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Big Daddy Of Engineering

Scale & technology endow Larsen and Toubro with a strong moat that rivals will find hard to breach…

Engineering and construction, power and hydrocarbons, machinery business, industrial products, electricals, heavy engineering, technology and ship building — L&T’s range of activities covers them all. For sheer size, no rival can match India’s biggest engineering firm. This behemoth with a Rs 1,00,000 crore market cap has seen quite a bit of action over the last few decades: corporate raiders in a period of stagnating profits, engineers bolting to the hot IT sector, and battles with the government for licences. Having weathered many storms, today L&T is a force to reckon with in the engineering and infrastructure space.

Sources of moat
Scale and technology. L&T’s main competitive advantage stems from the scale it has developed over the last few decades and the technology that it has acquired through alliances with the likes of Mitsubishi, Rolls Royce, Boeing and Westinghouse, among many others. Today L&T has an envious track record under its belt: it has built India’s first nuclear powered submarine; Asia’s highest viaduct; the world’s largest coal gasifier (equipment used to convert carbon fossils into carbon monoxide, hydrogen, carbon dioxide and methane); India’s largest range of switchgear; terminal 3 of Indira Gandhi International airport, Delhi; the Dhamra port; and launch and tracking systems for India’s space vehicle, Chandrayaan I. These are just some of the milestone projects that the company has completed over the years. Today L&T has acquired such an iconic status in Indian minds that whenever it takes up a landmark project, there is little doubt that it will execute it well.
A.M. Naik — bulldozing L&T to new heights. Since December 2003, when Naik took over as chairman, the L&T stock has created enormous wealth for its shareholders — upwards of 700 per cent. Over the same period, the BSE Sensex has gained around 250 per cent. Over the same time period, revenue and profits have grown at an annualised rate of 25 per cent and 29 per cent respectively.
Of course, the huge pick-up in infrastructure projects over the last decade also helped, but that still does not take away from L&T’s accomplishments under Naik.

Growth drivers
L&T has a number of growth drivers — nearly all focussed on infrastructure and engineering. These include the following:
Infrastructure. This segment includes roads, bridges, ports, harbours, airports, railways, buildings and factories, urban infrastructure and water. This segment constitutes 36 per cent of L&T’s current order book. Airport modernisation projects, metro rails in tier II cities, and ports are the major growth drivers here. L&T recently bagged the `5,900 crore Metro rail project in Hyderabad.
Power. This segment includes generation, equipment, electrification, transmission and distribution. It is the second-largest segment accounting for 32 per cent of the order book. The huge capacity additions planned in the 12th and 13th Plan are expected to keep the growth momentum strong for the company over the next several years as a large number of new power projects get underway.
Hydrocarbons. This segment focuses on upstream, mid- and downstream projects, pipelines, fertilisers and valves. Hydrocarbons currently constitute 12 per cent of the order book. With crude still hovering at near $100 per barrel, offshore E&P activities has picked up steam, throwing up opportunities for L&T. The company recently bagged a `1,450 crore order from Gujarat State Petroleum Corporation (GSPC) for building an offshore process platform in the latter’s Deen Dayal West Field in KG Basin.
Process. This segment includes minerals and metals and bulk material handling and accounts for 16 per cent of the order book. Opportunities in this segment come from capacity addition in the ferrous metals sector and industrial capex. Material handling demand is driven by railways, mining, ports and power sectors. L&T recently won a `625 crore balance of plant order from Tata Steel for its plant in Kalinga Nagar, Orissa.
Other smaller verticals. These include shipbuilding, defence and aerospace, construction and mining equipment, electrical and electronic products, and technology services. Together they account for 4 per cent of the current order book. In spite of their current low contribution, defence and aerospace will be humungous opportunity areas when they are eventually opened up more for the private sector.

Concerns
Organisational restructuring. Naik retires on September 2012. Before he goes, he has set for himself one final task that promises to change the face of L&T as we know it today. L&T is not a monolith. It operates 25 companies in 152 lines of business and Naik is stitching them up together. When he finishes up, L&T will be a significantly leaner machine with only nine verticals. Smaller companies with revenues of less than Rs 500 crore will either need to scale up or will be sold off. And all of this will happen in the next 15 months before Naik leaves. What L&T will look like after the split remains to be seen. Naik is betting that more focus (by splitting L&T into these verticals) will produce better results. However, corporate history is littered with examples of companies where such drastic organisational exercises have not worked out. Only time will tell whether several baby L&Ts are better than the single behemoth.
Macro headwinds. The macroeconomic problems that the country is facing currently are likely to have an impact on L&T’s performance. Being an infrastructure company, it is vulnerable to a slowdown in GDP growth rate. The slowdown of 2008-10 had, for instance, seen incremental orders dry up as the industry refrained from capital spending till the outlook improved. A similar slowdown in capex is being witnessed currently. High inflation, high interest rates, high commodity and crude prices are some of the key macro issues that could slow down the company’s revenue growth and margins.
Overseas competitors. In the power segment, L&T has to contend with Chinese and Korean players which are currently giving domestic players tough competition.
Difficulties in land acquisition. Land acquisition for mega projects is a thorny issue that has the potential to slow down the implementation of major infrastructure projects.
MENA crisis. The political turmoil in Middle East and North Africa has created a lot of uncertainty for the hydrocarbon segment. Several mega oil projects could get postponed.

Financials
In the most recently concluded financial year (FY11), the company reported 18.8 per cent revenue growth while its adjusted PAT grew 13 per cent year-on-year. Order backlog for FY11 stood at Rs 1,30,217 crore. Order inflows were up 15 per cent during the year, but much lower than the management’s guidance of 25 per cent. The company has given a revenue guidance of 25 per cent for FY12, which appears optimistic, given the slow growth that the global economy is expected to see this year.
Even in India, which accounts for 90 per cent of L&T’s FY11 order book, GDP growth estimates are being revised downwards.
Over the last five years, the company’s revenue has grown at a compounded annual growth rate (CAGR) of 25.76 per cent. Over this period its profit after tax has grown at 34 per cent. Debt-equity ratio stands at 1.26. Over the last five years, the company has clocked a high average return on equity of 27.9 per cent.

Valuation
Currently the stock is trading at a 12-month trailing PE of 24.8, which is lower than its five-year median PE of 32.6. This number, however, does not capture the recent slowdown in the sector (post recession). PAT growth, for instance, in the last three years at 24 per cent annualised is lower than that over the last five years (28 per cent). Similarly revenue growth in the last three years (FY08-FY11) at 21 per cent is slower than the 26 per cent the company witnessed during the last five years. What this means is that EPS growth may remain lower than that seen in the pre-2008 market. The stock is currently trading at price-earnings to growth (PEG) ratio of 0.82.
In view of the slowdown, wait for the stock to correct before investing in it.