Equitymaster Agora Research Private Limited Independent Investment Research 25 November 2011

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Larsen & Toubro Ltd

Buy (Target Price: Rs.1800)
Market Data
Price on reco. date (Rs) CMP - BSE / NSE (Rs) Change since reco. 52-week High/Low (Rs) NSE Symbol BSE Code No. of shares Free float Market cap (Rs m) 1266 (BSE) / 5.7% 1864 / 1217 LT 500510 608.9 m 100.0% 770,867

Investment Rationale Pessimism at its peak: Execution issues, rising working capital requirements and spiraling raw material costs are the key concerns plaguing the engineering and construction sector right now. Further, slowdown in investment cycle due to rising interest rates has impacted the order book and thus the future revenue visibility of these companies. Despite being a very seasoned player, Larsen &Toubro Ltd (L&T) is certainly not an exception here. While revenues in the September quarter increased at a healthy pace (a positive surprise indeed) profits grew at a meager pace of 4.4% YoY. Further, amidst slowdown in the business environment management lowered its order inflow guidance for the fiscal to 5% from an earlier estimate of 15%. Even margin forecast from the Engineering & Construction (E&C) segment was revised downwards due to the current inflationary environment and fixed price nature of the order book. Working capital management concerns emanated during the quarter due to continuous financial support extended to vendors. Muted near term earnings outlook and slowdown concerns have led the stock of L&T to correct by approximately 21% in the last three months. However, we believe that the current reaction is overdone and the market has already priced in the worst case scenario. Further, it may be noted that the current concerns are not structural in nature warranting any re-rating of the business. The stage at which India's economic development is in; infrastructure investments are expected to be the backbone of the country's growth for some time to come. This in turn will benefit companies like L&T whose core business lies in the infrastructure space. As far as the future growth prospects are concerned, it may be noted that the company has a healthy order book to the tune of Rs 1.4 tn. This provides strong revenue visibility into the future. The company is also looking to diversify and increase its presence in international markets. L&T aims to garner 15-20% of its revenues from international markets as compared to 10-12% garnered last year in order to eschew local concerns. This should further support revenue growth in the future. All in all, we believe that the current scenario factors in a pessimistic view presenting a good entry point for investors. The stock currently trades at 13.5 times our FY14E estimates, which is at the lower end the valuation band that we ascribe to the stock. This brings the risk-reward ratio into the favor of long term investors. Hence we recommend you to BUY the stock

Stock price performance

L&T 1-Yr 3-Yrs 5-Yrs -39.2% 17.3% 12.0% Index* -18.5% 21.2% 3.0%

Returns over 1 year are compounded annual averages * BSE Sensex

Shareholding (Sep-2011)
Category Promoter FIIs DIIs Others Total (%) 0.0 15.9 36.2 47.8 100.0

with a target price of Rs 1,800 from an 2 to 3 year perspective. Getting bigger with times: Being India's largest engineering company with exposure across a wide range of industries like oil and gas, civil construction, power and infrastructure does not come easy to L&T. While the repercussions have been seen in terms of exodus of quality people after their years of training on tough projects across the country and outside of it, L&T has still managed to grow consistently, while taking measures to taper the outflow of key people. What is, however, more heartening is that the company has been able to combine profitability with growth. This has been made possible by its participation in projects of increased complexity, especially in the hydrocarbon space. Over the past few years, L&T has increased its focus on strengthening competencies in the high technology intensive oil & gas upstream business, and this is being manifested by large proportion of its order backlog coming from this space. The company has also opened new engineering design centres in India and Middle East to cater to the high technology needs of its customers and is also expanding its manufacturing capacities. We believe that these initiatives are in the right direction and will stand L&T in good stead in the face of increasingly intense competition going forward. High revenue visibility: At the end of September 2011, L&T's engineering and construction (E&C) division (84% of standalone gross sales) had an order in hand position of nearly Rs 1,399 bn, which is almost 3.4 times the segment's trailing twelve month sales. We believe that such a big order backlog provides L&T with a high revenue visibility into the future. However, considering the current execution issues, we expect L&T's revenues to grow at an annual average rate (CAGR) of 15.5% during the period FY11 to FY14 (CAGR of 21.3% during FY08 to FY11). While the revenue growth has been curtailed as compared to the past it still provides enough comfort in terms of future visibility. Strong prospects in hydrocarbons: Deregulation combined with long term global demand for crude has been a positive for the company. There has been a radical change in the government's approach to E&P (exploration and production) activities in the country, which gives a clear indication about the seriousness in ensuring oil security. The thrust in development of new wells and improvement of output from old wells promises brighter prospects for L&T, which is a leading player in the engineering space of the oil and gas segment. Management has also stated that in the second half of financial year 2011-12 orders will be driven by the hydrocarbons segment. Increasing international foray: In the last fiscal, L&T's international revenues were approximately 10-12% of the overall revenues. However, in order to overcome the local slowdown concerns the company is targeting to increase its share of international revenues to 15-20% in the current fiscal. While right now majority of the international revenues come from Middle East the company is focusing on Far East regions as well. Strategy to foray into international markets will diversify and support the revenue growth. Investment Concerns Slow and inconsistent execution: L&T's order inflows over the past couple of quarters have been an area of concern. Although

the company has maintained its full year guidance of 25% growth in top-line we believe that it would be a daunting task for the management to achieve the same considering the current executions woes. Execution delays, which is a reality for the kind of business model that L&T possesses, could hurt company's performance in the future as well. Talent retention issues: As reiterated by L&T's management time and again, retaining talent has emerged as the biggest challenge for the company over the past 2-3 years. People are core to the engineering business as it involves key technological skill-sets. The company had indicated its fears about losing key personnel to competition. Unlike the past, most of the global engineering majors are looking at India and China for growth opportunities, and competition for talent, in that sense, is only going to increase for L&T. Background Larsen & Toubro (L&T) is India's largest engineering company with expertise in wide areas like infrastructure, oil and gas, power and process. The company has broadly segregated its business into two key segments - Engineering and Construction (E&C) and Electrical & Electronics (E&E). While the former contributed to around 84% of L&T's standalone gross sales in the 1HFY12 period, the latter contributed around 8%. Out of the remaining, a large share comes from the company's Machinery and Industrial Products business which contributed about 6.0% to the overall topline. At the end of September 2011, L&T's outstanding order book stood at Rs 1.4 tn. Industry prospects World-class infrastructure has emerged as one of the most important necessities for unleashing high and sustained growth and alleviation of poverty in any economy. And with poor infrastructure to support other growth initiatives, the Indian economy continues to be a laggard when compared to its developing peers. From a policy perspective, however, there has been a growing consensus that a private-public partnership is required to remove difficulties concerning the development of infrastructure in the country. The realisation finally seems to be setting in. This makes the future of the Indian engineering sector extremely bright. Apart from highway development and construction and modernisation of airports, the potential for the sector lies in the oil and gas space, where high global demand has led to increased action in exploration and production activities. Considering these factors, we expect the sector to grow strongly into the future. However, scale and execution capabilities will be the key mantras for success for the engineering companies. Key management personnel A.M. Naik, Chairman & Managing Director, of joined L&T as a junior engineer in 1965. He was appointed Managing Director & Chief Executive Officer of the company in April 1999 and then the Chairman and Managing Director in December 2003. He has successfully led the company through some of its most challenging times, and has enabled it to emerge stronger over the years. R. Shankar Raman , was appointed as a CFO of L&T in September 2011. He is a qualified Chartered Accountant and Cost & Work Accountant. He is also a member of Western Indian regional council of confederation of Indian industries. Over the last 3 decades Mr Raman has worked with various listed companies in the field of finance. Risk Analysis Sector:If one were to outline factors that have impaired India's growth over the past few decades, the poor infrastructure setup shall top the list. Considering the demand of a growing economy, which also boasts of second largest population in the world, existence of world-class infrastructure is no more an option but a necessity. The industry received a fillip beginning FY00, with the government showing increased focus towards developing a strong and sound infrastructure setup in the country. The government is now focusing on a private public partnership model (PPP) for infrastructure creation, which has seen a host of private sector construction players investing in the sector, mainly through the BOT model (Build-Operate-Transfer). While the opportunity is huge, considering the equally large execution risks involved (especially in the power sector), we shall assign a medium-risk rating to the sector. Company standing: L&T is the largest engineering company in India with presence across a wide spectrum of industries like

power, oil & gas, hydrocarbons and infrastructure. We have, thus, assigned a strong rating to the stock on this parameter. Sales: L&T is the largest engineering company in India and has generated average revenues to the tune of nearly US$ 7.1 bn per annum in the past five years. Further, in the current fiscal (FY12), we estimate the company to generate nearly US$ 11.4 bn in revenues. We thus assign the highest rating of 10 to the stock on this parameter. Operating margin: Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as raw materials, wages, and sales and marketing costs. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. The higher the margin, the better it is for the company as it indicates its operating efficiency. L&T's average operating margins for the past three years has been 13.4%, which we expect to marginally decline in during the next three. As such, we assign a medium risk rating of 4 to the stock on this parameter. Long term EPS growth: L&T has grown its net profits at a CAGR of 24.2% in the past three years. Taking a 3-year view, we believe that earnings growth of about 7% is possible. As such, the rating assigned to the stock on this factor is 4. Return on capital invested (ROIC): ROIC is an important tool to assess a company's potential to be a quality investment by determining how well the management is able to allocate capital into its operations for future growth. A ROIC of above 15% is considered decent for companies that are in an expansionary phase. Considering L&T's last three years' average ROIC of almost 8.1%, we have assigned a rating of 2 to the stock on this parameter. Dividend payout: A stable dividend history inspires confidence in the management's intentions of rewarding shareholders. L&T's average payout ratio has been a healthy 16.6% over the past 3 fiscals. Thus, we have assigned a medium-risk rating of 4. Promoter holding: A larger share of promoter holding indicates the confidence of the people who run it. We believe that a greater than 40% promoter holding indicates safety for retail investors. L&T, interestingly, does not have a promoter group and the largest shareholders in the company are the public sector banks and financial institutions. As such, we have not given any rating to the stock on this parameter. FII holding: We believe that FII holding of greater than 25% can lead to high volatility in the stock price. The FII holding in L&T at the end of September 2011 stood at 15.9%. Based on our parameters, the rating assigned is 5. Liquidity: The average daily trading volumes of L&T's stock over the past 52 weeks stand at over 295,370 shares. Such high liquidity level is a matter of comfort, as this might protect the stock from undue volatility in case of exchange of large holdings among market participants/investors. The rating assigned is 10. Current ratio: L&T's average current ratio during the period FY08 to FY11 has been 1.7 times. This indicates that the company is comfortably placed to pay off its short-term obligations, which gives comfort to its lenders. We assign a medium-risk rating of 5. Debt to equity ratio: A highly leveraged business is the first to get hit during times of economic downturn, as companies have to consistently pay interest costs, despite lower profitability. Considering L&T's average debt to equity ratio of 1.2 over the past five fiscals, we have assigned a medium-risk rating of 2 to the stock. Interest coverage ratio: It is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period. The lower the ratio, the greater are the risks. Given L&T's average interest coverage ratio of 9.4 times over the past three years, we accord a low risk rating of 10 to the stock on this parameter. P/E Ratio: The P/E ratio (price-to-earnings ratio) of a stock is a measure of the price paid for a share relative to the per share income or profit earned by the company. This is one of the important metrics to judge the attractiveness of a stock, and thus gets the highest weightage in our risk matrix. L&T's P/E on the trailing 12 month earnings stands at 18.3 times. Considering the

average industry multiple (engineering companies trade at a higher PE band) and future earnings growth prospects we have assigned a high risk rating of 3 to the stock on this parameter. Considering the above analysis, the total ranking assigned to the company is 59 that, on a weighted basis, stands at 4.3. This makes the stock a medium-risk investment from a long-term perspective. Risk Matrix
Rating accorded Rating Sector risk Company's standing Performance parameters Sales Operating margins Long term EPS growth Return on invested capital Technical parameters Dividend payout Promoter holding FII holding Liquidity Safety parameters Current ratio Debt to equity ratio Interest coverage ratio P/E ratio Final Rating** 5.0% 10.0% 5.0% 20.0% 5 2 10 3 59 0.3 0.2 0.5 0.6 4.3 5.0% 10.0% 5.0% 10.0% 4 5 10 0.2 0.3 1.0 5.0% 5.0% 10.0% 10.0% 10 4 4 2 0.5 0.2 0.4 0.2 Weightage* (A) Rating# (B) Medium Strong Weighted (A*B) NA NA

# Rating has been assigned on the basis of the company's performance over the past five years and expected performance over the next 3 to 5 years. Rating is on a scale of 1 to 10, with 1 indicating highest risk and 10 indicating lowest risk. * 'Weightage' indicates the relative importance in percentage terms of the parameter. For instance, for an investor, given all the performance metrics, return on equity should be the foremost criteria for buying/not buying stocks. ** The final rating has been arrived at by multiplying the rating/points given on each parameter with the respective weightage.

Valuations At the current price of Rs 1,266, the stock is trading at a multiple of 13.5 times our estimated FY14 earnings, which we believe makes it an attractive proposition for long-term investment. Although there are near term concerns over execution, rising working capital and deteriorating margins most of them have been priced in. We believe that the current scenario factors in a pessimistic view presenting a good entry point for investors As such, we recommend a BUY' on the stock as we expect it to fetch a CAGR of 16.7% over the next 2 to 3 year period. Valuations
(Rs m) Revenue (Rs m) PAT (Rs m) EPS (Rs) Price to earnings (x) Price to book value (x) Price to sales (x) FY11 FY12E FY13E FY14E

520,891 594,609 688,102 802,104 44,562 73.2 16.7 3.0 1.4 42,888 70.4 17.4 2.6 1.3 48,241 79.2 15.4 2.3 1.1 54,848 90.1 13.6 2.1 0.9

Financials at a glance
(Rs m) Net sales Sales growth (%) Operating profit Operating profit margin (%) Net profit Net profit margin (%) FY11 520,891 19.7% 77,575 14.9% 44,562 8.6% FY12E 594,609 14.2% 77,299 13.0% 42,888 7.2% FY13E 688,102 15.7% 86,013 12.5% 48,241 7.0% FY14E 802,104 16.6% 96,252 12.0% 54,848 6.8%

Balance Sheet Current assets Fixed assets Others Total assets 568,124 159,573 218,080 945,777 639,685 144,305 211,700 995,689 729,080 151,919 205,320 1,086,319 837,803 157,203 198,940 1,193,946

Current liabilities Net worth Loan funds Others Total liabilities

304,642 250,506 328,285 62,344 945,777

320,732 283,424 328,285 63,248 995,690

373,295 320,452 328,285 64,287 1,086,320

437,628 362,551 328,285 65,481 1,193,946

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