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Conglomerates are sometimes referred to as “corporate chaos” because of the complex web of businesses they manage. Shares of these companies tend to trade at a discount compared to standalone businesses, as investors find it difficult to gauge a fair value of the diverse businesses these behemoths house. India’s engineering and construction giant Larsen & Toubro has found itself at the receiving end of some very tough questions for these very reasons as investors believe it has spread itself too thin.
Over the last six years, L&T has invested nearly Rs 30,000 crore in different businesses, some of which have yielded nothing. While the sluggish business environment can be partly blamed for this, in some cases the investments preceded the opportunities. Shipbuilding and defence are two such examples. Consequently, the return ratios have also taken a hit. The company has also suffered large losses on some of its infrastructure projects which were bid under private-public partnership. L&T’s return on capital employed (ROCE) fell to 11 per cent in 2013-14 from a peak of 25 per cent in 2006-07.
Today, investors see little value in an engineering and construction company running a software services business or a retail lending business. They don’t see merit in the company owning and running power plants, ports or roads either, as the company’s core is engineering and construction which accounts for 70 per cent of its revenues. While conceding that the company needs to rationalise its portfolio of assets and businesses, L&T Chairman AM Naik is clear that the company’s profitability needs to be cushioned as turnkey projects are high-risk and low on margins. It’s this diverse portfolio of businesses that has helped the company tide over difficult times. “In FY13, we made a profit of Rs 1,400-1,500 crore out of services, which represents 27-28 per cent of the Rs 5,200 net profit. This cushioned some of the very bad jobs.” Naik’s found a middle path to protect investor interest without scaling down the projects business.
Winds of change
The company is on course to clean up its balance sheet and realign businesses so that both the long-term and short-term needs are met. While the near term will see asset sales and a leaner balance sheet, over the long term the company’s board is quietly creating a global mega corporation, which will compete with the world’s biggest engineering and construction behemoths globally. The project is codenamed L&T II. It entails a global workforce and its independent companies or business units will be headquartered in different geographies. Out of the dozen independent business units or companies that L&T’s core business is divided into, five will be based in West Asia.
Given the hydrocarbon boom in West Asia, which is an opportunity of nearly $150 billion, L&T has decided to headquarter its subsidiary in Sharjah. According to the Middle East Economic Digest, the construction market in that region is expected to double in the period 2012-17 from $1 trillion in 2007-12. Analysts believe the opportunity is too huge to ignore. Says Sanjeev Zarbade of Kotak Securities: “L&T has attained scale in India and has a proven track record in execution, now the company is using this to enter global markets. It has necessary infrastructure in West Asia and has also moved the head office of its hydrocarbon division to the same location. Although, some international projects may not be as remunerative as domestic ones, the company’s diversified mix of projects ensures that overall profitability remains largely preserved. The company is also in the process of unlocking value in its infrastructure assets, which will help improve return on capital.”
The company is also giving a major push to manufacturing, of which defence will be a very large part. L&T has invested Rs 1,700 crore in ship-building capabilities. Even though some investments in defence and manufacturing have not yielded returns, Naik says both will form the new core once the government starts sourcing indigenously.
Amit Mahawar of Edelweiss Securities says: “L&T has, over the last 6-8 quarters, witnessed single-digit revenue growth in the domestic market, which we believe is likely to improve materially over the next two years as execution picks up. Also, with improved clarity and regulatory changes in power, roads, defence and transportation, L&T is exposed to a strong upside which could add substantially to its growth outlook over the next three to five years. Its expansion in the West Asian markets will take the company to the next leg of growth, though with increased risk profile.”
Cleaning up IDPL
The company has already begun the process of divesting assets and raising capital through stake sales in its infrastructure subsidiary called Infrastructure Development Projects Limited (IDPL). The company has a portfolio of 27 projects with a total project cost of Rs 60,100 crore. The subsidiary has made equity investments of Rs 7,200 crore and has an equity commitment of Rs 5,600 crore for its current portfolio of projects. L&T plans to derisk its project portfolio by selling a minority stake in IDPL to Canada Pension Plan Investment Board through its Singapore subsidiary. The first tranche of Rs 1,000 crore has been announced, while the second tranche will come in 12 months. Explains Naik, “We need Rs 2,000 crore in cash to fund current projects so that L&T does not end up funding projects.”
The infrastructure subsidiary of L&T has been in troubled waters, as the projects that it bid under private-public partnership have not lived up to expectations. The company has decided to churn its portfolio of development assets so that low-yielding assets are sold and replaced with projects that have a higher internal rate of return (IRR). L&T will no longer bid for road projects that have IRR of less than 20 per cent. Naik says, “Five years from now, only projects with IRR of 20 per cent will exist, so that these can be spun off into a separate company."
IDPL has sold Dhamra Port to Adani. It was losing Rs 300 crore every year. The sale will release Rs 1,100 crore of cash, of which Rs 700 crore will go to IDPL and the rest, which was inter-corporate deposit, to L&T. The company intends to give out Katupalli Port on long-term lease and can raise, say analysts, Rs 350 crore. The company will not develop ports going forward. Even though the company’s power plant does not come under IDPL, L&T intends to exit the power generation business by selling its Rajpura power plant. Naik believes that the company has the capability to build and service turbines and boilers. “We want to focus on that and not run them. We may sell our power plant but it won’t happen overnight.”
Sale of a minority stake in IDPL and exit from ports and power generation business should give the company enough resources to fund IDPL’s capital expenditure of Rs 3,400 crore over the next three years. If the valuation is right, the company may list its 10 operating road assets in Singapore which may help it raise another Rs 2,000 crore.
Cushioning margins
L&T's headline margins may be in double digits, but its Korean and American competitors work on margins of 3-5 per cent. In order to protect the headline margins so that investors don’t penalise the company’s stock, Naik has chosen to improve the profit mix by building a services business (IT and finance). Naik says the net profit margin is 6 per cent in projects but 15 per cent in services, which helps cushion the headline margins. In 2012-13, L&T logged profits of Rs 1,400-1,500 crore from services, representing 27-28 per cent of the total net profit of Rs 5,200.
Piyush Patodia, director, Grant Thornton, says the biggest risks in infrastructure projects arise due to the long concession period, which leads to execution risk, financial risk and viability risk. Companies can mitigate this risk by becoming an asset consolidator or by integrating more into the value chain by getting into manufacturing or other value added service, which would enhance margin and provide the cushion required against risks.
L&T is attempting to do both. The company has also invested heavily in building manufacturing capacities. L&T will exit four manufacturing businesses where the business is less than Rs 2,000 crore. As domestic demand is weak, L&T is focused on exports. For instance, its valve business is doing well and currently is worth Rs 1,600 crore. While the construction machinery and heavy engineering units are doing well, defence manufacturing brings in Rs 1,000 crore. In 2014-15, manufacturing and services are expected to contribute around Rs 2,800 crore to the net profit.
L&T is the only Indian company to have capabilities in four segments — ship-building, field guns, missile launchers and weapon systems. It has a warship design group that can build warships from scratch, but is losing money for lack of orders. Naik says, “We will also focus on the field guns programme. Our Rs 1,700-crore investment in ship building will turn positive. That will make a difference to L&T’s overall top line and bottom line. Only six companies in the world can build nuclear submarines and L&T is one of them (in collaboration with partner Naval Design Group). Defence electronics is the next big opportunity as everything is dependent on communication and connectedness.” L&T is targeting at least Rs 25,000 crore from defence electronics contracts over the next five years and up to Rs 3,000 crore from the field gun programme.
Making L&T nimble
Given that the company has entered diverse and complex businesses which require focus and rapid decision-making, the company intends to follow a “hybrid holding structure” and give autonomy to independent companies and business verticals. In order to empower business units and give them autonomy, L&T has divided itself into nine verticals: buildings & factories; transportation infrastructure; heavy civil infrastructure; power transmission & distribution; water & renewable energy; heavy engineering, shipbuilding, power, metallurgical & material handling; electrical & automation; construction & mining machinery; and real estate. These will act like independent companies and will have their own internal boards. The boards and business heads have been put in place. Some of these companies will be headquartered in West Asia countries and they will service India from there. It might sound like more corporate chaos but L&T is determined to prove it has a new model for managing conglomerates.
| INTERNATIONAL ORDERS NO LONGER A RISK TO MARGINS |
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Even though economic growth has halved, L&T has reported double-digit growth in order inflows and revenues. But analysts and investors have remained cautious, as they believe that the company has sacrificed margins in order to grow the business. International orders have a significantly lower margin (5-6 per cent) than Indian projects (11-12 per cent). For L&T, international orders accounted for 33 per cent of the total orders won in 2013-14. This is perceived to be a significant risk as there isn’t enough clarity on the competitive landscape in international markets and margin erosion in the order book. Contrary to the market’s fears, the management believes the worst is over for the company’s margins. While the robust 15-20 per cent margins in the services business are able to support the company’s standalone margins, the margins for the international business too are expected to inch up this year. The last two years have been challenging for the company as the terms of trade changed significantly after the Arab Spring and the margins in the hydrocarbon projects fell to 3 per cent. Given that these projects have a gestation period of three years, most of the low-margin projects will soon be out of the system, which will automatically lift margins. R Govindan, vice-president (corporate finance & risk management) at L&T, says, “We have the ability to stabilise margins and the sharp fall in the margins is a one-time problem. Also, the business mix is changing and the share of construction is getting bigger where margins are not impacted, which makes us believe that we can sustain 8 per cent margins.” The competition has cooled after the Korean companies lost $5-6 billion in projects. With American and Korean companies becoming risk-averse, rationality has returned to the bidding process in these markets, making L&T confident about 8 per cent margins in international projects. The situation is also looking up in India as commodity prices have eased from earlier highs. Labour costs too have eased, claims Govindan. While terms of trade are set to improve in India, the company’s robust balance sheet is also better placed to take on big projects. At the same time, competition is becoming less intense in sectors where L&T sees opportunities. The Chinese are effectively out of the power sector and along with them others like Clayton, Hyundai and Samsung too have scaled back India plans in the last four years. In this backdrop, the company is looking at revenue growth of CAGR 22-25 per cent over the next five years with stable margins. Naik divides L&T to rule the future |
CLARIFICATION
This article has been modified to correct R Govindan's designation. We regret the error.
