Strategic Cost and Profitability Management A Critical Analysis of Larsen & Toubro 2009-2010 1 P age
Contents 1. Industry overview- Heavy Engineering and Construction... 3 2. Company Overview... 4 2.1. Background... 4 2.2. Board of directors... 5 2.3. Vision... 5 2.4. Business Offerings... 6 3. Industry analysis... 7 3.1. Growth Trends-... 7 3.2. Growth Drivers and Future Growth Trends... 9 3.3. Opportunities as seen by Larsen and Toubro-... 10 Infrastructure sector-... 10 Power Sector... 11 Oil and Gas sector... 11 4. Financials... 12 4.1. Key Financial Ratios... 12 4.2. Financial Ratios... 12 4.3. Du pont analysis... 19 5. SWOT analysis... 20 5.1. Strength-... 20 5.2. Weakness... 20 5.3. Opportunities... 21 5.4. Threats... 21 2 P age
1. Industry overview- Heavy Engineering and Construction The Heavy and Civil Engineering Construction subsector comprises establishments whose primary activity is the construction of entire engineering projects (e.g., highways and dams), and specialty trade contractors, whose primary activity is the production of a specific component for such projects. Specialty trade contractors in Heavy and Civil Engineering Construction generally are performing activities that are specific to heavy and civil engineering construction projects and are not normally performed on buildings. The work performed may include new work, additions, alterations, or maintenance and repairs. Infrastructure is a key ingredient in the recipe of development of any nation. It forms the backbone of the development process. Heavy engineering equipments represent the set of machines used for construction and generation of power. Infrastructure and power being key elements are receiving first priorities all over the world. Developing nations like China and India are on a building spree. This has bought better days for the industry in this decade. Instrumentation and Automation of processes is required in many areas. Equipments which replace manual handling and mass labour are in big demand to speed up the process of development. These trends led to huge growth in the Capital goods sector. Automation systems like human machine interface, electronic assembly systems, manufacturing execution systems, sensor systems are instrumental in growth of this sector. In today s world of environment conscious people, energy efficiency is important. Operational performance of infrastructure needs to qualify the stringent parameters to satisfy the clients. Companies are focusing on total solution building with operational efficiency. Infrastructure development which falls under the responsibility of Heavy Engineering and construction group is- Transportation means development o National highways o Airports o Ports o Urban transportation infrastructure and equipments o Rail transit systems and equipments Building and factories o Health, education and leisure facilities development o Construction of manufacturing equipments and setups Technological infrastructure o Telecom infrastructure Power infrastructure o Electrical utilities - Boilers, Turbines, Diesel Engines, Transformers, Switchgear, Motors and Generators o Power transmission o Renewable energy equipments 3 P age
Textile Machinery Machine Tools Earthmoving and Construction Equipment Process Plant Equipment which includes Pressure Vessels, Cooling Towers, Furnaces and Heat Exchangers 2. Company Overview 2.1. Background Larsen & Toubro (L&T) is India s largest and also one of Asia s largest vertically integrated engineering and construction conglomerates. Since its inception in 1938, the company has bagged approximately 105 awards, highlighting its expertise in engineering construction and achievements in business management. Efficiency in project execution and effective cost management enabled the company to post a 15% year-on-year growth in profit after tax to Rs5.78 billion (US$120.8 million) for the quarter ended June 30, 2009. Fueled by a healthy order book, net sales for the quarter rose 6.67% from the year earlier to Rs7.36 trillion (US$153.82 billion). New orders during the quarter were at Rs699.52 billion (US$14.62 billion). Of this, the international order book was at Rs96.08 billion (US$2.01 billion), which represent 13.74% of the segment s total order book. The company s strong results reflect strong infrastructure and industrial growth and its sound risk management framework. Large projects won during the first eight months of 2009 included airport projects in Bangalore and Sri Lanka; the expansion of power transmission and distribution center in the Gulf Region, India and Oman; and railway construction in the domestic market. The company s stellar results reflect strong infrastructure and industrial growth and sound risk management framework. In August 2009, the company won another order worth Rs3.64 billion (US$76.08 million) from UP Rajya Vidyut Utpadam Nigam Limited (UPRVUNL) for setting up a Coal Handling Plant at Anpara, Uttar Pradesh. During the same period, L&T secured another contract of Rs4.89 billion (US$102.2 million) from Neyveli Lignite Corporation Limited (NLC) for setting up Coal Handling Plant at Tuticorin, Tamil Nadu. Recently Company was in trouble due to low quality of construction at Bangalore Airport. The joint house committee of the Karnataka legislature had slammed the construction partners involved for faulty design. Recent two quarters have shown a performance below street expectation but company has a good pipeline of orders and looks promising in the longer run. 4 P age
2.2. Board of directors Larsen and Toubro has a visionary management which has taken it to where it stands today. Following are the members of Board of directors- 2.3. Vision Vision of the company reflects the collective goal of all the firms under the umbrella of Larsen and Toubro. It was concluded considering opinions of all the employees worldwide 5 P age
2.4. Business Offerings Engineering, Construction & Contracts Division - The Engineering Construction & Contracts Division of L&T is India's largest construction organisation. Its leading edge capabilities cover every discipline of construction civil, mechanical, electrical and instrumentation. The Division plays a crucial role in the development of India's infrastructure. Many of the country's prized landmarks - its exquisite buildings, tallest structures, largest industrial projects, longest flyovers, highest viaducts, longest pipelines have all been built by L&T. The projects undertaken are large scale and call for advanced capabilities in project implementation, timely completion, inflation management, quality and safety. L&T has also expanded its focus to the Middle East, South East Asia, Russia, CIS, Mauritius and African & SAARC countries. Heavy Engineering Division- It is one of the world's leading manufacturers of technology-intensive, custom-made equipment & systems for core sectors such as refinery, petrochemical, fertiliser, chemical, oil & gas, power (thermal & nuclear) as well as shipbuilding, defense and aerospace. HED has established a reputation for quality, based on its strong engineering capabilities and state-ofthe-art manufacturing facilities. New products and manufacturing technologies are developed at three Technology Development Centers. Having designed, manufactured and supplied critical hi-tech equipment & systems to more than 40 countries, HED has established a "Preferred supplier" relationship with many clients worldwide. Electrical & Electronics Division- It designs, manufactures and markets low and medium-voltage switchgear, switchboards, control and automation systems, metering and protection systems, petroleum dispensing pump and medical equipment. EBG products address the growing needs of diverse customers comprising farmers, urban households and commercial buildings. Besides, its products are required in healthcare equipment as well as a growing need for advanced protection, control and automation in a number of industries Power- L&T has synergised its internal strengths developed over decades in the areas of project management, engineering, manufacturing & construction and is focusing on opportunities in coalbased and gas-based power projects. This business provides turnkey solutions for setting up utility power plants, co-generation and captive power plants on EPC basis. L&T has formed two joint ventures with Mitsubishi Heavy Industries, Japan to manufacture supercritical boilers and steam turbine generators. In FY 2008-09, significant progress was made in setting up manufacturing facilities for supercritical boilers and turbines at Hazira Machinery & Industrial Products Division- L&T manufactures, markets and provides service support for critical construction and mining machinery - surface miners, hydraulic excavators, aggregate crushers, loader backhoes and vibratory compactors; supplies a wide range of rubber processing machinery and injection moulding machines; and markets valves and allied products and a range of sophisticated application-engineered welding alloys 6 P age
3. Industry analysis It is widely believed that the construction industry will be the major growth engine of the Indian economy. More than 150 industries directly or indirectly depend on the construction sector. Owing to the size and potential of the sector, the government policies on taxes, tariffs and spending on infrastructure projects have been keenly watched by various industry bodies. Current Environment- Sustained growth was reported in most of the countries over the last six months, except Japan, with governments pouring billions into infrastructure projects as part of their economic stimulus packages. The underlying trend among Asia-Pacific construction companies showed slight financial recovery, due to improved investor sentiment as the global economic environment started to improve. Beginning with the integration of unconnected roads in rural areas, China remained on track to grow with large key investments planned and even larger participation from the private sector. Despite the poor economic conditions, the region managed to attract billion worth of investment from the private sector, even as some Asian currencies depreciated. 3.1. Growth Trends- Investment attractiveness- Indian government has either removed or reduced the caps on the foreign investment in most of the sectors. 100% FDI under the automatic route is allowed for most infrastructure sectors - highways and roads, ports, inland waterways and transport, and urban infrastructure. Select Infrastructure sectors have defined caps for e.g. Telecom Services has a sector cap of 74% and Airlines have a 49% 8 sector cap of foreign that are not airline. Looking at the profitability numbers of the Indian infrastructure companies in the below table, they re posting healthy numbers. Investment looks lucrative in the sector. Period Profitability index - Y/Y dynamics Net revenue per company - Y/Y dynamics Historical Data Q3 2008 Q4 2008 Q1 2009 Q2 2009 Forecast Q3 2009 8.06% 11.64% 31.87% 15.41% 18.45% 30.08% 26.11% 34.80% 20.89% 18.28% EBITDA Margin - Y/Y dynamics -16.93% -11.48% -2.17% -4.53% 0.15% GDP increase- A notable feature of the growth of the Indian Economy from 2002-03 has been the rising trend in the Gross Domestic Capital formation (GCF). Gross Capital Formation (GCF) which was 25.2 per cent of the GDP in 2002-03 increased to 35.9 percent in 2008-09. Much of this increase is attributable to a rise in the rate of investment by the Private Corporate Sector. The rise in the rate of investment has been on account of various factors, the most important being the transformation in the investment climate, coupled with an optimistic outlook for the growth of the Indian economy. The positive perception about macroeconomic stability arising from the fiscal consolidation process 7 P age
has also been responsible for improvement in the perception. T he process of investment in the economy generates demand for capital goods. The demand for capital goods is derived from the investment intentions that get translated into investment decisions. The increase in the overall investment has mainly been on account of a rise in gross fixed investment. IIP numbers have been growing ever since. The growth in IIP is due to increased investment in the capital goods and capacity to produce. Another indicator that can drive activity in the capital goods space is an expansion in the basic and intermediate goods indices. These segments are typically the user industries for the capital goods produced. In 2009, this basket of companies have shown a strong growth and looking for capacity expansion which is a good sign for capital goods. Policy changes can be clearly seen in the below graph. Government has become supportive of infrastructure development post 91 reforms. The custom duties are declining ever since. IIP growth has shot up since 2001. 8 P age
3.2. Growth Drivers and Future Growth Trends This industry supports a lot of other industry for its production, so growth is largely dependent on expansion requirements of other industries and infrastructure requirements of the nation Let s look at the key drivers- Government spending- In the current economic crisis, Government decided to splurge an economic recovery package. During the recession demand has been dwindling so companies have invested in future growth. This has helped the capital goods space to maintain its position relatively better. Government is also looking forward to public private partnership to complete many of the projects. Nuclear deal for example has provided revenue stream to many of the companies in the capital goods space. The construction sector in India achieved strong levels of growth over the last six months. The Budget 2009/2010 put major emphasis on infrastructure development in the country. For instance, the construction of highway and railways will receive a major boost with allocations to the National Highways Authority of India (NHAI) for the National Highways Development Program (NHDP). Funding for the construction of railways also picked up. Government has an aggressive target of building 20 KM roads per day instead of current rate of 5. Government is also looking to ease the financing environment. Asia s third largest economy, India, is in need of greater infrastructure spending for the next ten years, if the country expects to follow China s lead of economic expansion. China spends three times more on infrastructure annually. The Planning Commission of India planning to spend stimulus package in the highway sector, port and power projects over the next five years. Meanwhile, India s electricity shortage reached a nine-year high in 2008, while highways, which move almost 80% of the goods transported in the country, account for only 2% of its roads. This lack of infrastructure, especially electricity, has eroded as much as 2% of the country s growth. Overall, India plans to commit some US$500 billion over the next five years primarily on public works, 70% of which will come from the country s coffers and the remainder from private investors Demographics- Changing demographics, rising populations, vast urbanization and growing standards of living are leading to great infrastructure boom in tier 2 cities in India. Many real estate and construction companies have initiated projects in tier two cities, which makes investment attractive for capital goods sector as well. Energy efficiency- The idea of designing and building constructing energy-efficient buildings and equipments that are kinder to the environment is one of the most important trends sweeping the construction and heavy engineering sector. Falling raw material prices during recession- Commodity prices continued to fall in the first seven months of 2009 for metals, lumber and other energy products. This has made investment in expanding capacity attractive temporarily. Urban transport planning projects- Some of the projects planned for the country include the Chennai Metro Project and the Delhi Metro Railways, worth around Rs340 billion (US$7.11 billion) and highway projects worth approximately Rs190 billion (US$3.97 billion). The highway projects stretching to 1409.93km include stretches like the Delhi-Agra, Kishangarh-Udaipur and Vijayawada- Elluru-Rajahmundry among others. 9 P age
Supply chain development- Private sector companies are investing on strengthening the logistics and supply chain capabilities. Infrastructure like ports, dedicated freight corridors are being built. Water processing- Increasing emphasis on waste water treatment and advanced technology based water plant projects in India and Middle East are increasing. 3.3. Opportunities as seen by Larsen and Toubro- Infrastructure sector- 10 P age
Power Sector Oil and Gas sector 11 P age
4. Financials Various tool and techniques are used to convert financial statement data into formats that facilitate the evaluation of a firm s financial condition and performance, both over time and in comparison with industry competitors. Among these tools are: Financial Ratio Analysis Du Pont Analysis Common Size Financial Statements 4.1. Key Financial Ratios Various tool and techniques are used to convert financial statement data into formats that facilitate the evaluation of a firm s financial condition and performance, both over time and in comparison with industry competitors. Among these tools are: Financial Ratio Analysis Du Pont Analysis Common Size Financial Statements 4.2. Financial Ratios 4.2.1. Liquidity Ratios- The important liquidity ratios are current ratio and quick ratio. The current ratio measures the ability of the firm to meet its current liabilities. Quick ratio is a fairly stringent measure of liquidity. It is based on those current assets that are highly liquid with inventories and pre-paid expenses excluded. Larsen & Toubro Ltd. FY 2009 FY 2008 FY 2007 FY 2006 FY 2005 Current Ratio 1.22 1.09 1.16 1.28 1.34 Quick Ratio 0.97 0.86 0.93 1.03 1.12 12 P age
The current ratio measures the ability of the firm to meet its current liabilities. Current assets get converted into cash during the operating cycle of the firm and provide the fund needed to pay current liabilities. On comparative analysis of the three major players in the Heavy Engineering industry, it can be said that BHEL in not only commands a healthy current ratio but also have been consistent. On the other hand, L&T s current ratio has been dipping in last five years, lately because of the global financial meltdown. This ratio is based on the current assets which are highly liquid. Inventories are excluded from the assets because inventories are deemed to be the last liquid components of current assets. L&T s quick ratio has been declining for last five years. Suzlon s quick ratio is much ahead of its peers. The difference between current and quick ratio is low for L&T and BHEL which suggests that the working capital is also low leading to a reduction in interest expense and profit margin. 13 P age
4.2.2. Activity Ratios Larsen & Toubro Ltd. FY 2009 FY 2008 FY 2007 FY 2006 FY 2005 Inventory Turnover Ratio 6.01 6.00 6.03 6.84 5.81 Fixed Assets Turnover Ratio 6.23 6.09 9.52 11.45 13.19 Total Assets Turnover Ratio 1.80 1.92 2.27 2.45 2.55 Debtors Turnover Ratio 3.89 3.88 3.42 3.37 3.62 Inventory Turnover measures the efficiency of the firm in managing and selling inventory. Among the three companies, L&T shows a high inventory turnover ratio. This is a sign of efficiency inventory management for the firm which translates into better profits. The faster the inventory sells, the fewer funds tied up in the inventory. BHEL s low inventory turnover is the result of the company carrying too much inventory. Suzlon s ratio is increasing year-by-year, which is a good sign for the firm. L&T holds very less inventory and hence its working capital cost reduces. 14 P age
TOTAL ASSET TURNOVER RATIO The total asset turnover ratio measures the firm s efficiency to manage its overall assets. L&T shows a highest total asset turnover ratio among the three which means smaller investment is required to generate sales. Suzlon is investing too much into its assets without gaining any change in its revenues. Its total asset turnover ratio is much lower compared to its rival L&T and indicates that the company is not generating a sufficient volume of business given its total asset investment. 15 P age
4.2.3. Leverage Ratios Larsen & Toubro FY 2009 FY 2008 FY 2007 FY 2006 FY 2005 Debt Equity Ratio 0.53 0.38 0.36 0.32 0.56 Interest Cover 13.09 28.57 25.07 11.56 13.74 The debt to equity ratio measures the extent of the firm s financing with debt. Suzlon has a very high debt, exceeding 1, and this has affected its net profit margin over the years. The company has been aggressive in acquisitions and thus financing its growth with debt which could result in volatile earnings. BHEL, on the other hand, has reduced its debt financing close to zero and that gives a very low debt equity ratio, which is good for the firm. L&T s ratio is reasonably good and under the limits. 16 P age
4.2.4. Profitability Ratios Gross profit margin, operating profit margin, and net profit margin represent the firm s ability to translate sales dollar into profits at different stages of measurement. The gross margin, which shows the relationship between sales and the cost of products sold, measures the ability of a company both to control costs of inventories or manufacturing profit margin, a measure of overall operating efficiency, incorporates all of the expenses associated with ordinary business activity. The new profit margin measures profitability after considering all revenues and expense, including interest, taxes and non operating items. L&T FY 2009 FY 2008 FY 2007 FY 2006 FY 2005 Gross Profit Margin 11.39% 12.19% 13.24% 9.82% 8.62% Operating Profit Margin 12.23% 12.98% 11.52% 8.63% 7.66% Net Profit Margin 10.06% 8.54% 7.74% 6.69% 7.33% Return on Equity 27.99% 22.81% 24.44% 21.95% 29.47% 17 P age
Contrary to general expectations that increasing raw material prices will eat into the margin, BHEL has managed to keep high its operating margin which means that the firm was able to control the growth of operating expenses by cost cutting initiatives and a change in product mix. On a comparative study with its competitor, it can be seen that L&T has managed its profit margins very well and also the difference between operating and the net profit is also low. This means that L&T has managed its expenses like administrative and other non operating expenses well. 18 P age
Return on Equity measures the overall efficiency of the firm in managing its total investment in assets and in generating return to its shareholders. L&T and BHEL have managed their equity efficiently and have reflected the productivity of the ownership capital employed in the firm. Suzlon lags behind because of its high debt to equity ratio and has to improve in this area. 4.3. Du pont analysis A good summary of the ratio analysis is provided by the Du Pony system, which explains how the financial ratios interrelate to produce the overall return shareholders, return on equity: Net Profit Margin x Total Asset Turnover = Return on Investment Return on Investment x Financial Leverage = Return on Equity This series of relationships enables us to identify and trace the potential strengths and weaknesses in the financial performance of a firm. For Larsen & Toubro, this system of analysis would show the following for the fiscal year 2009: NPM x TAT = ROI x FL = ROE 10.06 x 1.9 = 13.65 x 1.4 = 19.11 19 P age
5. SWOT analysis 5.1. Strength- Brand synonymous with quality Skilled human capital Construction and multi building projects on the feasible locations in India Structured national and international network Visionary top management Market reputation facilitates easy financing Presence in all sub sectors of the capital goods Total solution providing capability Private sector housing boom in India Due to large size, ability to affect the government policies in its favour Subsidiaries allow internal sourcing and reduce external costs Part of revenue stream is recurring The technological competitiveness of the Indian Capital Goods sector is low. Larsen and Toubro is one of the very few companies with a full spectrum of technological capabilities 5.2. Weakness All procedures not clearly defined Distance between construction projects reduces business efficiency Changing skill requirements and ageing workforce External allocation of large contracts is difficult Litigations related to low quality constructions (Banglore airport case) Decreasing order book value from oil and gas sector Labour in the Indian Capital Goods sector is highly cost competitive, even after discounting a comparatively low labour productivity. It is difficult for the Indian Capital Goods manufacturers to pass on the rise in prices to the customers, thereby impacting their profitability Quality of existing infrastructure is poor which poses significant challenges in completing the projects in time 20 P age
5.3. Opportunities Continuous private sector housing boom Public sector projects through public private partnership India s foray into nuclear energy after signing nuclear deal with US Development of logistics and supply chain in all industries Investment increasing in the GDP what ll help financing future capacity and hence capital goods sector Second tier cities showing a good sign of growth in future Rising GDP with a better appetite for investment 5.4. Threats Lack of political leadership s willingness in promoting and supporting growth Current economic situation had a big impact on construction industry Soon RBI will up the CRR, SLR and repo rates Political instability in some parts of the country makes it difficult to carry on large scale projects Stringent environmental norms coming up Low industry and R and D institutions interaction could lead to reduced chances of commercially viable technologies 21 P age