Outlook Profit on L%26T-1

8/3/2019 Outlook Profit on L%26T-1

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COV E R S TORY LARSEN & TOUBROIll F O R E S I G H TO R F 1N A N C

` . . . y o u f ind a m an inthe w orld w ho w il l k il lhiinselffo ur tim es a day ,has w ork ed for m orethan a hu ndred, y ears,started m ore th an 60per cent of the com panyhim self w ith dev otionand passion, and no tbo thered, abo ut his ow nfam ily . Th e day y ou f indsuch a m an, he is m ysuccessor, " declared A M Naik, the69-year-old chairman and CEOof Larsen &Toubro (L&T), in an interview with a businessmagazine earlier this year. He was addressing theissue of his successor -- Naik is due to retire inSeptember 2012. "There is no such person," hewent on to conclude. "And therefore, you cannotrun L&T as you ran it before."

30 I c)nt lo , l ; PlHOJ IT I October2011


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'IA L M E S S ?L A R S E N & T O U B R O ' S C O M P L I C A T E D S T R U C T U R E A N D P O O R G O V E R N A N C ES T A N D A R D S R A I S E Q U E S T I O N S A B O U T I T S S U S T A I N A B I L I T Y

Jaishankar Krishnamurthy N Mahalakshmi


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C OV E R S TOR Y LA iRSEN & T O U B R OAll diretors of L& T,including A M Naik,have consistently soldshares in 2010

A M Naik sold 290,091 sharesbetween Jun-Nov 2010. Since Dec 2008,

he has sold 22.7%o of his holdin

K Venkataramanan, president,EPC, sold 102,105 shares from

Aug to Nov 2010

Naik's passion - and possessiveness - for L&T is under-standable. He has spent nearly half a century in the or-ganisation and, since taking over as CEO in 1999, turnedthe company into a personal fiefdom of sorts. That's causefor comment anywhere, but especially so in L&T: it countsamong the handful of widely-held companies that are pro-fessionally managed, with no single owner controlling thecompany. L&T is supposed to be run by its board, whichconstitutes a mix of full-time directors, nominee directorsappointed by inert government-owned financial institutionsthat hold a substantial stake in the company, and indepen-dent directors. Only, the chairman of the board is N aik him-self. And all business decisions, including his own pay, areinfluenced by him.No one's complaining - yet. Overflowing coffers and a

bulging order-book, thanks to the favourable economic en-vironment and L&T's credo of execution excellence, meantno one really cared if it was a one-man show or whetherthere was enough bandwidth at the top for a company of itssize. Governance could take a back seat as long as there wasenough for everyone. And there was.Today, this mammoth organisation is made up of 38,000employees in 15 3 businesses (bundled under 63 strategicbusiness units), 125 subsidiaries with consolidated revenuesof Rs 53,204 crore, and stands at the cusp of a painful trans-formation. The current structure is just too complex. Good,

32 I r lutlnnt PIll II I ; October 2011

bad and ugly businesses are clubbed together. It's not ahappy situation for investors and that's putting it mildly.The fear is that the very factors which brought L&T to

this pivotal position could conspire to stunt its growth. Weare talking about the breakneck growth strategy the com-pany adopted under Naik; the intensifying competition inthe civil construction business which constitutes 85 per centof revenues today; the heightened risks associated with theproject development business that will determine its futurecourse; and the stepping down of the irreplaceable CE O.

Ever since Naik went public in January 2011 with his inten-tion to divide L&T into nine virtual companies, the shareprice has gone only one way - down. Of course, not all ofthe fall can be attributed to the conglomerate 's restructur-ing because shares of all construction players have taken aknock during the period. Curiously though, Naik sold abouta tenth of his stake a few months before the split was madepublic and currently holds 1.7 million shares. And he's beena seller through the period, although the numbers are notalarming. It is not just Naik - all the directors have beenbusy selling shares through 2010. Are they doing this in allawareness of the repercussions of the change that is nowwidely seen as a big negative for shareholders? Or, did theysell in anticipation of a generally weak stock market envi-ronment? That 's open to question. But i t 's more than reasonenough to wonder: is the L&T stock indeed past its peak?


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In the f i rs t week of N ovember 2010, 1when the stock wa s c lose to i ts peak of

R s 2,192, all directors sold acombined 78,000 shares

Our repeated efforts to get a meeting with the manage-ment proved futile. A detailed list of questions mailedto the corporate communications department too wentunanswered.

LOSING THE WAYHow did L&T get here? The enterprise was one of thebiggest beneficiaries of the growth in the Indian economybetween 2003 and 2008 - turnover tripled from Rs 10,000crore to Its 30,000 crore and profits quadrupled from Its600 crore to Its 2,400 core. Only a handful of companieseven came close to it in size and, during this period. L&Tannounced two bonus issues of 1:1 in 2006 and 2008. Itsbalance sheet was solid.Undeniably, L&T has rightfully earned its reputation as

one of India's most admired engineering and construc-tion companies. But with newcomers like GMR and GVKbagging prestigious projects, L&T's might appeared chal-lenged. With the mainstay construction business bringingin sufficient cash, bidding for big projects seemed like anatural progression to maintain the growth momentum.It was also a win-win for the company: there was hugegrowth opportunity to be exploited in big infrastructureprojects across the spectrum, from roads to ports, and thiswould also secure orders for its mainstay engineering andconstruction business.

O ptio n bo untyDirectors' compensation at L&T tops that of any othercompany in the history of Indian business

C u r r e n t h o ld i n g S o l d s i n c e J u n e 2 0 0 9

A M N a i k 1,703,909 505,402

J P Nayak 1,150,004 ; 71,850Y MDeosthalee 1,102,672 60,000KVenkataramanan 583,419 102,105K VRangaswami -

150,000 50,000

N H ari haran 13,477 14,425

Source: BSE, NSE , B loomberg

The zest for more did not stop there. L&T also scoutedaround for other businesses it could enter quickly. Commer-cial real estate was doing well and L&T decided to bid forthe Rs 1,809 crore Seawoods project (total project cost esti-mated at over Rs 6,000 crore) in Navi Mumbai. Then cameits power foray - the sector was charged up with indepen-dent power producers making exceptional returns, capital-ising on the power shortage in the country. L&T's largestand m ost aggressive bid was Hyderabad M etro Rail (projectcost Rs 16,400 crore). L&T also bid for ports, put up a fac-tory for building ships, another for the manufacture of spe-cial steel and even started a venture to undertake mineralexploration. As if this is not enough, the company is plan-ning to buy a coal mine in the future to ensure fuel supplyfor its power projects. Going by the size of the purchasesmade by other compet itors , L&T could be coughing up overa bi l l ion dol lars for mines.

That wasn' t nearly enough, though. And so L&T also t r iedits luck in the software and financial services space. It madea bid for Satyam C om puter after its fal l from grace, offeringRs 1,400 crore, but eventually lost the race to Tech Mahin-dra. In the financial services space, its arm, L&T Finance,took over Cholamandalam Asset Management Company.Later, L&T Finance wa s spun off and listed separately.If there was any common thread linking all these ven-

tures, it wasn't visible. Indeed, L&T's approach to expan-

October2011I ()utli,,4, I'11()flT 33

T o t a l


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COVER STORY LARSEN &TOUBRO

One-way diveFalling profits from the core business reflect increasing cost and competitive pressure

inTeF Y D B

T o t a l a s s e t s C a s h & b a n k b a l a n c eF Y D 9

1.459

95

sion seemed as haphazard as throwing darts at a board,blindfolded. The result: an unwieldy corporate ownershipstructure with too many businesses to handle. In the pastfour years, L&T's subsidiaries have ballooned, from 61 to125, making it nearly impossible to analyse the companyand understand what's going on, leave alone attempting toforecast its earnings.Cut through the clutter and see what's at stake. In thesepast four years alone, L&T, despite having li tt le or no expe-

rience as a developer, has committed investments of aboutRs 70,000 crore (this includes its own capex for putting upsteel plants and shipyard, and another Rs 62,700 crore forown project developments). Thus, L&T's capes now extendsto greenfield projects across diverse businesses.THE ROT IS YET TO SHOWThe real effects of L&T's transformation from an engineer-ing and construction company to an infrastructure develop-ment and f inance company will become apparent only whenit executes its planned development projects of Rs 62,700crore over the next fou r years. However, what 's already obvi-ous is that its profitability in the construction business willonly go downhill due to lack of entry barriers. This realisa-tion probably triggered L&T's transition to becoming a de-veloper but the projects the company is taking on involvelonger gestation and come with lower profi tabi li ty.Some stress is start ing to show already. L&T's return on av-erage net assets (total assets less cash and investments) hasfallen from 17 per cent in FY 08 to 10 per cent in FY 11, as mostof i ts projects are sti l l in the developm ent stage (See graphic:One-way dive). Part of the trouble is that competi t ion is play-ing havoc across the infra spectrum but the managem ent hasto shoulder its share of blame too - its aggressive approachwill push down its return profile and, in the worst case, endup saddling the balance sheet with a pi le of debt.In the case of some projects, L&T's bidding appears to

have no basis in reality and the company will now have to

34 ! Out loo l , I ' I tO ITF October 2011

pay the price for it. For the Sea wood s project, it bid Its 1,809crore whereas rivals bid far lower (DLF: Its 1,530 crore; IndiaBulls: Its 1,059 crore). The second and bigger fiasco is theHyderabad M etro Rai l bid. Where the government had indi-cated viability gap funding of Rs 4,853 crore at the time ofbidding, L&T won the project by quoting Rs 1,458 crore, thatis , less than a third of the governm ent-stated f igure. The bidwas at least 30 per cent lower than its nearest rival TranstroyIndia (Rs 2,200 crore) and Reliance Infra (Rs 2,991 crore).Was that bravado or foresight? Sources say that the compa-ny wil l take a significant hit in the Hyderabad M etro project .Part of the reason why L&T is able to bid aggressively is

because it works with a higher leverage, which maximisesreturn on equity. Unlike most other players, L&T has suchan incredible credit record, thanks to its steady cash flows,that banks are willing to extend a h igher proportion of d ebt,and at better rates. While this appears to be a smart strat-egy, considering the external risks to the company; a highleverage tends to leave l i t tle room for error of judgement.

66 L&T's order-bookcomes with a fairshare of risk as well- 22per cent of theorders are from itsown developments andabout 30per cent ofthe orders are fromthe power sector


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Over the past four years, L&T's borrowing levels have al-most tripled and part of the funds were used for lendingby L&T Finance. Even after stripping off the impact dueto L&T Finance, borrowings have increased from roughlyIts 6,000 crore to Its 15,500 crore. The debt levels in L&Tare not of much concern today but it 's disconcerting thatthe borrowings will increase quite substantially as the com-pany develops its projects with estimated investments ofRs 62,700 crore. Since the company plans to finance projectsat a debt-equity of 4:1, the debt for these projects alone willbe Rs 50,000 crore. The problem is, since most of them arebuild-own-operate-transfer (BOOT) projects with long ges-tation periods, income levels will remain low and interestexpenses will soar even after the completion of the projects ,hurting consolidated profits.So far, the full impact of the increase in debt has not beenfelt as in FY11 the company has capitalised Its 58 3 crore,or 40 per cent of the total interest expense (10 per cent ofprofit before tax) in projects that are still not complete. Asconstruction ends, the full interest expense will be debitedto the P&L account. Just to put this in perspective, thiscapitalised interest would have shaved off Its 10 from thecompany's reported earnings per share last year (See tableon page 38: Unpleasant surprise). There is absolutely noth-ing wrong with capitalising interest but it underscores thepotential effect on earnings when all these expenses hit thecompany's P&L as the projects get completed. In the near-term, high interest rates are an additional worry.So far, if there is one reason analysts remain more optimis-tic about L&T than any other infra company, that reasonhas to be its impressive order-book. But the current order-book comes with a fair share of risk as well - 22 per cent ofthe orders are from L&T's own developments and about 30per cent of the orders are from the power sector. (See graph-ic: Camoufla ge ) It's worth noting that since power projectswill be executed by the joint venture between L&T andM itsubishi , where the company has a 51 per cent s take, onlyhalf the profits will accrue to the company. Furthermore,with the large increase in the capacity of the power equip-ment manufacturing sector, and due to increased competi-t ion from Ch ina, profit margins on these projects have comedown sharply in the last three years.HIDDEN FINANCIAL COSTSDig deeper into the balance sheet and you can see the hid-den boulders that will make the company's onward journeya rocky one. Only, by the time the company starts trippingon them, there may be new leaders at the top. Naik willretire in 2012. Former CFO, YM Deosthalee, who hasstepped down from L&T and moved over to become chair-man of L&T Finance, has 1.1 million shares.

It is in this context that L&T's complicated ownershipstructure becomes questionable. The maze lends the man-agement considerable discretion in accounting treatments,

which can camouflage the real picture. As it appears now,this discretion in accounting can very well inflate short-term profits at the cost of long-term returns. Here's how.Standalone company, L&T, provides services to its build-own-transfer (BOT) projects, for which it gets paid. Sincethe service provider has ongoing commercial operations,any reimbursement or fees paid by the start-up companywould increase net income even as the companies to whichit provides these services, the BOT projects, will not accountfor the expenses in their P&L account as they are allow ed tocapitalise expenses (or show them as work in progress or asadditions to f ixed assets) t il l the completion of the project.Sample this: L&T Infrastructure Finance, a division of

L&T Finance, charged Nabha Power (a BOT project) ad-visory fees of Rs 7.94 crore for arranging bank finance forthe latter. While L&T Infrastructure Finance books an in-

I come of Rs 7.94 crore, which boosts the bottomline of theconsolidated entity, the books of Nabha Power show it aswork-in-progress, which has no impact on the bottomline.As a result of this differential treatment, L&T's consolidat-ed profits have gone up by its 7.94 crore. ' Last f iscal, L&TInfrastructure Finance earned Rs 24 crore in such fees fromvarious start-up ventures, thereby increasing the consoli-dated profit of L&T Finance to that extent.

What is Rs 24 crore for a company of L& T's size, you mayask. Granted, it's a pittance. But the effect of such treat-

I ment can't be ignored as it has implications for the corn-

On the houseThe company's development orders have seen athree-fold jump in recent years

O r d e r - b o o k i n t oP o w e rD e v e l o p m e n tO t h e r s ( E x t e r n a l )

100,23965,109

70,319

October 20111 rwflr,r,k 1'141141 35

130,217

7.73515,470

47,1147,017

30,072

63,15123,439

41,669

F Y 1 1Y 0 9 F Y 1 0


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C O V E R S T O R Y L A R S E N & T O U B R O ."Would these directorsget the same level ofremuneration f theywere to seek employmentoutside?Pradip ShahFounder, fndAsia Fund Advisors

"For a company that is ascomplex as it is by the C EO 'sown admission, is the boardreally well equipped toadvise on cr itical issues?Anil SinghviM anaging d irector . 'can Investment Advisors

members. He asks, "Directors ' compensation must be basedon opportunity cost of employment - would these directorsget the same level of remuneration if they were to seek em-ployment outside?"There are also questions over the L&T Employee Wel-

fare Foundation that was formed in 2004 during the sale ofUltratech Cement to Grasim. After the sale of the cementbusiness to L&T, following the protracted battle, Grasimhad sold the 14.95 per cent stake it had accumulated inL.&T back to the Welfare fund for Rs 47 0 crore (this waspart of negotiated deal). This purchase was financed by wayof loans from L&T since the Welfare Fund was a new en-t i ty with no m oney. Currently, the foundation hold s 12.2 percent stake, after dilution of equity. The market value of thisfoundation is Rs 10,000 crore, but there is very little clarityon how this fund will be uti lised.It's not only the quantum of compensation - although

that's enough to make jaws drop. It is a question of the inde-pendence of directors. Independent director and chairman

40 I Outl,.,k PROI'I I I October 2011

of the remuneration comm ittee, S Rajagopal, refused to answer Outlook Profi t's calls, saying he was not authorised tcspeak to the media. Rajagopal, 76, has been on L&T's boarcsince 2002, first as nominee director for UTI (Special Un.dertaking) until 2006, after which he has continued as arindependent director. "If you have a director on board of acompany for nearly a de cade, can he really continue to be in-dependent," Singhvi asks, "Wouldn't proximity play a role inhis remaining independent?" M Damo daran, ex-chairman ofthe Securi t ies and E xchange Board of I ndia, agrees. "Somedirectors stay on in the boardroom longer than the furniture- i t 's not done. Y our independence tends to get impacted indirect proportion to the length of the relationship with thecompany management/promoters." For the record, apartfrom the Rs 21 lakh remuneration (last fiscal) he gets fromthe company, Rajagopal has been granted 6 0,000 stock op-tions. It may be recalled that in 2007, L&T had issued op-tions to LTC's nominee directors, to which the insurancemajor has raised objections, saying the directors were repre-

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"21 d irector's independ encetends to get im pacted indirect pr oportion to thelength of'the relationshipwith the managementM DamodaranEx-chairman, Securities and Exchange Board of India

sentatives of the institution and could not, therefore, acceptstock options in their individual capacity. There's no law bar-ring individuals from accepting stock options from compa-nies but it 's a grey area from the governance point of view.Singhvi's 11AS had advised investors to vote against there-appointment of two independent directors - S Rajagopaland SN Talwar - who were to retire by rotation, on grounds

that the company did not have any stated policy on theage of directors and their tenure on the board. Rajagopalhas been on the board for ten years, and S N Talwar, 73 ,has been around for seven years. Besides L&T, Talwar is adirector of 55 other companies. That is a fair point.Speaking with a business magazine earlier this year, ananonymous L&T hoard member was quoted saying thateven the board looks up to Naik for directions. If indeedtrue, it is obviously undesirable. "The combination of achairman and chief executive role is the ultimate negationof corporate governance. If you are on the board, you aresupposed to ask questions to the management, and the

CEO must answer those questions. If you wear both hats,you ask and answer quest ions to yourself," says Damod aran.For a company that is run by the board, the board memberssurely need to exert greater authority. "For a company thatis as complex as i t [L&T] is by the C EO's own admission, isthe board reall y well equipped to advise on cri tical issues?"asks Singhvi.

It is not just non-executive directors. Naik himself is 69and issues of succession are being talked about only in thepast one year, whereas they should have been consideredmany years ago. "Why is the CE O's retirement age differentfrom that of others?" asks Singhvi. "Is i t because he d id notwant to groom a successor for himself for obvious reasons?So, is that. not a major failure?"VALUE CREATION - REALLY?Shares of L&T have certainly taken a beating in the pastyear but many analysts still justify a `buy' based on a sum-of-parts valuation. The implicit assumption in such calcula-tions is that the company will spin off certain projects aftertheir development is over, which will unlock shareholdervalue. But spin-offs are really subject to projects gettingcompleted without any major cost and time overruns. Evenif you buy the sum-of-parts theory, you cannot ignore thefact that the consolidated balance sheet will take someamount of' stress in the initial years of development, untilrevenues start kicking in. Some of the projects L&T hasin hand do not give enough comfort - for instance, theSeawoods venture, for which the company bid Rs 1,800 croreand paid Its 1,000 crore upfront in 2008, has just startedafter a three-year delay because of pending approvals. TheHyderabad M etro rail project is delayed due to protests overthe Telengana issue.The split that the company is now working on to address

the issue of succession is a futile exercise. Creating virtualcompanies with separate boards will add to the headcountbut not serve the purpose unless the idea is to run the com-panies independently. If the idea is to create a holding com-pany structure and lis t companies separately, i t wi ll destroyvalue for existing shareholders because L& T will no lon gerget the same valuation - holding companies always tradeat a discount to their asset value because they may neverbe sold to realise their real worth. Even a full-fledged ver-tical split may be detrimental because size does matter inthe infrastructure business. Also, splitting the companiesvertically will make the smaller companies vulnerable totakeover.Given the intense competition in the construction

business, the risks involved in project development, and themanagement transition, there is nothing going for L&T atthis point except that it is better than most other bets inthe infra pack. But that certainly is not enough to carry thestock through these troubled times. And the directors, bytheir actions, are not telling you any differently. D

October 2011 t (P tl.,k PROFIT 14 1

Outlook Profit on L%26T-1

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