Vikas Khemani

The growth of an economy is a function of consumption, investment and net exports. The movement of these factors in tandem is a prerequisite of sustainable economic growth. Big variations in any one of these without appropriate support from the other two makes economies vulnerable to crisis. This theory explains why India has been prone to external shocks over the past five years. The share of consumption in real GDP has increased about five percentage points to 71% over the past five years, while the share of investment has remained more or less constant. Such high consumption rates are not sustainable for an emerging economy such as India. This has resulted in an increased reliance on external flows, rendering the country vulnerable to global shocks. Hence, a weak global economy has resulted in the rupee depreciating around 35% since FY08. 

The depreciation should now, however, start acting as a boon as exports increase and import substitution occurs. The evidence of currency acting as a self-correcting mechanism is well-documented in history with economies (including India’s 1991 and 2000-01 currency depreciation episodes) improving in manufacturing post-currency depreciation. We believe there is not much difference this time around as well. Hence, a weaker currency in conjunction with an improved global outlook should boost manufacturing. This will kickstart the investment cycle as pent-up demand clears. 

Apart from exports, the Cabinet Committee on Investment (CCI) has cleared projects worth 3-4% of GDP in the past three to six months. The impact of this move will play out in the forthcoming quarters. In the medium to long term as well, there is a strong case for revival of the investment cycle. Our themes in 2014, therefore, are manufacturing and revival of the investment cycle and, given this background, my stock of choice is Larsen & Toubro (L&T), the best in the capital goods sector.

Global footprint

L&T, which started in 1938 to manufacture dairy equipment, has come a long way. Today it holds the enviable position of being India’s largest engineering and construction behemoth with unequivocal expertise across major verticals such as roads, ports, power, niche factories and building construction, mining, defence, etc. It has successfully executed projects worth more than ₹250,000 crore over the past decade across the domestic infra space. Despite GDP losing pace over the past three years, L&T has exhibited its diversified dominance and unique business flexibility by leveraging its superior execution capability and balance sheet might by successfully scaling up in businesses such as niche factories and building segment with more than ₹50,000 crore worth of new orders at a time when industrial capex is tumbling. This bears testimony to how a firm can leverage its skilled employee base, execution track record and strong brand name to overcome headwinds. L&T’s long-term strategy of exploring scalable businesses with a target of dominating market share has helped it gain its current size and stature in the Indian infrastructure space.

While L&T had been an exporter for long, it was in 2001 that it made a conscious decision to go global. The move was in keeping with the times — avenues for larger business prospects at home were shrinking in the wake of continuing recession and the drying up of capital-intensive infra projects. A thrust on international business over the years has led to the overseas revenue stream growing steadily. The company has surmounted national barriers and extended its activities to the Indian Ocean rim countries. L&T’s international footprint is increasing with worksites in more than 20 countries, including South, South East and West Asia, Russia and CIS and Africa. It has enhanced its international exposure materially with order book from export markets growing nine-fold over the past decade to ₹25,000 crore in FY14YTD. 

L&T has adequately strengthened its penetration and reach in the West Asian market in hydrocarbon and power T&D segments, which now contribute 80-85% to its order intake from overseas. A recent major breakthrough was the bagging of a multi-billion order for Riyadh Metro construction. This win not only aligns well with L&T’s expansion plans in the international arena, but also reinforces confidence in the company’s ability to execute big-ticket international orders in the infra space. With mega projects on the anvil in West Asia over the next few years, L&T is well entrenched to benefit from the next infra wave in the region.

Spurring growth

Over the past five years, L&T has invested more than $1 billion in new ventures such as heavy forgings, ship building and BTG. The current downturn has been a major hindrance to these new businesses gaining meaningful traction and most are currently significantly underutilised (<15% capacity utilisation). These will act as future growth drivers. We believe these three businesses are scalable and have a peak revenue potential of ₹40,000 crore (currently at ₹3,500 crore) over three to five years. We are confident about the company’s ability to take these businesses to a new scale over the next five years.

 L&T has so far invested around ₹21,500 crore in BOOT road projects, ports, metro, etc. These investments have created some amount of drag on the company’s return on equity. The management’s focus on efficient capital allocation and freeing capital from non-core areas will lead to significant upside in the return ratio (from 13.3% currently to 16.5-17% over the next three years). Asset sales will also reduce the overall burden on L&T’s cash flow, given that the company already has total equity commitments worth ₹8,100 crore over the next five years. We believe that if capex picks up in 2015, L&T will see an improved traction in revenues (including new businesses) and hence will see an improvement in Ebitda margins (from 13% currently to around 14.5%) as operating leverage kicks in. The stock trading at 18X FY15 earnings per share makes it a good risk-reward bet for playing the Indian investment cycle.

Edelweiss has a buy call on the stock, but the writer does not own the stock in his personal capacity