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S. Vaidya Nathan

As a focussed play, L&T is growing from strength to strength.

AN investment with a one/two-year perspective can be contemplated in the stock of Larsen & Toubro. The stock has consistently traded at a price in excess of Rs 700 after the demerged engineering and construction business was listed.

We remain positive about the outlook for the company and its stock and our buy represents an upgrade from the immediately preceding call of `hold' recommendation earlier this year, which was driven by what appeared an imminent litigation by shareholders; this process has, however, resolved swiftly.

Business Line has a buy recommendation outstanding on the stock at Rs 400 , which was preceded by a sell at about Rs 300; we changed tack at that stage on the ground that the stock would attract a greater degree of interest in the homestretch to the demerger taking effect and, more so, as a pure engineering and construction play. The price trends after L&T was listed, shorn of its cement business, point to the emergence of such interest.

The cement business had been a drag on L&T earnings and cash flows despite being the largest player in terms of capacity. This business made profits only in a few quarters — that, too, spread out over the years — when cement prices were ramped up to high levels. Without this burden, the value attached to the engineering and construction business has taken the escalator in a hurry.

The decision to scale down equity to Rs 25 crore (from Rs 250 crore) and split the stock also had played a hand in the strock's re-rating, which, in our view, is likely to be sustainable.

The sizeable reduction in debt burden, the nominal level of interest cost that L&T pays now, and the likely ramp up of shareholder funds, which is an important parameter in bidding for projects to the pre-demerger levels over the next year or two, helped improve the stock valuation.

It is well-placed to scale up debt levels to bankroll growth, as finances are likely to be available at finer rates consequent to the risks attached to the company having declined appreciably. This should strengthen its position while bidding for new projects.

Over the past 15 months, the growth in L&T's order-book position has been impressive. The pick-up in industrial activity, the increased investment demand, the focus on the infrastructure sector and the focus on tapping and diversifying the export market have pepped up the order-book. With its well-established presence in the engineering and construction space, L&T has an edge when it comes to infrastructure projects.

The order-book position should comfortably take care of revenues over the next two years. This would ensure stability in the earnings stream, as L&T should manage profitability. Its record of doing so over the past year, despite the spurt in the prices of steel, cement and other construction materials indicates flexibility and strength in passing price escalation to customers. It is likely that there would be a sizeable decline in the contribution from other income that could moderate earnings growth.

The residual stake of about 10 per cent stake held in UltraTech Cemco (which holds the erstwhile cement business of the company) could also be a source of sizeable one-time cash flow, especially if the divestment happens after its merger with the cement business of Grasim takes place.

The L&T stock, along with Siemens, BHEL and ABB, is likely to be a preferred play in the engineering and construction space. It is, however, likely to command a lower price-earnings multiple as it derives a larger proportion of its revenues from the low-margin construction business.

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