UBS Investment Research
L & T
C ompany meeting takeaways
Event: Execution in the power sector is on track
There have been concerns lately on progress of project execution in the power
generation sector. L&T highlighted that execution of power projects in its order
book are on track, except for the Karchana project of Jaiprakash. Though ordering
in the power generation segment is likely to be low, it expects good growth in the
T&D segment both in the Middle-East and India.
Impact: Listing of the development business could be in a year’s time
Major funding requirements in this business would set-in in about a year’s time
and hence listing would be appropriate. This in our view would free-up the parent
entity to invest in other growth ventures (~US$350m likely investment in FY12,
similar amount invested in FY11; listing of Finance sub, another investment-heavy
business, has already been done this year). L&T continues to be conservative in
this business and would be selective in adding new projects. It would continue to
follow a strategy of exiting projects after eliminating execution risks.
Action: Operating leverage could provide support to margins
Vertical integration has been the key driver for margin expansion over last several
years, though further upsides on this count are unlikely. Operating leverage could
aid margins. It believes commodity price volatility is the key risk and there has not
been a significant change in the competitive landscape. EBITDA margins in the
BTG business could be ~15% in a few years on the back of indigenization.
Valuation: Reiterate Buy, Top pick in Indian infrastructure space
The stock is currently trading at lower than the average of its historical range.
Meeting with L&T- key takeaways
Power segment: L&T stated that execution of power projects contained in
its order book, except the Karchana project of Jaiprakash, is on track (L&T
had stated in the Q1 conference call that there are land-acquisition related
issues in this project, and its execution is not a part of the guidance for
FY12). While power generation orders will be low this year, it expects good
growth in the T&D segment in the Middle East as well as India (it also stated
that orders in the Buildings and Factories have surprised on the upside so far).
Out of the Rs35bn order that it received from the PPN Power Generating
Company in Q1FY12 for gas-based power projects, it has booked only one
unit of Rs14bn so far. The balance two units could be booked in December-
PPN is likely to issue Notice to Proceed to the EPC contractors as it could
receive comfort on gas availability by then. Though no ordering is taking
place on gas-based power projects, prospect negotiations are on and orders
will be placed whenever clients get comfort on gas availability.
Margins: L&T thinks that vertical integration has been the key driver of
margin expansion since 2005. Further upsides on this count are unlikely
though. Operating leverage could provide some support margins, though
commodity price volatility remains the key risk (about 35% of the contracts
are fixed-price). There has been no significant change in competitive
landscape that could impact margins. Long-term margins in the E&C
business are likely to be about 12% (we factor 12.1% EBITDA margins in
FY12; margins in FY11/FY10 were ~12.7%/12.8%; L&T has guided for 50-
75bps downside risk to margins in FY12). There is no material impact likely
on margins due to change in execution mix between different segments.
BTG margins: As this is a manufacturing business, margins are likely to be
higher than EPC margins, and could be about 15% in a few years time.
Margin improvement will be driven by indigenization- will take about a year
for turbines and about a couple of years for boilers.
Development business:
— Listing: Likely in about a year’s time, when major funding requirements
will come in. Though, both timing and form are not yet finalized- listing
for example could happen separately for different verticals- projects in
different verticals are at different stages of execution (road portfolio is
currently more mature and all 16 projects could be operational in about a
year’s time). L&T has 97.65% stake in this entity (it had purchased the
stake of PE investors last year).
— Additions to portfolio: Significant additions are unlikely going forward
and L&T will continue to be selective/conservative. Road projects could
be added if it gets good IRRs. T&D- it has bid, but not been successful so
far. Power- inclined towards Case 2 projects, with necessary linkages in
place and pass through mechanisms. Urban infra- is gradually exiting,
though Seawoods would be an addition (the company is positive on
transit-oriented developments). Railways- looking at opportunities in
monorail/metros across cities (Tamil Nadu might come up with a 111km
monorail project, though not known yet if it will be on a PPP basis).
Water/gas grids- could be big, but are nascent as of now.
— Thought process behind entering this business: 1) Significant business
opportunity in the infrastructure development space, 2) Forward
integration for the company (strategy of vertical integration has been
followed by the company across its various business segments), 3) Equity
upside from leveraging execution expertise and balance sheet strength (it
is better positioned in this regard in comparison to competition) and 4)
Adds a steady revenue stream on the relatively volatile/lumpy E&C
business.
— Exit strategy: Strategy is to benefit from equity upside after eliminating
execution risk. Typically would like to divest after two years- once base
traffic and traffic growth patterns are established. Unlikely to hold entire
stake for the full concession period of a project.
— Relationship with parent: Operates on arms-length basis. The
development business takes quote from independent consultants to
validate the pricing offered by the E&C arm for executing a project. It has
the flexibility to award projects to outside entities (has done that in the
past), though right of first refusal is with the E&C arm if it matches the
outside bid.
— Orders pending: Most of the orders from the development portfolio have
been placed on the E&C arm. Pending orders are- 1) ~US$1bn of
728MW hydro projects (to be placed in a few years, currently projects are
in DPR stage), 2) Balance order from Hyderabad Metro (major proportion
has already been placed- about US$1.6bn), 3) Dhamra Port expansion and
4) KPCL power project (likely in FY13).
Hyderabad Metro:
— Risks: L&T has very good control over two out of three key risk
elements- execution (has been involved in Delhi, Chennai and Bangalore
metros and is executing the Mumbai monorail) and financing (strong
balance sheet). For understanding revenue risks, L&T did a due diligence
for a long time- for about a year. It expects about 18% equity IRRs from
this project.
— Revenues: It expects about 50% of revenues from ridership and about
50% from real estate rentals and advertisement. Three independent
consultants provided ridership estimates ranging from 12-22m; L&T used
~15m in its projections. Total real estate development is about 18msqft,
though it plans to develop about 6msqft in the first phase (it has a very
good understanding of the Hyderabad real estate market as it is present
there as a developer). It has assumed no revenues till the end of the fifthyear
from the agreement date, though the concession agreement allows it
to start operations on a line (the project has several lines) as and when it
is completed.
— Land acquisition: Over 90% of the land required for the project has been
acquired and it is not a major issue in this project. Execution has already
commenced though it will be in full swing only in about a year’s time.
Power projects:
— Rajpura project: Expects equity IRRs of ~15%- the threshold level for
the company for annuity projects. Execution of 2x 700MW has
commenced. Execution on the remaining unit of 1x 700MW has not
started and is currently on hold, pending coal linkage.
— KPCL: This 2x 800MW project (in 50:50 JV with the Karnataka govt), is
likely to be booked as an order in FY13. This project was not included in
the order inflow guidance for this year.
Ports:
— Dhamra: The port currently has a capacity of 27mt capacity and the
likely throughput in FY12 is 15mt. The company is finalizing more take
or pay contracts. Capacity can be increased upto 90mt. The port has a
draft of 18m and can take capsize vessels of 180,000DWT- it is in a sweet
spot given that other ports in the region have lower draft. This JV port is
under IDPL.
— Katupalli: This container port, 40km north of Chennai, has a capacity of
about 1.1m TEUs. It would be operationalized within a year’s time. It is
currently not a part of IDPL.
Subsidiary investments: Likely to be Rs15-20bn this year, primarily in the
development business. Balance investments would be in shipbuilding and
forging subsidiaries.
Valuation
We have a Buy rating with a SOTP-based PT of Rs2,100.
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.
