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UBS Investment Research
L & T
M eeting with management - key takeaways
Event: We met with the management of L&T recently
Key takeaways from our meeting were: 1) Pick-up in activity levels in general this
year compared to last year; 2) Ordering is likely to be strong in Hydro-carbons,
metals and infrastructure. In the power sector, the generation segment has some
issues, while transmission/distribution are likely to be strong; 3) Key reason for
L&T’s margins being higher compared to peers is its integrated business model,
wherein it participates along the entire E&C value chain - design, engineering,
project management, construction and manufacturing.
Impact: Margin downside due to growth in overseas markets unlikely
The company also stated that: 1) Growth in export markets is a diversification
strategy and not for filling-up capacity - overseas growth is not at the cost of
margins and 2) the objective of entering the development business is to benefit
from the equity upside that arises from ownership of complex projects that L&T
executes. So far, L&T has made ~25% returns on projects that the development
business has exited.
Action: Reiterate Buy, Top pick in Indian infrastructure space
The company believes that government action is key and financing is unlikely to
be a key constraining factor for the development of the infrastructure sector in
India. We like L&T for its strong competitive advantages, across-the-spectrum
presence, good execution track record and robust balance sheet.
Valuation: SOTP-based PT of Rs2,100, trading at lower end of band
The stock is currently trading lower than the average of its historical range.
Meeting with L&T - key takeaways
Reasons for high margins - The key reason is the business model of L&T.
It participates along the value chain of the E&C business: 1) Aggregation, 2)
Detailed design and engineering, 3) Manufacturing and 4) Construction (only
the labour portion is sub-contracted). We factor a 60bps decline in
standalone margins for FY12 (guidance of 50-75bps downside risk) and
believe that operating leverage/productivity enhancements could limit dip in
margins (Please refer our note L&T: Looking at key investor concerns dated
30 June 2011).
Management of volatility in commodity prices - About one-third of the
contracts are fixed-price and this has been reducing over the years - almost
the entire order-book used to be fixed-price about seven years ago.
Commodity price risks are managed through: 1) building contingencies in
bids that could be about 5%, 2) back-to-back arrangements/contracts for
supply of raw materials, 3) ordering out the commodities (as much as
possible) as soon as a contract is received and 4) lowering commodity
requirement through better engineering and execution efficiencies. L&T has
been able to increase margins in the last few years in spite of commodity
cycles and we think that any raw material cost push could be offset by strong
operating leverage.
Exports - Unlikely to go above 20% of revenues. Key overseas markets for
the projects business include Middle-East, Africa and Far East. For products
business, the reach is likely to be wider.
Nascent areas - Few business segments, currently nascent, have huge
potential: 1) sanitation, desalination, 2) railways, 3) nuclear (L&T builds
according to the specifications of the technology providers but can execute a
significant proportion of a nuclear power plant), and 4) defense (have
capabilities across the spectrum, except ammunition).
Order book - About 7% of the order book could be slow-moving. Margin
dilutive bidding is not undertaken and hence the growth in order-book is not
at the cost of profits.
Development business - The objective of entering the development business
is to benefit from the equity upside that arises from ownership of complex
projects that L&T executes. About US$3bn is the total equity requirement in
this business and about US$1bn has been invested so far (including grants
and profits made from project exits).
Experience in Development business - So far, L&T has made about 25%
returns on projects that the development business has exited. Out of the
seven road projects that are operational, toll revenues have been below
original expectations in only one project.
Human resources - Availability of trained/skilled manpower remains a key
challenge. L&T trains a large number of fresh employees to bring them up
the skill curve - a large company like L&T can afford to do it (bear the
training cost and also the cost of reworks).
L & T
Larsen and Toubro (L&T) is India's largest engineering and construction (E&C)
company, and is the only dedicated engineering procurement and contracts
(EPC) company in India. It also has interests in electrical goods such as
switchgears and control panels. L&T has several subsidiaries engaged in various
businesses such as IT services, financing of industrial equipment, collection of
toll from roads constructed under the BOT scheme, and power generation. It has
also diversified into shipbuilding and power plant equipment businesses.
Statement of Risk
We believe the main risks to our price target and estimates are: 1) a change in
order inflow estimates, 2) execution issues.
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