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L&T: Riding the India story!
Jan 19, 2006

Performance Summary
India’s largest engineering company, L&T, has announced robust results for the third quarter ended December 2005, Strong accretion to the order book, on the back of increased infrastructure and industrial investments, has aided the company’s topline performance. Operating margins have expanded for both 3QFY06 and 9mFY06. For the nine-month period, net profits have declined by 16%, mainly due to the fall in other income.

Financial performance (Standalone): A snapshot
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Sales 32,489 36,910 13.6% 88,860 101,263 14.0%
Expenditure 30,889 34,441 11.5% 85,077 96,613 13.6%
Operating profit (EBDITA) 1,600 2,469 54.4% 3,782 4,650 22.9%
Operating profit margin (%) 4.9% 6.7%   4.3% 4.6%  
Other income 605 873 44.3% 5,109 3,395 -33.5%
Interest 140 225 60.3% 372 470 26.4%
Depreciation 215 266 23.6% 643 821 27.6%
Profit before tax 1,849 2,852 54.2% 7,877 6,755 -14.2%
Share of profit from integrated JVs 21 45   141 42  
Extraordinary income/(expense) - 235   - 617  
Tax 547 538 -1.6% 1,516 1,961 29.3%
Profit after tax/(loss) 1,324 2,593 95.9% 6,502 5,453 -16.1%
Net profit margin (%) 4.1% 7.0%   7.3% 5.4%  
No. of shares 129.9 134.8   129.9 134.8  
Diluted earnings per share* (Rs)         65.2  
P/E ratio* (x)         29.1  
* On a trailing-12 months basis            

What is the company’s business?
Larsen & Toubro (L&T) is India’s largest engineering company with expertise in wide areas like infrastructure, oil and gas, power and process. The company has broadly segregated its business into two key segments – Engineering and Construction (E&C) and Electrical & Electronics (E&E). While the former contributes to around 82% of L&T’s revenue, the latter is around 11%. Out of the remaining 8%, a large share comes from the company’s IT services business. During the period between FY02 and FY05, the company has grown its revenues and profits at CAGR of 17% and 33% respectively.

What has driven performance in 3QFY06?
E&C steals the show: Almost 60% of L&T’s 3QFY06 topline growth has been due to the strong performance of company’s E&C division (82% of 9mFY06 sales). Growth in the segment revenues has been brought about by a robust accretion to the order book. L&T booked order worth Rs 67 bn during 3QFY06 (91% of total orders booked), which implies a growth of over 100% YoY. During the quarter, the company won a couple of large projects from ONGC. While the first project worth Rs 10 bn was for constructing four well platforms and interconnecting pipelines for ONGC’s Bombay High North and Bassein fields, the second project worth Rs 13 bn was for a major offshore project. The company also won Rs 2.6 bn order from the Hyderabad International Airport (HIA) for construction of passenger terminal building. Notably, this is the second bid contract that L&T has won from HIA after the Rs 5 bn EPC deal that it struck with the former in 2QFY06. At the end of December 2005, the company’s outstanding order book for the E&C division stood at Rs 229 bn, almost double the segment’s entire sales during FY05.

Segment-wise performance…
  3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Engineering & Construction
Revenue 28,204 30,873 9.5% 76,504 84,482 10.4%
% share 85.1% 81.8%   84.1% 81.5%  
PBIT margin 5.1% 7.4%   4.6% 5.9%  
Electrical & Electronics
Revenue 3,109 3,905 25.6% 8,626 11,105 28.7%
% share 9.4% 10.3%   9.5% 10.7%  
PBIT margin 11.1% 15.7%   11.2% 14.5%  
Others
Revenue 1,823 2,970 62.9% 5,863 8,009 36.6%
% share 5.5% 7.9%   6.4% 7.7%  
PBIT margin 6.7% 11.6%   9.4% 12.2%  
Total
Revenue 33,136 37,748 13.9% 90,993 103,596 13.9%
PBIT margin 5.8% 8.6%   5.5% 7.3%  
* Excluding inter-segment adjustments

The company’s electrical and electronics (E&E) division also performed strongly during the quarter, with revenues growing by almost 26% YoY. As earlier, strong performance of this segment has mainly been a result of increased investments in the Indian power sector, especially in the transmission and distribution (T&D) segments, which are the main areas where the E&E business caters. A higher share of revenues from the E&E segment also augurs well for L&T, as this would propel L&T’s overall margins. As a matter of fact, while the E&E business constitutes to around 11% of the company sales, it provides for almost 21% of the total PBIT (as per 9mFY06 numbers).

Lower input costs aid margin expansion: A 13.7% YoY decline in raw material costs (as a % of sales) has aided L&T’s margin expansion during the third quarter of FY06. These costs declined from 36% of sales in 3QFY05 to just over 22% of sales in 3QFY06. Softening commodity prices seem to have had this positive effect on L&T’s raw material costs during the said period. All the other cost heads have however, witnessed expansion. Based on segments, while PBIT margins of the E&C division has improved by 230 basis points to 7.4% during 3QFY06, those for the E&E division have expanded by 450 basis points.

It boils down to the bottomline: Robust growth in the topline coupled with expansion in operating margins has helped L&T post a strong bottomline growth during the third quarter. However, net profits have declined for the nine-month period, mainly due to decline in the other income component. L&T has recorded an extraordinary income of Rs 235 m for 3QFY06 from ale of its glass container business. For the nine-month period, the extraordinary income of Rs 617 m is due to the sale of glass container and dairy processing equipment businesses. If one were to remove toe effect of extraordinary income from the nine-month performance, the net profits would have declined by around 26% YoY.

Performance in the recent past…
  3QFY05 4QFY05 1QFY06 2QFY06 3QFY06
Sales growth (YoY, %) 36.0 21.7 21.7 13.0 13.6
Profits growth (YoY, %) 30.0 16.6 16.6 (67.3) 95.9
Operating margins (%) 4.2 10.1 10.1 2.2 6.7
* Extraordinary effect in 2QFY06 net profits

What to expect?
At the current price of Rs 1,900, the stock is trading at a price to earnings multiple of 18.8 times our estimated FY08 earnings. On a price to sales basis, the stock is trading at 0.9 times our estimated FY08 sales. These valuations make the stock almost fairly valued from a two-year perspective.

In order to fund its future capex requirements, L&T had recently launched India’s first Japanese Yen denominated FCCB issue aggregating Rs 4.5 bn, which are redeemable after 5 years at a premium of 3.3% over face value. The bonds are convertible into GDRs at a conversion price of Rs 2,498 per share, which is almost 31.5% over the current market price.

Considering the strong accretion to the company’s order book, we expect L&T’s revenues to grow at a robust rate into the future. Also, while margins are likely to witness some improvement on the back of lower commodity (raw material) prices, investors need to read with caution the company’s rapid forays into the international arena, as contracts outside India, which having larger ticket sizes, also have high ‘failure costs’ attached to them. Overall, L&T remains our preferred play in the engineering sector.

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