The Hindu Business Line : Larsen & Toubro: Buy

L&T's 2,400 tonne gas injection platform headed for Abu Dhabi, among the heaviest deliveries to be made out of India.Execution of such projects will serve as a reference point for a buoyant order-book.

LARSEN & Toubro's strong order flows, diversification in international markets and efforts to focus on core businesses have enhanced the long-term earnings growth prospects and imparted a high degree of visibility.

The L&T stock (Rs 1,844) trades at 18 times its FY-06 expected per share earnings. The stock's premium valuation compared to other players in the sector appears justified on the back of a solid order backlog and order books. Buy with a two/three-year perspective. Returns can, however, be moderate in contrast to the manifold gains over the past couple of years.

With a sound track record, L&T has emerged as a key beneficiary of a boom in industrial capital expenditure and huge investments in the infrastructure segment. The company's qualification in almost all segments of infrastructure work, coupled with the relatively bigger size of its balance-sheet, gives it an edge over other infrastructure players in the country.

Order-book momentum

After a sluggish phase up to December 2004, L&T's order-book picked up sharply and the trend has continued. The company now has an order backlog of over Rs 20,000 crore. About 39 per cent of the order backlog comes from the infrastructure segment, indicating that the company has capitalised on the boom in this sphere. The order-book position is also robust. The existing order-book and imminent order flows are likely to translate into a 20 per cent annual growth in top line over the next two/-to-three-years.

Positive factors

The following aspects also strengthen the case for an investment:

To focus on the core businesses, L&T has gradually divested other fringe activities from its mainstream.

While it exited the milk and dairy segment last fiscal, the tractor and glass container businesses were sold this year. These moves are likely to improve the resource utilisation of the company.

L&T's initiative to increase overseas revenue is starting to yield results. For the half-year ended September exports accounted for 22 per cent of revenues from engineering and construction segment. Execution of projects in West Asia and select African nations is likely to serve as a reference point for bagging orders in other foreign markets.

L&T's foray into these markets through joint ventures and associates will mitigate the risks related to entering unknown territories.

L&T is one of the early entrants in the build-own-operate-transfer (BOOT) models for infrastructure projects, which require capital participation by the company as well. The company plans to consolidate the various special purpose vehicles formed for the purpose and transfer it to a holding company.

Once such a consolidation happens, it may help L&T raise capital at the holding company level. This move will not only enable future participation in large projects, but also hive-off the risks involved in BOOT projects.

Hydrocarbon, the key

L&T has shown heightened interest in bidding for projects in the oil and gas business, including expansion and modernisation of refineries, construction of oil platforms and pipelines. Two recent orders of Rs 1,000 crore each from ONGC shows that the company is well on the hydrocarbon trail. L&T already holds pre-qualification for such projects in West Asia. In the domestic market, apart from ONGC, exploration activities by British Gas and Cairn Energy can pave the way for further order flows.

Ample opportunities for gas in the Kakinada belt are likely to throw open prospects for deep-water engineering. L&T is already on the lookout for joint ventures and acquisitions in deep-water expertise. If the company is able to capitalise on these imminent opportunities, then hydrocarbon may become a major revenue contributor.

Financial performance

Revenue growth was subdued in the recent quarter. The growth is likely to be robust by the end of the fiscal when a majority of the order backlog translates to revenues.

L&T's operating margins have been a tad lower than its peers'. A surge in staff expenses attributed to performance-linked bonuses also acted as a drag on operating profits; this is, however, an initiative that is beneficial from a long-term perspective. This reward has been instituted for the first time and its impact will be lesser in the future, as the effect of one-time payment abates.

We believe volumes will drive margins. Lower steel prices are also likely to provide a support cast. Further, revenues from electrical and electronics segment have expanded. The proportion of turnover from this segment will widen further once the Chinese operations in this segment commence in early 2006. As this segment operates on higher margins, it is likely to improve the profitability level.

We remain bullish on the stock and reiterate buy. Any reversal in the current capex spending trend by industries may drag revenues from industrial infrastructure projects and remain a key risk.

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