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L&T: Deriving scale benefits
Jul 21, 2006

Performance summary
India’s largest engineering company, L&T, has announced strong results for the first quarter ended June 2006. On a standalone basis, revenues and net profits have grown by 12% YoY and 10% YoY respectively. However, if one were to exclude the extraordinary income of 1QFY06, net profit growth for 1QFY07 stands at 50% YoY. Operating margins, led by lower raw material and purchase costs, have witnessed a strong 2.2% expansion over 1QFY06.

Financial performance snapshot (Standalone)
(Rs m) 1QFY06 1QFY07 Change
Sales 31,063 34,769 11.9%
Expenditure 29,568 32,329 9.3%
Operating profit (EBDITA) 1,494 2,440 63.3%
Operating profit margin (%) 4.8% 7.0%  
Other income 491 474 -3.4%
Interest 98 158 60.8%
Depreciation 294 309 5.0%
Profit before tax 1,593 2,448 53.7%
Extraordinary income/(expense) 382 -  
Tax 545 877 60.9%
Profit after tax/(loss) 1,430 1,571 9.9%
Net profit margin (%) 4.6% 4.5%  
No. of shares 131.8 139.1  
Diluted earnings per share (Rs)*   73.8  
P/E ratio (x)*   27.5  
* 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 three key segments – Engineering and Construction (E&C), Electrical & Electronics (E&E) and Machinery & Industrial Products (MIP). While E&C contributed to around 73% of L&T’s standalone 1QFY07 revenue, E&E’s contribution was to the tune of 12%. During the period between FY03 and FY06, L&T has grown its consolidated revenues and profits at compounded rates of 17% and 34% respectively.

What has driven performance in 1QFY07?
E&C leads the charge: L&T’s E&C division has once again led the company’s topline growth. During 1QFY07, robust growth in order booking (121% YoY) aided growth if this division. As a matter of fact, L&T booked orders worth Rs 63.2 bn in its E&C business (86% of total orders booked) during the first quarter, thus taking its order backlog to nearly Rs 275 bn (2.4 times the division’s FY06 revenues and 97% of total order backlog). What is more important to note is that a large chunk of the backlog is made up of orders related to the hydrocarbon and defense sectors (around 47% of E&C’s order backlog), where, on the basis of the superior technological expertise requirements, margins are relatively superior as compared infrastructure segment.

The quarter also saw L&T strengthen its presence in the Middle East region, as it signed a joint venture agreement with a leading Kuwait-based diversified company – Bader Al Mulla and Brothers Co. This venture will focus on construction projects in oil & gas, power and infrastructure, and will enable L&T to benefit significantly from the construction boom in the region.

Segment-wise performance…
(Rs m) 1QFY06 1QFY07 Change
Engineering & Construction
Revenue 24,247 26,189 8.0%
% share 75.8% 72.9%  
PBIT margin 4.3% 7.6%  
Electrical & Electronics
Revenue 3,239 4,244 31.0%
% share 10.1% 11.8%  
PBIT margin 12.4% 15.9%  
Machinery & Industrial Products
Revenue 3,211 3,368 4.9%
% share 10.0% 9.4%  
PBIT margin 9.7% 17.2%  
Others
Revenue 1,303 2,103 61.5%
% share 4.1% 5.9%  
PBIT margin 8.8% 9.4%  
Total
Revenue 31,999 35,904 12.2%
PBIT margin 5.8% 9.6%  
* Excluding inter-segment adjustments

As for the electrical and electronics (E&E) business, while revenues grew at a much faster pace than in the E&C division, the relative lower contribution to total revenues diminishes the impact in the overall revenue growth. Nonetheless, increased investments in the power sector continue to benefit this division’s business for L&T and with the government moving aggressively on its ultra mega power projects, we believe that growth could be much higher for this business as we move forward.

Lower input costs aid margin expansion: L&T has reported a 2.2% expansion in operating margins during 1QFY07, mainly due to decline in raw material expenses, from 27% of sales in 1QFY06 to 21% in 1QFY07. Softening commodity prices seem to have had this positive effect on the company’s input costs during the fiscal. Lower cost of purchase of trading goods has also aided the overall margin expansion during the quarter. Based on segments, while PBIT margins of the E&C division have improved from 4.3% in 1QFY06 to 7.6%, those for the E&E and MIP business have also expanded. The management has indicated that improved product mix and consequently higher average realisations have helped the margins of the latter two divisions during 1QFY07.

Extraordinary impact on bottomline: Despite the strong expansion in operating margins, lower other income and higher interest costs have led to L&T’s bottomline reporting a 10% YoY growth, almost two percentage points lower than the growth in topline during the said quarter. However, if one were to exclude the extraordinary income that the company had received during 1QFY06 (as profit on sale of dairy and milk processing equipment business), the 1QFY07 net profit growth zooms to nearly 50% YoY.

What to expect?
At the current price of Rs 2,025, the stock is trading at a price to earnings multiple of 14.3 times our estimated FY08 consolidated earnings. Considering strong accretion to L&T’s order book, we expect the company’s revenues to grow at a robust rate in the next 2-3 years. Also, margins are likely to witness further improvement on the back of lower input prices and better realisations from high-end contracts in the hydrocarbon and defence spaces.

We had recommended a ‘Buy’ on the stock in May 2006 at Rs 2,363 with a target price of Rs 3,120 from a long-term perspective. We maintain our view on the stock.

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