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L&T: Engineering growth! - Views on News from Equitymaster
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L&T: Engineering growth!
Jul 29, 2005

Performance Summary
India’s largest engineering company, L&T, had announced its results for the first quarter of FY06 a couple of days back. The company has reported yet another quarter of sterling performance with its topline and bottomline witnessing strong YoY growth. Even the operating margins have expanded by 70 basis points. Strong order booking in the E&C segment aided growth in 1QFY06.

(Rs m) 1QFY05 1QFY06 Change
Sales 26,599 31,282 17.6%
Expenditure 25,567 29,853 16.8%
Operating profit (EBDITA) 1,032 1,429 38.5%
Operating profit margin (%) 3.9% 4.6%  
Other income 337 549 63.0%
Interest 99 98 -1.1%
Depreciation 207 294 41.8%
Profit before tax 1,062 1,586 49.3%
Share of profit from integrated JVs 98 7 -92.7%
Extraordinary income/(expense) - 382  
Tax 359 545 51.9%
Profit after tax/(loss) 801 1,430 78.4%
Net profit margin (%) 3.0% 4.6%  
No. of shares 124.4 131.8  
Diluted earnings per share* (Rs) 24.3 43.4  
P/E ratio (x)   28.4  
(* annualised)      

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 consolidated gross sales, the latter is around 10%. 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 compounded rates of 17% and 33% respectively.

What has driven performance in 1QFY06?
E&C drives growth, yet again:  Underlying strength of the infrastructure and core industries has helped L&T rake in a strong order booking during the quarter, which has consequently aided its topline growth. The company has reported receipt of nearly Rs 39 bn worth of orders during the quarter, out of which Rs 32 bn came alone from the E&C segment. The order booking has witnessed a growth of 47% YoY over 1QFY05. At the end of 1QFY06, L&T’s order backlog stood at Rs 183 bn, a growth of 8% YoY and almost 1.4 times FY05 consolidated revenues.

The infrastructure sector, with a share of 38%, continues to contribute the largest to the E&C segment’s order backlog. Investors should note that revenues from the infrastructure segment (which involves building of roads, railways and airports) generally command lower margins than higher-end segments like hydrocarbons that involve more complex engineering assignments. As such, higher revenue contribution from the former will only put pressure on L&T margins in the future, which we have duly factored in our projections.

Segment-wise performance…
  1QFY05 % of total 1QFY06 % of total Change
Engineering & Construction
Revenue 22,769 83.6% 26,292 82.2% 15.5%
PBIT 1,194 71.9% 1,132 60.7%  
PBIT margin 5.2%   4.3%    
Electrical & Electronics
Revenue 2,508 9.2% 3,304 10.3% 31.7%
PBIT 225 13.5% 419 22.5%  
PBIT margin 9.0%   12.7%    
Others
Revenue 1,971 7.2% 2,381 7.4% 20.8%
PBIT 241 14.5% 312 16.8%  
PBIT margin 12.2%   13.1%    
Total
Revenue 27,248 100.0% 31,977 100.0% 17.4%
PBIT 1,659 100.0% 1,864 100.0%  
PBIT margin 6.1%   5.8%    
* Excluding inter-segment adjustments

L&T’s electrical and electronics (E&E) division also aided the topline growth during 1QFY06. Revenues from the segment witnessed a YoY growth of 32%, the fastest among all business segments of the company. Strong performance of this segment has mainly been a result of the upturn in the investment cycle that has seen new capacities being built up by the Indian power sector. Also, as reported by the management, the segment has benefited from improved production efficiency and cost and resource optimization measures practiced by client industries. We expect the strong growth momentum of this business to continue in the future as the transmission and distribution (T&D) segment of the power sector, which is one of the key areas where the E&E business caters to, is likely to see increased investments, both in the public and private space.

Margins expand despite input cost pressure:  Despite an increase in cost of production from 78% of sales in 1QFY05 to 81% in this quarter, L&T has managed to expand its operating margins by 70 basis points. This is largely owing to reduced staff costs and sales and administration costs. As a matter of fact, the latter declined by 280 basis points to 8.6% of sales in 1QFY06. Based on segments, while PBIT margins of the E&C division continues to remain under pressure and have declined by 90 basis points, those for the E&E division have improved by 370 basis points. Pressure on E&C margins is seemingly on account of high contribution from the low-margin infrastructure segment and the company’s increased foray in the international markets where it has undertaken some low margin projects as a strategy to make an entry and survive competition from global engineering majors.

It all boils down to the bottomline:  Strong topline growth and expansion in margins has filtered down to aid L&T’s bottomline growth during the fiscal. Also, the company has reported an extraordinary income of Rs 382 m on account of sale of dairy and milk processing equipment business. Excluding this, the profit growth declines to 31% YoY from the otherwise 78% YoY, as shown in the first table above.

Performance in the recent past…
  4QFY04 1QFY05 2QFY05 3QFY05 4QFY05 1QFY06
Sales growth (YoY, %) 11.8 64.6 44.1 36.0 21.7 17.6
Profits growth (YoY, %) 7.7 26.1 357.8 30.0 16.6 78.4
Operating margins (%) 8.5 3.2 3.3 4.2 10.1 4.6

What to expect?
At the current price of Rs 1,230, the stock is trading at a price to earnings multiple of 16.7 times our estimated FY06 standalone earnings. A huge order backlog of Rs 183 bn for L&T’s E&C division provides the company with a high revenue visibility into the future. Considering a further accretion to the order-book on account of the company’s premier position in the engineering space and that the execution of the current orders will take around 15-18 months, we expect L&T’s revenues to grow at a robust rate into the future.

We had recommended a ‘Buy’ on the stock in June 2005 at Rs 1,100 with a target price of Rs 1,540 in the medium to long-term. With an estimated 24% CAGR in earnings during the period FY05 to FY08, we believe that the stock is attractively priced compared to other Indian majors in the E&C business. We, thereby, maintain our positive view on the stock.

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