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L&T: All’s well! - Views on News from Equitymaster
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L&T: All’s well!
Oct 29, 2005

Performance Summary
India’s largest engineering company, Larsen & Toubro (L&T), has announced mixed results for the second quarter and first half of FY06, reporting a decline in net profits for both the periods. While the company has maintained a decent growth in the topline, suppression in operating margins and the effect of an extraordinary income in the corresponding quarter of the previous year has taken its toll on the bottomline. Notably, if one were to exclude the effect of the extraordinary income of 2QFY05, the net profit for the latest quarter would have grown by 69% YoY.

Financial performance (Standalone): A snapshot
(Rs m) 2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Sales 29,846 33,716 13.0% 56,445 64,998 15.2%
Expenditure 28,695 32,965 14.9% 54,263 62,818 15.8%
Operating profit (EBDITA) 1,151 751 -34.7% 2,183 2,181 -0.1%
Operating profit margin (%) 3.9% 2.2%   3.9% 3.4%  
Other income 4,168 1,973 -52.7% 4,504 2,522 -44.0%
Interest 133 147 10.2% 231 245 5.9%
Depreciation 220 260 18.2% 428 554 29.7%
Profit before tax 4,966 2,318 -53.3% 6,028 3,903 -35.2%
Share of profit from integrated JVs 22 (9) -142.9% 120 (2) -101.9%
Tax 611 878 43.7% 969 1,423 46.8%
Profit after tax/(loss) 4,377 1,431 -67.3% 5,178 2,478 -52.1%
Net profit margin (%) 14.7% 4.2%   9.2% 3.8%  
No. of shares 129.9 129.9   129.9 129.9  
Diluted earnings per share* (Rs) 134.8 44.0   79.7 38.2  
P/E ratio (x)         35.3  
(* annualised)            

What is the company’s business?
Larsen & Toubro (L&T) is the largest engineering, procurement and construction (EPC) company in India and also has interest in fields of technology and electricals. The company has divided its current operations in two major divisions viz. engineering and construction (E&C) and electricals and electronics (E&E).

What has driven performance in 2QFY06?

E&C leads topline growth: L&T’s E&C division (88% of 1HFY06 sales) has continues to lead the company’s topline growth, as has been seen in the segment’s strong performance in the periods under consideration. Revenues from the segment have grown by over 12% YoY, led by strong order booking, which grew by 78% over 2QFY05. At the end of the quarter, this division’s backlog stands at over Rs 193 bn, which are almost 1.7 times the segment’s gross sales in FY05. The infrastructure sector, with a share of over 30%, continues to contribute the largest to the E&C segment’s order booking. Readers should note that revenues from the infrastructure segment (involves building of roads, railways and airports) generally command lower margins than higher-end segments, like hydrocarbons that involve more complex engineering assignments and as such, higher revenue contribution from the former will only put pressure on L&T’s margins in the future. While the company has gradually reduced the contribution from infrastructure over the years, it has again picked up pace in recent times, owing to the government’s increased focus towards the sector.

The segment has also benefited from the government’s increasing emphasis on rapid investment in oil and gas exploration and production (E&P) activities. Strong demand for oil and gas from across the world has led to increased activities in the E&P space and this has benefited companies like L&T, which have the requisite competencies in executing complex tasks of such nature.

Segment-wise performance…
  2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Engineering & Construction
Revenue 25,605 27,963 9.2% 48,374 54,255 12.2%
% share 89.5% 87.8%   89.8% 88.3%  
PBIT margin 3.3% 5.6%   4.2% 5.0%  
Electrical & Electronics
Revenue 3,008 3,895 29.5% 5,517 7,200 30.5%
% share 10.5% 12.2%   10.2% 11.7%  
PBIT margin 13.3% 14.8%   11.3% 13.8%  
Others
Revenue 2,069 2,658 28.5% 4,040 5,039 24.7%
% share 7.2% 8.3%   7.5% 8.2%  
PBIT margin 9.2% 12.1%   10.7% 12.4%  
Total*
Revenue 28,613 31,858 11.3% 53,890 61,454 14.0%
PBIT margin 5.0% 7.8%   5.7% 7.1%  
* Excluding inter-segment adjustments

Construction and staff costs dent margins: High construction costs due to rising prices of minerals and metals and increased staff costs on account of the company’s initiatives of retaining people has dented operating margins during both 2QFY06 and 1HFY06. While construction costs increased from 15% of 2QFY05 sales to over 20% of 2QFY06 sales, staff costs expanded from less than 7% to just over 8% during the said period.

Extraordinary impact on the bottomline: Apart from a contraction in operating margins, a one-time income of Rs 3.5 bn as profit on sale of the cement business, which L&T had recorded in 2QFY05, has had an effect on the company’s bottomline during the latest quarter. If one were to exclude the effect of the extraordinary income of 2QFY05, the net profit for the latest quarter and first half would have grown by 69% and 50% YoY respectively.

Performance in the recent past…
  4QFY04 1QFY05 2QFY05 3QFY05 4QFY05 1QFY06 2QFY06
Sales growth (YoY, %) 11.8 64.6 44.1 36.0 21.7 21.7 13.0
Profits growth (YoY, %) 7.7 26.1 357.8 30.0 16.6 16.6 (67.3)
Operating margins (%) 8.5 3.2 3.3 4.2 10.1 10.1 2.2

What to expect?
At the current price of Rs 1,345, the stock is trading at a price to earnings multiple of 18.3 times our estimated FY06 earnings. On a price to sales basis, the stock is trading at a multiple of 0.9 times our estimated FY06 consolidated sales. While the 1HFY06 EPS is almost half of what we have estimated for the full year FY06, investors should note the engineering companies’ record most of their income and profits during the second half of the fiscal, due to finalization and award of majority of contracts during this period. As such, we would not be revising our number downwards based on the first half performance. We expect the company to record strong growth in the next two quarters.

A huge order backlog of Rs 193 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 company has emerged as a formidable force in the Middle East, we expect L&T’s revenues to grow at a robust rate in the future. Overall, we are positive on the company from a 2-3 year perspective.

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. The stock has already met our target and has then declined in line with the overall market sentiment. Considering the company’s strong growth prospects and its increasing presence in the high margin hydrocarbon and process segments, we maintain our recommendation on the stock.

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