>LARSEN & TOUBRO: High investments in non-core and long gestation businesses

Best positioned to tide over the slowdown


■ Growth slowdown inevitable, but concerns exaggerated: L&T is one of the most diversified and the largest E&C player in India. It has far out-paced competition particularly on profitability thanks to 1) its highly integrated operations, 2) strong preference from private sector clients, 3) economies of scale, and 4) stringent risk management and controls. We believe that the concerns on slowdown, though not unfounded, but are exaggerated given 1) high order replacement ratio (>1.3x) despite sluggish environment, 2) superior cash flow generation and 3) strong long term potential.


■ Re-focus on globalisation – a step in the right direction: While L&T is considered one of the largest E&C players globally; it derives only c.10% revenues from international markets. However, with domestic outlook weakening substantially, the company has stepped up efforts in overseas markets, primarily Middle East. While this presents several near-term challenges, primarily stiff competition from Korean and European counterparts (much larger presence and are well entrenched in these markets), it will provide important geographical diversification, which is a step in the right direction in our view. The efforts have also started to pay off with some important break-through in the last year or so.


■ Near-term earning expectations need to be reset lower, but core returns healthy: Current earnings expectations need to be reset lower, in our view; we highlight that our standalone EPS estimates are c.11% below consensus as we have built in conservative set of assumptions on order inflows, margins, asset utilisation etc. While core business returns are set to decline from current levels (RoIC at 32.3% in FY11), they should remain enviable and healthy (we estimate c.22% in FY13-14E period).


■ Stock cheap by historical standards, opportunity to enter: After the recent correction, stock is trading at 11.7x FY13E EPS (adjusted for conservatively assigned values to non-standalone businesses), which is c.15% discount to Sensex (vs historic premiums of over 25-30%; the discount is similar to the ones during 2009 bottoms). We believe valuations have more than factored the impact of slowdown, while long-term fundamentals remain strong. We initiate coverage with BUY and Dec’12 TP of `1,275.


■ Key concerns: 1) High investments in non-core and long gestation businesses, 2) impending changes in business structure, 3) continuing deterioration in macro environment.


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