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L&T: Bullish on EPC

Mar 12, 2002

In a bid to strengthen its core business of Engineering, Procurement and Construction (EPC), Larsen & Toubro (L&T), seems to be set to bid for PSUís like Bharat Heavy Electricals Limited (BHEL) and Engineers India Limited (EIL). Consolidation and growth in L&Tís domestic and the international markets seems to be the reasoning behind this proposed move. We try to analyse the synergies that could be realised if L&T is able to acquire these companies.

L&Tís EPC division contributes nearly 60% to the revenues. The level of investments in the economy determines the demand for the divisionís products and services. Due to a slowdown in the domestic market (from where nearly 99% of L&Tís EPC revenues are derived), the topline growth has remained flat and the margins are lower due to competition from global players. The division has been trying to increase its presence in the international markets. On this front, the company has been able to book a few orders but no significant growth in this segment is forecasted.

The revenues of this division are largely dependent on the level of infrastructure spending in the country. The roads sector has been encouraging for the company with huge investments made by the government for the Golden Quadrilateral project. On the industrial infrastructure front, the slowdown in the economy has led to limited spending by companies on capital goods.

9m FY02 annualised L&T BHEL
Turnover (in m) 73,730 55,564
OPM 10.0% 7.9%
PAT (in m) 3,151 3,200
Net profit margin 4.3% 5.1%
EPS 12.7 12.8
PER 15.2 13.4

Now letís look at BHEL. It is Indiaís largest engineering and power generation equipment company. It has supplied generating equipment for 65% of Indiaís total generating capacity. It has a wide product portfolio and manufactures everything from insulators to oil field equipment and locomotives to light aircrafts. Inconsistency in performance has been a weak point for the company. Its considerable exposure in the international markets makes it attractive for a buyer like L&T, as it will be able to gain exposure to these markets. BHEL is a huge company with interests in a large number of areas and in its present form it is not going to be easy for any company to manage this behemoth. The company has employee strength of around 52,000 and employees account for a significant 23% of its operating expenses.

On the other hand, EIL is engaged in engineering, procurement, construction, supervision and project management services in different areas such as petroleum refineries, pipelines, petrochemicals, oil & gas processing, fertilizers, metallurgy, offshore structures & platforms, ports & terminals, chemicals and power. The company has a large focus on R&D with state of the art facilities and a technically skilled manpower. The government holds over 94% stake in the company. EIL is a profit making company with a lean workforce of about 3,500 employees.

There are a few key questions that pop up at this juncture. What will an acquirer have to pay for a controlling stake in each of these companies? In case of BHEL, the government currently holds 67% stake. To acquire a strategic stake, the buyer will at least have to take 30% from the government and 20% through the open offer route. At the current price level of Rs 174, the 50% buyout would cost the acquirer around Rs 17 bn. Apart from the pricing, another factor that could rock the boat is that BHEL manufactures certain defense equipment for the government. So, this sensitive issue has to be sorted out before the stake sale. Also, it is worth mentioning that in its present form BHEL is too huge to manage, so any potential buyer will have to look at all these aspects before any decision is taken.

Again, in case of EIL, the buyer will have to pay nearly Rs 5 bn for a 50% stake in the company according to current market price.

L&T is likely to gain an entry in to the lucrative international markets if it is able to acquire BHEL, whereas an EIL acquisition will give L&T a highly skilled manpower base and a state of the art R&D facility. The crucial question is whether L&T is financially strong enough to bid for both the companies together. We will look at three possible scenarios as to how L&T might be able to fund the acquisitions.

In the first scenario we assume that L&T bids for the two companies on its own strength. L&T generates nearly Rs 3.4 bn as profits annually and it has liquid reserves (cash/bank balances et cetera) of Rs 3.8 bn. Thus L&T is likely to have nearly Rs 7 bn to fund its acquisition plans. In this case, it is likely to take debt to the tune of Rs 15 bn in order to fund the acquisitions completely. The gearing ratio in this scenario will become nearly 1.5x, which is still manageable (presently the gearing is 1.1x).

The second scenario is that L&T joins hand with some other strong corporate (may be Grasim). Then this joint effort may not put as much pressure on the gearing ratio.

A third possible scenario will be the demerger of the cement division of L&T, which will generate additional cash flows for the company. The replacement value of the cement business, which has a capacity of nearly 15 million tonnes, will be around Rs 52 bn assuming a replacement value of Rs 3.5 bn for a 1 million tonne plant. Assuming L&T parts with a 50% stake, it will receive Rs 26 bn from this transaction. This amount is adequate to fund the acquisitions.

As of now no deadline has been proposed by the Government for the sale of these PSUís, so it is going to be a wait and watch game. The only drawback BHEL is that it lacks efficiency and any move to increase their efficiency like pruning the manpower will attract increased attention from multinational EPC companies. This is likely to give a better valuation for BHEL. On the other hand EIL, is a relatively more efficient company and it is likely to be valuable for any acquirer. The stake sale of BHEL and EIL is most likely on the second list of the government hence as time passes these companies may attract greater attention.

From L&Tís perspective, the disinvestment of BHEL and EIL again raises the issue of the hive off of its cement division. So far the management has failed to meet its internally set deadlines to take a final decision on this issue. Maybe, the upcoming disinvestments will trigger a decision. A decision in favour of the hive off should unlock value and benefit the shareholder.

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