The following are excerpts from the recently-issued Stock Analyst Report on Larsen & Toubro Limited, published by Morningstar Analyst Manish Vaswani. Registered Morningstar Members gain exclusive access to our full L&T Analyst Report (PDF), including financial and company overviews, fair value estimates, consider buying/selling prices, bull and bear breakdowns, stewardship and risk analyses. Not a Registered member? Get these reports immediately when you sign up with Morningstar for free.
Larsen & Toubro's (L&T) strong business franchise, solid project execution track record, and a broad exposure to diverse industries have helped the company grow revenue and earnings, both in domestic and international markets.
However, even though L&T operates in diverse businesses which provide multiple revenue streams, we believe the company doesn't have an economic moat, since a majority of its revenue is derived from low-margin engineering and construction (E&C) business.
L&T has earned excess returns (on invested capital) over and above its cost of capital in three of the past five years, and we expect this trend to continue. L&T occupies a dominant position in the highly competitive domestic E&C industry, and has created a strong brand image as a result of nearly seven decades of strong project execution performance.
The company's order book is well-diversified across industries such as infrastructure (roads, ports, rail and shipbuilding), power (generation and transmission & distribution), process, hydrocarbons (upstream, mid & downstream and pipelines), and construction.
L&T has benefited from a surge in domestic infrastructure development activities, especially from infrastructure spending by the government through public private partnership routes. Infrastructure now accounts for nearly half of the current order book (as of December 31, 2012).
Even though order inflows from the infrastructure segment continue to be robust in the current fiscal, we think L&T may be overly exposed to this segment, and any slowdown in infrastructure spending will materially harm the company's future growth and profitability. L&T derives more than 75% of its revenue from the E&C segment.
However, owing to the highly competitive nature of the E&C industry, these margins are lower compared with those in other businesses the company operates in.
Additionally, any margin enhancement due to cost optimization and operational efficiency improvement measures may not be sustainable, owing to volatility in commodity prices and intensifying competition in the industry. Since we expect low-margin E&C segment contribution levels to remain at an elevated 75% level, we do not expect sustainable excess returns on invested capital for the consolidated operations.
The company also derives 6% of its revenue from the electrical and electronics ("E&E") segment, 5% from its machinery and industrial products ("M&IP") segment, 5% from its financial services ("FS") segment, 2% from the development projects segment, and another 6% from other segments, including information technology and mining and aviation.
Although L&T obtains higher margins from these segments as compared to the E&C segment, we do not expect any material improvement in revenue and margin contribution from these segments, except the financial services segment in the mid-term.
Increased competition in various segments, such as from ABB, Sneider and Havells India in the E&E segment and from JVC, Caterpillar and Jaypee Engineering & Hydraulic Equipment Ltd in the M&IP segment, also constrain future growth to much lower levels compared with 30% to 40% as seen in the past.
In the financial services segment, the company has a presence in equipment finance, rural finance, infrastructure finance, and asset management. We expect FS revenue to increase at a compounded annual growth rate of 35% in the forecast period primarily owing to an expected increase in infrastructure financing coupled with continued growth in rural financing, leading to a 10% estimated contribution (from 5% level in 2012) to overall consolidated company revenue in 2017. We expect this enhanced contribution from the FS segment to result in overall improved margins for L&T in the forecast period.
However, due to the E&C segment's weighting (average 75%) in overall revenue in the forecast period, we expect consolidated margins to improve gradually in the next five years, leading to excess returns (over and above the company’s weighted average cost of capital) only in the last two years of our explicit forecast period.
The company is steadily increasing its footprint in the international market (primarily the Middle East), especially in the E&C segment through various subsidiaries and joint ventures.
Exports' revenue contribution has increased to about 21% in current fiscal 2013 from 17% in 2008. However, competition in the Middle East market is very intense, with the likes of global E&C majors such as SNC-Lavalin Group and Leighton Holdings Limited (which has lost AUD 1 billion in the last four years) competing for low margin fixed price contracts, wherein adequate cost management becomes crucial, and any cost overruns can lead to even lower margins.
We believe that this strategy of increasing business--especially in the Middle East—conveys enhanced risk and suboptimal return to L&T, and we do not expect L&T’s international business to provide any sustainable competitive advantage in the long term.
Valuation, Growth and Profitability
Our fair value estimate for Larsen & Toubro is INR 1,289 per share, which implies forward fiscal 2013 price/earnings of 18.1 times, an enterprise value/EBITDA of 12.3 times, and a free cash flow yield of 0.1%. We employ a 8.9% weighted average cost of capital, which reflects a 13% cost of equity and a 7% pre-tax cost of debt, to discount projected future cash flows. We forecast the company’s E&C sales revenue to grow at a compounded annual growth rate of 16%, with this segment continuing to contribute about 75% of overall revenue during the forecast period.
A robust order book which provides visibility for the next two-and-a-half to three years, expected increase in government spending on infrastructure and pick-up in orders from the power and hydrocarbon sectors as the economy starts to improve from fiscal 2014 underpins this growth. However, we expect increasing competition from global and local majors to limit growth to average 16% compared with 29% of the last five years.
We also expect the E&E and M&IP segments to rebound from fiscal 2015, owing to an improved domestic capital spending environment leading to average growth rates of 9% and 5% respectively (compared with 18% and 13% respectively in the last five years).
We believe the financial services business will continue to grow at a healthy average rate of 35% due to expected increase in infrastructure financing and continued growth in rural financing, albeit slower than the 67% recorded during the last five years.
Additionally, we also expect the company’s development projects business, to grow at an average annual rate of 22% (slower than the average 55% levels in the last five years) and other businesses, which include information technology, mining, and aviation, to grow at an average 15%, comparable to the past five years.
We model cost of goods sold to average 73.5%, which is slightly higher than the average 73.1% in the last three years, reflecting higher commodities and labor costs which will more than offset gains from cost control and productivity enhancement initiatives.
We model average operating margin at 11%, a decline of about a percentage point from the last three years, reflecting pressure on margins due to increased competition in its businesses and higher operational costs. Return on invested capital improves to approximately 10% (compared with our 8.9% cost of capital assumption) by fiscal 2017, suggesting the firm is still far from establishing an economic moat.
Risk
Since more than three quarters of the company’s operating revenue comes from its engineering and construction business, L&T has done well to diversify across sectors in the domestic market.
However, infrastructure has started to emerge as a dominant part of the company’s overall E&C portfolio, accounting for almost half of the current order book. This exposes a good portion of the company’s earnings and cash flow to potential slowdowns in infrastructure spending by the government or private sector.
Increasing competition from global E&C players and local construction firms combined with continued slowdown in the overall economy and persistent inflationary conditions could further lead to pressure on the company’s margins.
Projects in the E&C industry are awarded on a case-by-case basis and largely dependent on the reputation and project management capabilities of various companies, and L&T has historically done well based on its merits. However, any mismanagement of a major project could have significant implications for the company’s operations.
Additionally, if L&T were to become embroiled in a controversy related to corrupt practices, like the one highlighted recently about a senior company executive indulging in fraud to win a World Bank contract, it could have serious long-term ramifications for L&T’s reputation and business.
Other risks facing the company, especially in the power, infrastructure, defense, fertilizer, water and railway sectors, stem from potential changes in government policy as well as availability of resources to finance large projects.
Furthermore, delays in securing environmental clearances, land acquisition issues, fuel shortages and competition from Chinese equipment manufacturers could lead to further delays in setting up new power plants.
L&T’s increased presence in international markets also exposes the company to foreign currency exchange rate risks, and intense competition from global majors for lower margin projects.
