Larsen & Toubro: Potential 50% Upside For This Infrastructure Major

| About: Larsen & (LTOUF)
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Summary

Larsen & Toubro, India’s largest infrastructure company has surged by 69.5% in 2014.

The rally in the stock is likely to continue with government change and a positive budget being the near-term triggers.

Valuation gap compared to peers points to a potential 47% upside over the next 24 months. Lowering of interest rates can accelerate the upside.

Strong order inflow expected in FY15 and strong revenue guidance for FY15 will keep the stock firm.

Thesis Summary

Larsen & Toubro (OTC: OTC:LTOUF) is India's largest engineering and construction company with FY14 sales of $14.2 billion and a current market capitalization of $26 billion. The company's stock has been in the pink of health with the stock surging by 69.5% in YTD2014. The stock surge has been backed by big changes in the Indian political landscape, which are likely to bring about major economic reforms. This article discusses the reasons for the recent stock upside, the positives from government change in India, the benefits from the recent budget and the reasons to remain bullish on Larsen & Toubro with a two year investment horizon.

Company Overview

Larsen & Toubro Limited operates as a technology, engineering, construction, and manufacturing company and is India's largest infrastructure company. Larsen & Toubro Limited is the biggest legacy of two Danish Engineers, Henning Holck-Larsen & S.K. Toubro who built the organization 1938 and the company was converted into a limited company on February 7, 1946.

The company operates through seven segments: Engineering & Construction, Electrical & Electronics, Machinery & Industrial Products, Financial Services, Developmental Projects, IT & Technology Services, and Others.

As of FY14, Larsen & Toubro had revenue of $14.2 billion and an order backlog of $28 billion giving the company a revenue visibility of two years. In the last five years, the company's sales and order book have grown at a CAGR of 18% while the company's EBITDA has grown at a CAGR of 14%.

Reasons For The Recent Rally

India had been struggling with policy paralysis under the last government and the infrastructure sector was worst hit. In September 2013, the opposition party in India announced Narendra Modi as a candidate for the Prime Minister's post. Narendra Modi, with his state development model, had proved his credentials as a pro-development leader.

With a likely defeat of the ruling party, Larsen & Toubro trended higher from $14 in September 2013 to $21.15 by mid-May 2014. The 51% rally was driven by hopes of government change.

After the election results were declared and the opposition party indeed won by an absolute majority, Larsen & Toubro trended higher to current levels of $27.65. The second leg of the rally was driven by a confirmation of government change and favourable economic policies.

Besides the political factor, Larsen & Toubro's rally was also supported by strong results for 4Q14 (year ending March 2014). The company's revenue and net profit for 4Q14 grew by 11% and 25% respectively along with a 14% growth in order intake for the year. With the company's results beating analyst estimates, the rally for Larsen & Toubro continued.

The Budget Sets The Infrastructure Investment Tone

While the new government came to power in May 2014, I was waiting for the government's annual budget to judge the likely investment trend in the infrastructure sector. On July 10, 2014, the budget for 2014-15 was announced and I believe that it is a major catalyst for Larsen & Toubro.

As of March 2014, 78% of the company's order book was from the infrastructure segment and the segment is the single most important growth driver for Larsen & Toubro. The positive point here is that the government has announced huge investments in infrastructure over the next one year through public-private partnerships. With Larsen & Toubro being the biggest infrastructure player in India, the company is well positioned to benefit from the investments.

To put things into perspective, an investment of $6 billion is planned for national highways, $2 billion for harbor projects, $0.6 billion for water infrastructure and $2.4 billion for rural road development projects. Besides this, the government also expects to award 15 new port projects in FY15.

In FY14, the company's order book increased by 13% even amidst low policy action. Order book growth should be robust in FY15 with a huge pipeline of projects to be awarded over the next one year. I must also mention here that India's infrastructure needs a big ramp-up and the kind of investments announced for FY15 will sustain over the next decade if policy action remains positive. The impending growth for infrastructure companies is therefore very significant.

Interest Rate Decline Is Another Catalyst

In the last policy meet, the Indian Central Bank kept the repo rate unchanged at 8%. However, the Reserve Bank of India cut the statutory liquidity ratio by 50 basis points to 22.5% to allow banks to expand credit to the non-government sector.

With a decline in SLR, the Reserve Bank has signaled policy reversal and whenever the next policy action comes, it is likely to be a decline in interest rates. This is likely to be a big catalyst for the infrastructure sector in general and for Larsen & Toubro in specific.

Relatively lower cost of debt will help the company fund big projects and generate relatively higher rates of return. I believe that interest rates will remain stable for the remainder of 2014 as weak monsoon keeps inflation concerns high.

However, interest rate cuts are likely in early 2015 as expected by analyst from Bank of America. This implies that 2015 will have a new stock upside trigger for Larsen & Toubro and rate cut coupled with positive policy actions can close the valuation gap discussed below earlier than expected.

Flurry Of Order Wins Indicate Change In Business Environment

Since the change of government, the order inflow for Larsen & Toubro has been robust and it underscores the point that the business environment is changing with the new government. Larsen & Toubro has won a flurry of new orders in the recent past and I expect the order wins to continue and accelerate after the budget announcements.

On July 1, 2014, Larsen & Toubro won a $0.4 billion order for its power transmission & distribution business infrastructure segment and the order came from the government sector company.

On July 2, 2014, Larsen & Toubro won a construction order for $0.34 billion with the order being bagged by Larsen & Toubro Saudi Arabia LLC for procurement and construction of a high voltage substation network for a fertilizer company. While this order win was from outside India, it does add to the positive sentiment and underscores the company's long-term commitment to expand overseas.

On July 3, 2014, Larsen & Toubro won another order worth $0.25 billion for the construction of an international airport in the state of Kerela. I must mention here that the finance minister has proposed development of new airports through public private partnership and Larsen & Toubro will have similar order inflows in the foreseeable future.

I just wanted to focus on the company's rapid order growth as it underscores the point that progress towards robust infrastructure development is indeed happening with the new government coming to power. While I have mentioned these recent order wins, Larsen & Tubro has won several other infrastructure projects since the new government came to power in May 2014.

After a 13% order growth in FY14, Larsen & Toubro expects order growth to be 20% in FY15. However, with the big budget announcements, order growth can potentially surprise on the upside in FY15.

EBITDA Margin Will Improve

In FY14, Larsen & Toubro reported an EBITDA margin of 11.8%, 120 basis points higher than the FY13 EBITDA margin of 10.6%. I believe that the company's EBITDA margin will trend higher in FY15 and this is another potential stock upside catalyst.

As of FY14, 78% of the company's order book was from the infrastructure sector, which had an EBITDA margin of 12.3%. Further, 33% of the company's order inflow was from international markets, which command a higher EBITDA margin as compared to domestic markets. While the company's EBITDA margin for FY14 was 11.8%, the EBITDA margin from international sales was higher at 12.3%.

Since Larsen & Toubro has a robust international order inflow in FY14, the execution of the orders in the current financial year and the next (order book visibility of 2 years), will result in higher EBITDA margin. Further, with 78% of the order book coming from the infrastructure segment, which has an EBITDA margin of 12.3%, the company's overall EBITDA margin is likely to tend to 12.3% in FY15 from 11.8% in FY14. I believe that this development should impact the stock positively.

Attractive Valuations

Even after a 69.5% upside in the year 2014, Larsen & Toubro is trading at attractive valuations as compared to peers. The valuation gap implies that Larsen & Toubro has more upside.

Larsen & Toubro currently trades at a forward (2015) EV/EBITDA valuation of 16.5. Close peers such as ABB and Thermax are trading at a forward (2015) EV/EBITDA valuation of 28.4 and 19.9 respectively.

While Jaiprakash Associates is trading at a 2015 EV/EBITDA valuation of 10.5, the company has been reeling under a debt crisis and is a much smaller company as compared to Larsen & Toubro. Therefore, ABB and Thermax are best peers for judging the valuation premium or valuation gap.

Considering an average forward EV/EBITDA for the two peers at 24.2, Larsen & Toubro is still trading at a discount of 47% as compared to peer valuation. I believe that the valuation gap will be closed down over the next 24 months (on a conservative basis).

Larsen & Toubro has been among the fastest growing infrastructure companies and there are two reasons for this discounted valuation as compared to peers.

First, the company has been revising its order book and strategy by removing all slow moving orders. Over the last one year, the company has removed slow moving orders of $2.5 billion from its order book. Potential revenue being removed has relatively depressed valuations. However, with this process complete, the company's valuations will adjust in-line with peers as new order inflow offsets the order removals.

Second, Larsen & Toubro is a more complex organization as compared to peers and a part of the valuation gap can be attributed to the complexity of the organization. However, Larsen & Toubro plans separate IPO and listing for L&T Infotech and L&T Tech Services by July 2016.

For the same reason, I have considered a time horizon of 24 months for a potential 47% upside. The IPO for these two subsidiaries will result in value unlocking and decline in overall complexity of the organization.

I must mention that between July 2014 and July 2016, there can potentially be other catalysts that fill the valuation gap before 24 months. In particular, the company's FY15 revenue and order inflow guidance can be revised upwards.

For now, the company expects revenue growth of 15% and order inflow growth of 20%. However, as discussed above, the order flow has been robust after the formation of the new government and I expect the order inflow growth to be in excess of 20% for FY15. This can potentially be a major stock upside catalyst as it enhances the company's revenue visibility.

Conclusion

Larsen & Toubro has navigated through the most difficult period in India's economic and infrastructure growth. As the new government brings a ray of hope, the stock has surged by 69.5% in 2014 from depressed valuations.

However, the company still has a valuation gap of 47% as compared to peers and I believe that this valuation gap will fill over the next 2 years. Better than anticipated policy actions and sooner than anticipated interest rate cut can accelerate the upside for Larsen & Toubro. The budget for 2014-15 has increased my optimism for the infrastructure sector and the stock. I believe that big orders will continue to flow for the company and serve as additional upside triggers.

On the downside, I believe that the impact on inflation from not such a great monsoon in India needs to be closely watched. Delay in lowering interest rates can be a source of negativity. However, I believe that this is largely offset by positive policy actions.

Overall, Larsen & Toubro is a strong buy at these levels. Investors need to note that the trading liquidity is not very high in the OTC. However, individual and institutional investors can invest in the stock directly in the Indian stock exchanges. Larsen & Toubro is a part of the Indian benchmark index and has high liquidity and trading volumes.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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