Stock Review: Larsen & Toubro

 

The Larsen & Toubro stock moved up nearly two per cent after the company decided to seek shareholders' approval for the transfer/sale of its electronics and automation (E&A) division. According to various estimates, valuation of the E&A deal (if the sale comes through) has been pegged at `10,00014,000 crore, three-five times the division's annualised revenues in the first nine months of the financial year 2011 (9MFY11). This is much higher than the `7,500-8,000 crore ascribed by analysts in their sum-of-the-parts estimates. Sharekhan analysts believe any strategic premium attached to the E&A business would be value accretive for L&T. The division has been facing tough competition in the domestic market from multi-national companies and has reported falling margins for the nine months ended December. The latest move, to separate the E&A division, is part of L&T's restructuring exercise to exit non-core businesses, where the company is not a clear leader or returns are dilutive.

FUNDING INFRA DEVELOPMENT

If L&T manages to get a premium from the sale, the money will be useful in funding the capital guzzling infrastructure development business, which has become a key focus area for the company. L&T has lined up a capex of `61,300 crore for it, which will require an equity contribution of `18,400 crore ($4.2 billion), considering a 70:30 debt to equity ratio.

Considering the average valuation of `12,000 crore ($2.6 billion), the deal will partly help in funding of the infrastructure development business. This will put less pressure on the balance sheet and lead to a better control over interest costs, finally resulting in better earnings growth or profitability and upgrades to core business valuation due to improved prospects.

UNCERTAINTY, RISK

In terms of financial performance, the sale is not expected to make much of a difference to overall revenues, as it contributed less than 10 per cent of L&T's total revenues (seven per cent to be precise) in 9MFY11 and made similar PBIT margin as its core engineering and construction (E&C) business. Thus, any loss of revenues and profit due to the sale of E&A is expected to be compensated by the engineering and construction division, given the mammoth opportunities (especially roads and power), which have gained pace recently. Questions, however, remain according to Sharekhan analysts as to the timely completion and returns from the development projects that are likely to add a bit of uncertainty to the stock. Though the business logic seems to be sound, analysts such as Bharat Parekh of Bank of America Merrill Lynch are not optimistic about the company's move to exit E&A and particularly the products business, which is less risky (less lumpy and volatile) and does not need as much capital compared to the projects business. "We are not convinced that the new infra assets of L&T could create higher value versus its asset light E&A business," he says.

CONCLUSION

The company will become a pure projects company and hence a risky bet (in terms of investment) if it follows the sale of E&A with machinery and industrial products division (again seven per cent of total revenues), which makes almost double the OPM of E&C—around 19 per cent in 9MFY11. Further, the entire infrastructure space has become competitive over the years, as other relatively smaller players are also exhibiting new capabilities in various infrastructure segments for fuelling future growth. Hence, the company is better off having a good mix between products and projects businesses, feel analysts. However, in the short term, all eyes are pinned on the company's ability to achieve 2010-11 order inflow growth prediction of 25 per cent (target of `87,000 crore), given muted growth of eight per cent in the same at 49,450 crore in 9MFY11. Till that time, the view is cautious, despite the stock providing return potential of 34 per cent considering an average sum of the parts target of `2,285.