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L&T: Shareholders losing out?

Aug 16, 2002

L&T since first announcing the demerger of its cement division has seen its value fall considerably. The continued dithering over the cement division demerger has depressed sentiment on the L&T stock. L&T, apart from its EPC business, also operates a huge cement capacity of nearly 16 m tonnes. The companyís competency in constructing cement plants enabled it to enter the cement sector in the mid 90s. Over the years, the cement division has been a drain on profit of the company as a whole.

Aggressive cement capacity additions since start of the business has made L&T the second largest producer of cement but it has also meant a high incidence of debt in the books of L&T. Even though the operating profits of the cement division have been higher compared to other divisions, the high debt has led to a higher incidence of interest expenses. The profits of the cement division and consequently the whole company have suffered due to this reason. The poor overall performance, pulled down by cement, is affecting the companyís return on equity.

Lately, the cement division, which contributes 30% towards the turnover of the company, has been plagued by poor realisations, which has impacted profitability further. This has further delayed breakeven of the cement division. Falling cement realisations have also put a strain on the operating margins of the division.

The L&T board had proposed demerger of the cement division, as early as 2000. Since then the company has been non-committal and the demerger is still just a proposal. Significant progress was made in October 2001 when Grasim acquired 10.1% stake in L&T from Reliance industries. But since then there has been no action initiated to demerge the cement division in favour of Grasim, the new strategic partner.

L&T: Cement valuations
ConservativeOptimistic
Enterprise Value (EV/ tonne in US $)65 70
Enterprise Value (EV in Rs m) 47,775 51,450
EV net of debt* (EV in Rs m) 22,775 26,450
Value per share91106
* Assuming a debt of Rs 25 bn for the cement division.

We have tried to value the cement business on replacement cost basis. On the replacement cost basis, a 1 m tonne plant with a captive power generation capacity of 15 mw could cost an estimated Rs 3,250 m. Based on this assumption, the per tonne value of L&Tís 16 m tonne cement capacity works out to $ 65 per tonne. On a per share basis, value of the cement business works out to Rs 92.

Over the years, various acquisition deals involving cement companies have taken place in the country. On an average, the cost of acquisition has been nearly $ 55 per tonne. On a conservative basis even if an enterprise value (EV) of $ 65 is accorded to L&Tís cement plants then the per share value of the business works out to Rs 91.

L&T: EPC valuations
ABBBHEL
Total market cap 12,206 43,580
Net sales 10,416 68,505
Market cap/ sales1.20.6

To arrive at a fair value of the EPC businesses, we can compare the EPC operations of L&T with companies like ABB and BHEL. ABB commands a market cap to sales ratio of nearly 1.2, as it is an efficiently managed company. BHEL has a much lower market cap to sales ratio of 0.6, which may be due to the fact that it is a PSU. Taking the above figures into consideration L&T can be given a market cap to sales valuation of 1. Consequently, the per share value of L&Tís EPC business works out to Rs 191.

The above valuation exercise illustrates that reasonable value of the cement business works out to Rs 91, while the value of L&Tís other businesses mainly EPC works out to Rs 191, as compared to a the current market price of Rs 168. A demerger of the cement business is likely to unlock value and reward shareholders. Looks like the ball is in the managementís court.

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