Larsen & Toubro (L&T), India's engineering and construction behemoth, has been experiencing a surge in success. The company boasts a record order book, largely fueled by massive projects in the Middle East, particularly in Saudi Arabia. However, this impressive growth is not without its risks. L&T's increasing reliance on fixed-price contracts in a volatile geopolitical landscape raises concerns about the company's long-term profitability and the sustainability of its impressive working capital gains.

L&T's order backlog has swelled to an impressive INR 4.7 trillion, with international projects accounting for a significant 39%. A closer examination reveals an alarming concentration: 92% of this international order book stems from the Middle East, with Saudi Arabia alone contributing a staggering 80%. Furthermore, 42-43% of the total order book consists of fixed-price contracts, up from the historical average of one-third. This shift towards fixed-price contracts in the Middle East, while potentially lucrative in the short term, exposes L&T to unforeseen risks, particularly in a region fraught with geopolitical uncertainty.

The company argues that meticulous risk assessment and favorable payment terms mitigate these concerns. L&T emphasizes its commitment to timely execution, a crucial factor in maximizing margins on fixed-price contracts. The company highlights its efforts to bolster its Middle Eastern presence, relocating senior personnel and establishing local contract management teams to address potential challenges proactively.

However, recent events cast a shadow over this optimistic narrative. Saudi Aramco, a key customer and a likely significant contributor to L&T's Middle Eastern order book, recently announced a CapEx cap for hydrocarbon projects, driven by the Saudi government's directive to maintain oil production at a steady level. While L&T downplays any immediate impact on existing projects, the news raises concerns about the sustainability of future order inflows from a customer that has fueled L&T's recent growth.

The question arises: is L&T betting too heavily on a single card – the Middle East – in a game where the rules are constantly changing? The ongoing war in West Asia, the fragile global economic outlook, and the looming US presidential elections all contribute to a heightened sense of uncertainty. The spectre of supply chain disruptions and escalating costs, fueled by geopolitical tensions and increased competition for resources, further amplifies the risks inherent in L&T's fixed-price contracts.

This reliance on the Middle East stands in stark contrast to L&T's muted performance in the domestic market. Domestic order inflows and revenue growth have been subdued, impacted by the looming general elections in India. The company anticipates a temporary slowdown in public CapEx during the pre-election period, further dampening prospects in the near term.

While L&T touts its impressive working capital gains as a counterbalance to concerns about margin pressure, the question of sustainability looms large. The company's revised working capital guidance for FY'24, hovering around 16.6%, reflects the favorable payment terms associated with international projects. However, this reliance on external factors raises questions about L&T's ability to maintain these gains in a changing landscape.

The company's argument that margins will improve sequentially over the next few quarters hinges on timely execution and the release of contingencies built into fixed-price contracts. However, the unpredictable nature of geopolitical events and their potential impact on execution timelines make this a risky proposition.

Emerging Market Growth vs. Domestic Orders

The following chart showcases the growth of L&T's International Order Book compared to Domestic Order inflow, derived from the provided transcripts.

L&T's Middle Eastern gamble, while currently paying off handsomely, raises red flags. The company's heavy reliance on fixed-price contracts in a volatile region, coupled with a potential slowdown in domestic opportunities, suggests that L&T may be walking a tightrope. The company's ability to navigate these uncertainties and maintain its growth trajectory while preserving profitability will determine whether its Middle Eastern gamble proves to be a winning hand or a risky bluff.

Key Data Points

"Fun Fact: L&T has built some of India's most iconic landmarks, including the Statue of Unity (the world's tallest statue), the Atal Bridge (India's longest sea bridge), and the new Ram Temple at Ayodhya. The company even played a critical role in India's Chandrayaan 3 moon mission."