L&T: Q4 numbers disappoint, but valuations don't

Company has historically traded at 28% premium to the Sensex but now valuations on a par with the benchmark

Frustrated with the challenges afflicting economic growth at home, Larsen & Toubro (L&T), the country's largest engineering and construction (E&C) company, has been seeking growth opportunities abroad. While it has succeeded in doubling international revenues in FY13 to Rs 12,110 crore, this has come at a price. The company's margin in the international business is 8.5 per cent while it is 11.5 per cent for India. This internationalisation is neither sufficient to compensate for the slowing growth at home nor is it very profitable. So, even as international business orders account for 17 per cent of the order book inflows of Rs 88,000 crore in FY13, analysts are quite excited. This shift in business mix has affected profitability.

During Q4 FY13, the company's operating margins declined 180 basis points (bps) to 12.1 per cent, while operating income declined four per cent year-on-year (y-o-y), even as revenues grew 10 per cent.

The decline in margins has also been affected by a fall in margin of the E&C business. This E&C business saw margins decline 230 bps in Q4 to 12.2 per cent. Consequently, Q4 net profit too, declined seven per cent y-o-y, even though for the full year, profit after tax grew 10 per cent.

Falling margins is an issue as much as high interest rates for the Street. Since May 13, the stock rose six per cent on hopes of a rate cut by the Reserve Bank of India while the Sensex rose two per cent.

After looking at the sharp rise in interest costs, there is no doubt the company would be a big beneficiary of rate cuts. L&T's interest cost went up 132 per cent y-o-y in Q4 FY13, while for the full year, its interest cost increased 47 per cent. The company says the spike in interest charge was due to higher average level of borrowings and rise in funding costs.

The road ahead does not look any better. Though L&T expects order flows to grow 20 per cent and margins to remain stable, the Street is not comforted by this prognosis. Also, its earnings growth is unlikely to keep pace with the 50-per cent dilution in its equity base due to the bonus issue for the near term.

However, the saving grace is that valuations are not rich. Given that L&T's price/earnings ratio is now in line with the Sensex, unlike the 28 per cent premium the stock has commanded, analysts say valuations are fair. Emkay Global says: "Its core engineering and construction operations are discounting FY15 earnings at 14.1x. These valuations display a high level of pessimism and a lack of froth."