The Hindu Business Line : Larsen & Toubro: Buy

With a sound track record, L&T has not only managed to capitalise on the domestic infrastructure and industrial capex boom, but also successfully managed to expand its geographical footprint through strategic tie-ups.

Expanding geographical presence
Entry into super critical boilers
Subsidiaries hold key to unlock value

L&T appears all set to consolidate its position in Oman.

Larsen & Toubro's expanding geographical footprint, entry into niche businesses, consistent order flows and buoyant growth by subsidiaries enhance the company's earnings prospects.

At the current market price, the stock trades at 23 times its expected earnings for FY-07 on a consolidated basis, assuming a 15 per cent earnings growth. Possible unlocking of values in key subsidiaries through divestment of stake may also support valuations. The stock's premium valuation compared to other players in the sector appears justified on the back of a solid order-book and a business mix that positions the company as a unique engineering and infrastructure player in the country. We reiterate a buy on the stock with a two-three year perspective. Returns can, however, be moderate in contrast to the manifold gains over the past couple of years.

With a sound track record, L&T has not only managed to capitalise on the domestic infrastructure and industrial capex boom, but also successfully expanded its geographical footprint through strategic tie-ups. Further, the company's timely moves to equip itself for new opportunities, coupled with a relatively strong balance-sheet, gives it an edge over other infrastructure players in the country.

Momentum in order book

L&T's order-book continues to remain robust with a backlog of Rs 30,700 crore for the half-year ended September 2006. This translates to a 52 per cent increase on year-on-year (Y-o-Y) basis. The current order mix is skewed in favour of infrastructure, with the same accounting for 34 per cent. While the company's electrical and industrial divisions have traditionally contributed better margins, the engineering and construction segment, given the nature of projects, has kept the margins lower than other core engineering companies. However, with an increasing presence of the lucrative oil and gas segment in the order-book (24 per cent as of September), we expect the margins from the infrastructure segment to improve.

Mr A. M. Naik, CMD.

The company is also trying to optimise utilisation of resources by cutting down on orders below Rs 50 crore, which accounted for less than 40 per cent of the total orders in the last quarter against 70 per cent in the quarter-ended September 2005. Better utilisation of assets through selective order accretion is also likely to lend some support on the margin front.

Expanding on strengths

L&T has taken giant strides in expanding its geographical presence. L&T Oman, a joint venture between L&T India and Zubair Corporation, one of the largest industrial houses in Oman, appears all set to consolidate its position in the region. The venture bagged a greenfield township project in October and expanded its presence in the residential space. L&T Omanrecently tied up with Sohar Industrial Port Company for establishing Oman's first facility for large oil rigs and structures, a major milestone in its hydrocarbon trail. While the venture is already positioned as an integrated construction and electromechanical systems solutions provider, we expect the recent projects (realty and oil rigs) to make L&T Oman's business mix more lucrative in terms of returns and also increase its presence in the gulf region.

In China, the recently inaugurated switchgear facility will cater to the local needs and may well be a potential outsourcing hub, thus bringing cost benefits. The credibility built by L&T in China is evident from its bagging orders of about Rs 1,500 crore over the last two years in the critical equipment category (such as reactors and coal gasifiers), amidst international competition. Unlike Oman, where L&T inked a venture with a local player, foraying into manufacturing in China can be risky. Given the company's track record in doing business with China, there are unlikely to be hiccups in its venture. Our valuations, however, do not factor the revenue from this stream for now.

On the domestic front, L&T has been ramping up capacity of its automation facility scheduled for completion by May 2007. The control and automation facility business of the company provides electrical and automation solutions for oil and gas, water and infrastructure segments and is a natural extension of its core businesses. With increasing demand in the user segments, the expanded capacity in automation is likely to see sustained demand.

Holding potential

L&T also appears to be gearing up for the huge power project investments coming up in the country. Its recent tie up with Japan's Mitsubishi Heavy Industries will give L&T access to produce super critical boilers to meet the requirements of the mega power projects planned. BHEL is now the only local player equipped in this power range. While this venture holds huge potential with ultra mega power project orders starting to flow, we expect stiff competition as a number of bidders are tying up with overseas companies which can offer cost-advantages. L&T's success in this segment will depend on its pricing strategy.

A possible divesting of stake of key subsidiaries in future may hold value for investors. L&T's fully-owned subsidiary — L&T Infotech — has been growing at a scorching pace with the bottomline more than trebling in the last half. L&T has plans to further strengthen this company through the inorganic route before divesting stake through a possible listing in 2008. As a step forward, it recently acquired a US-based electronic design services firm with presence in US and India.

Another subsidiary, L&T Finance, has seen capital infusion of Rs 100 crore in the first half year alone even as L&T recently made a move to acquire about 10 per cent stake in City Union Bank. We expect this subsidiary to emerge as a key business in the company's portfolio and a possible divesting candidate in future.

Risks

For the September quarter L&T's operating margins expanded by 380 basis points to 6.4 per cent, but remains lower than typical infrastructure players. There is also the risk of hike in raw material costs and absence of price escalation clauses in some overseas projects.

We, however, expect volume growth to provide some support to margins. Huge capital expansion may result in subdued per share earnings in the near term. Delay in the take- off of new forays may also result in sub-optimal capital and resource utilisation.

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