We are assuming coverage on L&T with an OW rating and PT of Rs 3202, implying upside of 35%, based on our SOTP valuation. Surprises to our 26% earnings CAGR estimate through FY10 could arise from i) forays into power plant equipment and defense markets, areas currently dominated by strong PSU incumbents, and (ii) margin upside, which 1Q08 numbers suggest.

1Q FY08 earnings delivered a pleasant surprise on account of higher-than-expected margins:

L&T’s 1Q08 adjusted PAT was Rs 2.91 billion, up 58% yoy, way ahead of our and street expectations. Revenues registered 30% yoy growth. The OP margin, at 9.4%, was up 240bp – E&C and MIP segments were the key drivers. Margin improvement arose from operating leverage, improved pricing, and better sourcing. The order backlog of Rs 416 billion, at 2x FY07E revenues, provides visibility on revenue growth.

Our SOTP PT of Rs 3,202 factors in strong organic growth, upside from new ventures and value unlocking in subsidiaries:

Our valuation includes:

i) Rs 2,268 for the core business, based on DCF (implies a P/E of 26.3x FY09E earnings);

ii) Rs 478 for subsidiaries and associates - key among these are L&T Infotech (Rs 155), L&TIDPL (Rs 109), and manufacturing subsidiaries/ associates (Rs 83); and

(iii) Rs 352 from potentially successful forays into power plant equipment and defense.

L&T is our preferred play on the capital and infra spending boom in India and the Middle East:

India is likely to see capex of USD 320 bilion of over the next five years, and the Middle East to invest massive amounts in key infrastructure over the next few decades, e.g. power (USD 458 billion), refineries (USD 90 billion) & water (USD 39 billion).