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In our July issue on companies having economic moats, we had picked Larsen & Toubro (L&T) due to its sheer size and technological superiority. Over the past few decades, L&T has grown into India’s biggest player in the capital goods sector. The technologies that it has acquired through alliances with the likes of Mitsubishi, Rolls Royce, Boeing and Westinghouse have played a critical role in its growth.
However, the health of the capital goods sector is closely tied to the economic cycle. Owing to the ongoing downturn this stock’s price declined into triple digits recently.
Current concerns
Along with its Q2FY12 numbers, the management announced a two-third cut in incremental order inflow for the full year FY12 to 5 per cent. FY13 could also be a flattish year for the order book.
One of the most crucial sources of orders, the power sector, has been going through a difficult time on account of fuel-linkage related problems, the deteriorating financial health of state electricity boards, and the current structure of rate-based competitive bids. The recent circulation of a draft note regarding import duties on power equipment totalling 14 per cent (but with a different structure) was another turn-off for both the power sector and the capital goods space. After contracting by -26.5 per cent in October, the capital goods sector contracted by another -4.6 per cent y-o-y in November (part of IIP numbers).
Besides power, the investment cycle has stalled for other verticals too due to the high interest rate environment and policy issues. With FY13 also expected to be a difficult year, L&T’s management is looking for growth avenues abroad. According to R. Shankar Raman, the company’s chief financial officer, L&T plans to increase its revenue share from overseas projects from its current 10-12 per cent to 15-20 per cent.
As new projects get deferred or cancelled, a situation could arise where many firms would chase the few orders that come up. This would erode margins within the sector. However, L&T’s management has said that the company is preparing for such an eventuality by adopting cost-cutting measures.
Valuation
L&T’s current P/E multiple of 17.77 is at a discount of 29 per cent to its five-year median P/E of 24.94. When we had last written about this company in our July 2011 issue, it was trading at a P/E multiple of 23.
Over the past five years, the company’s earnings per share (EPS) has grown at a CAGR of 30 per cent. This translates into a price-earnings to growth (PEG) ratio of 0.63 (compared to 0.92 in July 2011).
Price to book value ratio of 3.17 is 41 per cent lower compared to the company’s five-year average of 5.35. Enterprise value to sales (EV/sales) ratio stands at 1.98, 21 per cent lower than its five-year average. Dividend yield is currently at 1.14 per cent.
In our previous coverage of L&T in the July 2011 issue, we had recommended that investors should wait for concerns to get priced in. That has already happened. Interest rates appear to have peaked and a turn in the rate cycle seems imminent. Once interest rates start coming down the investment cycle could revive. Valuations of this capital goods major are extremely attractive. Investors with at least a three- to five-year investment horizon should purchase this stock at its current levels.
Disclaimer: This content is for information only and should not be considered investment advice or a recommendation.
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