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L&T: Scale and cost benefits

Oct 19, 2006

Performance summary
Indiaís largest engineering company, L&T, has announced decent results for the second quarter of FY07, with standalone topline and bottomline growing by 11% YoY and 41% YoY respectively. Savings in input and sub-contracting expense has provided a fillip to operating margins, which has almost trebled to 6.4% for the quarter.

Financial performance snapshot (Standalone)
(Rs m) 2QFY06 2QFY07 Change
Sales 33,716 37,361 10.8%
Expenditure 32,965 34,979 6.1%
Operating profit (EBDITA) 751 2,382 217.0%
Operating profit margin (%) 2.2% 6.4%
Other income 1,964 1,117 -43.1%
Interest 147 106 -27.7%
Depreciation 260 336 29.3%
Profit before tax 2,308 3,057 32.4%
Tax 878 1,045 19.0%
Profit after tax/(loss) 1,431 2,012 40.7%
Net profit margin (%) 4.2% 5.4%
No. of shares 132.2 280.0
Diluted earnings per share (Rs)* 38.7
P/E ratio (x)* 33.0
* On a trailing 12-months basis

What is the companyís business?
Larsen & Toubro (L&T) is Indiaís 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 Ė Engineering and Construction (E&C), Electrical & Electronics (E&E) and Machinery & Industrial Products (MIP). While E&C contributed to around 72% of L&Tís standalone 2QFY07 revenue, E&Eís 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 2QFY07?
E&C does it again: In line with its performance in the past few quarters, the E&C division has yet again led the topline growth for L&T. During 2QFY07, this segment recorded a revenue growth of 8.4% YoY. Decent growth in order booking and execution of the already large backlog has helped this divisionís performance during the quarter. At the end of September 2006, the E&C divisionís order backlog stood at 293 bn, almost 2.5 times the segmentís full year sales in FY06. The cumulative order bookings for the first half of this fiscal stand at Rs 110 bn, which is a 59% YoY growth over the bookings made in 1HFY06. Investors should note that more than the large order backlog, a large part of the same (over 40%) is made up of orders related to the hydrocarbon and defense sectors, where, on the basis of the superior technological expertise requirements, margins are relatively superior as compared to the infrastructure segment.

A couple of notable achievements during the quarter were the companyís acquisition of a defense electronic research company (Spectrum Infotech) and signing of contract with Scania of Sweden (one of the largest commercial vehicle maker in the world). We expect the acquisition in the defense space to provide added teeth to L&Tís capabilities, considering that the huge potential lies in the form of government prioritizing private sector participation in supply of defense equipments. As far as the Scania deal is concerned, while L&T will serve as a distribution arm for the formerís trucks, the product will complement L&Tís existing range in the construction and mining space.

Segment-wise performanceÖ
(Rs m) 2QFY06 2QFY07 Change 1HFY06 1HFY07 Change
Engineering & Construction
Revenue 25,275 27,494 8.8% 49,527 53,682 8.4%
% share 74.2% 71.2% 74.9% 72.0%
PBIT margin 5.5% 7.8% 4.9% 7.7%
Capital employed 32,687 25,968
Share in total capital employed 82.4% 74.8%
Return on capital employed 7.4% 15.9%
Electrical & Electronics
Revenue 3,809 4,670 22.6% 7,049 8,914 26.5%
% share 11.2% 12.1% 10.7% 12.0%
PBIT margin 14.6% 15.8% 13.6% 15.8%
Capital employed 3,258 4,591
Share in total capital employed 8.2% 13.2%
Return on capital employed 29.4% 30.7%
Machinery & Industrial Products
Revenue 3,517 4,355 23.8% 6,728 7,723 14.8%
% share 10.3% 11.3% 10.2% 10.4%
PBIT margin 12.0% 14.4% 10.9% 15.6%
Capital employed 2,667 2,422
Share in total capital employed 6.7% 7.0%
Return on capital employed 27.5% 49.9%
Revenue 1,479 2,119 43.3% 2,777 4,223 52.1%
% share 4.3% 5.5% 4.2% 5.7%
PBIT margin 6.9% 11.0% 7.8% 10.2%
Capital employed 1,062 1,732
Share in total capital employed 2.7% 5.0%
Return on capital employed 20.4% 24.9%
Revenue 34,080 38,638 13.4% 66,080 74,542 12.8%
PBIT margin 7.3% 9.7% 6.6% 9.6%
Capital employed 39,674 34,713
Return on capital employed 10.9% 20.7%
* Excluding inter-segment adjustments

As far as the electrical and electronics (E&E) business is concerned, revenues grew by 27% YoY during 2QFY07. Growth in this segment should be seen on the backdrop of a benign investment scenario in the power sector, which has continued to benefit L&T in the past as well. The Machinery & Industrial Products (MEP) business recorded sales growth of 15% YoY. The managemnet has outlined increased volumes and higher price differentials as the key factors for growth of the segment during 2QFY07.

Savings in input costs aid margins: L&Tís operating margins have almost trebled in 2QFY07. And a large part of this expansion has been due to savings in raw material costs, led by softening commodity prices. These declined from 26.7% of sales in 2QFY06 to 24.1% in 2QFY07. Even sub-contracting costs declined as a percentage of sales, thereby aiding the overall margin expansion. Based on segments, while PBIT margins of the E&C division have improved from 4.9% in 2QFY06 to 7.7% during 2QFY07, those for the E&E and MIP business have also expanded smartly.

All falls to the bottomline: Sharp expansion in operating margins and lower effective tax rate has helped L&T reports a strong performance on the bottomline front, which has grown by 41% YoY during 2QFY07. The companyís effective tax rate has declined from 38% in 2QFY06 to 34% in 2QFY07.

What to expect?
At the current price of Rs 1,285, the stock is trading at a price to earnings multiple of 18.9 times our estimated FY08 consolidated earnings. We remain positive on L&Tís strong growth prospects in the future. Apart from the strong accretion to L&Tís order book, we are also buoyed by the companyís increased presence in the high margin hydrocarbon and defense businesses. This shall aid the companyís return ratios in the future. We had recommended a ĎBuyí on the stock in May 2006, which we maintain at the current juncture.

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