Naik divides L&T to rule the future

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. Indias 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&Ts 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 dont see merit in the company owning and running power
plants, ports or roads either, as the companys 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 companys profitability needs to be cushioned
as turnkey projects are high-risk and low on margins. Its 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. Naiks 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 companys board is quietly creating a global mega corporation, which will
compete with the worlds 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&Ts 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 companys 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 companys 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 wont 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 IDPLs 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 dont penalise the
companys 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&Ts 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

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 isnt enough clarity on
the competitive landscape in international markets and margin erosion in the order book.

Contrary to the markets fears, the management believes the worst is over for the companys margins.
While the robust 15-20 per cent margins in the services business are able to support the companys
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 companys 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