L&T: Growth pangs

Operating margins come under pressure at L&T

Larsen & Toubro's September quarter results illustrate a continued buoyancy in the capex cycle. Operating margins have, however, slumped owing to surging sales, administration and other expenses.

As a result, even an improved performance of its engineering and electrical division could not prevent operating profit margins falling 183 basis points y-o-y to 2.17 per cent in the quarter.

Sequentially, too, operating margins fell 244 basis points in Q2 FY06. Hence, it was no surprise that the stock fell almost 3.1 per cent to Rs 1,343 on Friday. The stock has underperformed the Sensex over the last one month - down about 13 per cent compared with a 11 per cent fall in the broader market.

The management said they have taken steps to expand operations, especially in the Gulf and Africa. As a result, sales, administration and other expenses expanded almost 51.1 per cent y-o-y to Rs 417.18 crore in the previous quarter.

Meanwhile, the key engineering and construction unit has seen revenues expand almost 9.2 per cent y-o-y to Rs 2,796.3 crore in Q2 FY06, thanks to recent orders: for instance, the Rs 714 crore order from Tata Steel.

Also, earnings before interest and tax margins of the division have expanded 232 basis points to 5.63 per cent and that was largely owing to its recent contracts, which enabled the company to pass on fluctuations in steel prices to customers. EBIT margins, sequentially, of the engineering division expanded 134 basis points in the September quarter.

Also, the electrical and electronics division has seen its EBIT margins expand 146 basis points y-o-y to 14.78 per cent in Q2 FY06, thanks to a focus on higher value product segments such as control and automation.

Higher operating costs saw the company's overall operating profit (excluding other income) drop 38.7 per cent y-o-y to Rs 73.25 crore in the September quarter.

The company's growth is expected to be strong as there are signs of a slowdown in the capex cycle. As a result, the stock trades at almost 19.25 times estimated FY06 earnings.

Marico: growth factored

Marico has been a big beneficiary of the re-rating of the Indian market over the last three years. Three years ago, the stock traded at only about 8.5 times forward earnings, and continued to be in the 8 to 11 times band till late last year. Just in the past one year, Marico's valuation has jumped to 19 times estimated FY06 earnings.

True, there was a scramble for mid-cap companies in the rally, but Marico's valuations have increased because of a sharp improvement in profitability owing to a sharp drop in copra prices and on strong growth prospects for its Kaya skincare business.

In the first six months of this fiscal, Marico's operating margin jumped 240 basis points to 11 per cent. Operating profit, as a result, jumped 40 per cent, although growth in revenues was much lower at 10 per cent.

Raw material expenses, as a percentage of sales, fell by 670 basis points in the six months. Also, the company has been able to leverage on the brand equity of Parachute and keep selling prices more or less constant. As a result, savings on input costs largely flowed into the bottom line.

A part of the savings was used to increase advertising and sales promotion expenses to 12 per cent of revenues, which augurs well for sales growth.

But it remains to be seen whether the improvement in margins is sustainable. In the last ten years, Marico's PBT margins have varied been between 6.3 and 8.5 per cent. For instance, between FY2000 and FY2002, margins had increased by 200 basis points to 8.3 per cent, but had declined to 7.3 per cent by FY04.

Adjusted for exceptionals, Marico's PBT margin stands at 9.4 per cent for the first six months of this fiscal, higher than the previous peak of 8.5 per cent. But it remains to be seen whether these high margins continue, given the keen competition in the hair oil and edible oil segments.

Apart from the jump in profitability, the Marico stock has got a re-rating because of the fast paced growth expected in the Kaya skin care business, which has now grown to 41 clinics.

Although this segment accounts for only about 4 per cent of consolidated revenues, the fact that the company is planning to roll out more clinics, as well as extend the brand into products seems to have got the markets excited.

But current valuations of 21 times trailing earnings and 19 times forward earnings largely capture these growth prospects, unless of course Marico has more surprises on the profitability front.