L&T: Hold

Recommendation: Hold

S. Vaidya Nathan

IT IS only non-sustainable revenue streams that have kept Larsen & Toubro's reported earnings levels in the black.

Knock them off, and the sustainable earnings stream for the July-September 2000 quarter and the first six months of fiscal 2000-2001 is steeped in red.

Clearly, the company is paying a stiff price for its high degree of diversification. The cement business (the company is the largest player in the industry) seems to be casting a shadow on the earnings stream. This division, which was expected to break-even last fiscal, continues to be in the red.

But the steep decline in the performance cannot be attributed to the cement business alone. There are other problems, though the IT business may have delivered some value. A high level of financial charges continues to weigh on the bottomline as the debt levels are fairly high.

Had the company managed to maintain its operating profit margin, the heavy financial charges (close to Rs 175 crore) may not have mattered much. But with the OPM at their lowest level in the last six quarters, there has been a dent in the bottomline.

The OPM had moved into the single-digit territory of less than 9 per cent in the first quarter (April-June 2000) itself. This was in sharp contrast to the 13.55 per cent margin in the 1999-2000 first half period and the full year margin of 11.04 per cent for 1999-2000.

For the latest quarter, the OPM slipped to 7.24 per cent, leaving little room for a respective earnings stream. The turnover growth continued to be sluggish, with little improvement from last year. As against less than a percentage point increase in revenues, expenditure is up 7.74 per cent.

This has led to a 44 per cent decline in operating profits. Top it with the heavy interest and depreciation charges, the reason for the slip up in performance is complete. In the first six months too, the growth in revenues was only marginally better, but the slippage on the profitability front is evident in the numbers.

Where is L&T headed?

If things go as per the latest announcements, the company may well have the cement business off its back some time in the next six-eight months. But given L&T's track record in this respect, it may be better to wait for things to take a concrete shape.

The cement business is to be demerged and vested in a separate company. A stake for L&T shareholders as well as a foreign partner is on the cards. What the demerger will do is to remove a major drag on its financials. It may lead to better value provided the issue of ownership claims and choice of foreign partner is handled in a manner that would improve shareholder value over the medium-to-long term.

This demerger assumes importance as L&T's cash flows are under strain. For a company of its size, the sustainable cash flows of around Rs 48 crore pale in comparison to the nearly Rs 600 crore that was managed last fiscal. The low level of cash flows may act as a stress factor on the company's growth plans. It is in this context that the roping in of a partner for the cement business assumes significance.

The demerger of the cement business may also lead to a shifting out of significant part of the debt burden from L&T's balance-sheet. Only then would the shape of L&T's residual businesses become clear, though it is a safe to presume that the picture would be better.

More bleeding in store

But before the cement business is demerged, some more bleeding may well be in store. Not only has there been a flattening of volumes, prices have come under pressure in markets where L&T has a major presence. This could affect the performance in the third quarter and may be even beyond.

The slowdown in the broad industrial economy could also affect the fortunes of other businesses such as engineering and construction. The cut in expenditure by the government and the rise in oil prices, whose effects may be felt some time down the line, could also hamper growth prospects.

Even last fiscal, the performance dipped in the second half. This seems likely this year too and, perhaps, in a more pronounced manner. In this backdrop, the stock may hold some more downside risk though it is down 75 per cent from early January. But shareholders with a long-term perspective could stay invested as there may be some re-rating once the cement business is got out of the way.