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L&T: What is the fair value?

Dec 6, 2002

Larsen & Toubro (L&T) has been the limelight in the media for a number of reasons ranging from cement demerger and disagreements with the AV Birla Group and so on. But since the L&T board is expected to meet today for finalising on cement division demerger, we did an analysis to gauge the fair value of this division.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. But 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 affected 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 after the Grasim open offer saga, the management has once again opened up the process and going by reports, one cane expect some positive news on this front soon.

L&T Ė Cement valuations

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 US $ 65 per tonne. On a per share basis, value of the cement business works out to Rs 91 per share. Just to put things in perspective, over the years, various acquisition deals in India involving cement companies (both multinationals and domestic majors) have taken place in the country. On an average, the cost of acquisition has been nearly US$ 55 per tonne.

L&T: Cement valuations
(Rs m)ConservativeOptimisticCemex of Mexico
Enterprise Value (EV/ tonne in US $)65 70 158
Enterprise Value (EV in Rs m) 47,775 51,450 627,465
EV net of debt* (EV in Rs m) 22,775 26,450 328,859
Value per share (Rs)91106 1,128
* Assuming a debt of Rs 25 bn for L&T's cement division.

L&T Ė EPC valuations

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 time, 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 per share.

A comparative view on EPC valuations
(Rs m)ABBBHEL
Total market cap 10,807 42,564
Net sales 10,416 76,563
Market cap/ sales1.00.6

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 200. 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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