the calendar year," said Jefferies India’s analysts in a report dated 3 January.

The brokerage believes the capex cycle uptick remains in favour of industrial stocks..