Mumbai: Shareholders of Larsen and Toubro Ltd (L&T), India’s largest engineering and construction company, are paying the price for its heavy investments in capital-intensive sectors such as infrastructure over the past five years in a shift away from its so-called asset-light strategy.

These investments made through different subsidiaries, including L&T Infrastructure Development Projects Ltd (L&T IDPL), have nearly halved the returns to shareholders as measured by the return on equity (RoE), according to analysts, who expect the pressure on returns to persist.

While L&T’s businesses in the technology and power sectors are performing well, the company’s investments in road projects and the much-delayed Hyderabad Metro rail network have squeezed returns.

L&T is the largest road concessionaire in the country, with 17 road projects involving a total estimated project cost of 18,200 crore. The projects, of which 13 are operational, reported a traffic growth of 7% in the quarter ended 30 September but continue to post a loss.

L&T is also developing the Hyderabad Metro project, the first phase of which is likely to be completed only in 2018, past its original completion date of June 2017. This has led to cost overruns and pushed back the timeline over which the project is expected to turn profitable.

From L&T IDPL alone, the RoE has fallen to under 10% as on date from 18% about five years ago, said Maybank Kim Eng Securities India analyst Anubhav Gupta.

“L&T’s RoE suffers due to poor returns from investments in infrastructure projects such as roads, mass transit railways, ports, etc. With a decline in construction earnings, RoE should decline to 8.8% from 12.1% over FY15-17," Gupta wrote in a 2 November report, while lowering L&T shares to a “sell" rating.

According to a 21 October report by Motilal Oswal Securities Ltd, L&T’s investments in subsidiaries (including loans and advances) have risen to 20,400 crore from 1,300 crore between fiscals 2008 and 2015. Over this period, L&T’s standalone RoE declined to 13% from 28%.

These investments were largely in units such as L&T IDPL, L&T Finance Holdings Ltd, power development, shipbuilding, forgings, hydrocarbons, information technology and technology services, among others.

The biggest millstone around the company’s neck is the Hyderabad Metro project, according to analysts.

“The Hyderabad Metro project does not have any equity value and the company will post losses and possibly require write-offs. Successful divestitures, similar to the past, will be difficult to replicate, given viability issues around Metro/many roads," Ambit Capital analysts Nitin Bhasin and Utsav Mehta wrote in a 14 October report.

They estimate the Hyderabad metro project will incur a cumulative loss of 2,200 crore in the first three years of operations.

“We believe L&T will incur cumulative losses more than the equity invested by L&T in the Hyderabad metro project."

The project was estimated to cost 17,000 crore and received a viability gap funding of 1,458 crore from the central government in 2013. Viability gap funding is money provided by the government to projects that have an economic value, but may not be financially viable.

Analysts estimate L&T’s equity in the project at around 3,400 crore, with the rest being raised as debt.

According to the Motilal Oswal report cited above, the Hyderabad metro project is expected to make a loss of 1,100 crore on an annual basis till fiscal 2020 and only turn profitable from fiscal 2022.

L&T had in September 2010 signed a concession agreement for a period of 35 years with the then Andhra Pradesh government to construct, operate and maintain the metro rail on three elevated corridors spanning 72km. The state has since been divided, with Hyderabad being transferred to the newly created state of Telangana, although it will serve as a joint capital until 2024.

The company’s management believes that the outlook for the Hyderabad metro project is improving.

The ground reality with the Hyderabad metro project has improved significantly with the Telangana government becoming proactive, helping the project move forward, said an L&T IDPL senior official, who requested anonymity as he is not authorized to speak to reporters.

The first phase will see some segments of the metro project getting completed by June 2017, and the remaining in 2018, the official said.

Analysts are also concerned about the quality of L&T IDPL’s road portfolio.

L&T’s road portfolio is “poorer in quality vis-à-vis its peers" with nine of the 13 operational projects not being able to generate sufficient cash from operations, the Ambit analysts wrote. They expect the roads portfolio to continue to post losses over the next few years.

With L&T’s infrastructure investments putting pressure on shareholder returns, the company is now under pressure to divest assets and return to an asset-light model. Divestments are also needed to reduce the company’s net debt, which was at 98,264.97 crore as on 30 September.

Motilal Oswal analysts estimate consolidated debt to rise to around 1,03,066.5 crore by the end of current fiscal year due to higher costs and an increase in debt associated with the Hyderabad metro and road projects.

This month, L&T announced the sale of its Kattupalli port in Tamil Nadu to Adani Ports and Special Economic Zone Ltd. Other projects may also be up for divestment, even though the management maintains that it will not rush into sales.

The company is holding onto its assets for the want of a premium valuation, said an investment banker, asking not to be named as he is not authorized to speak to the media.

“We are in the business of developing projects, commissioning them and churning them. We are not in the business of operating them through 20-25 years," said L&T’s chief financial officer Shankar Raman on 30 October.

“There are two types of sellers. One is distressed sellers; they have to sell to fix their balance sheet. So it’s the right time for them (to sell assets). Then there are value sellers. I don’t think it’s the right time for value sellers," Raman said.

He said that the company may look to monetize its infrastructure assets through the newly introduced infrastructure investment trust model.

On 15 October, Mint reported that L&T plans to list five operational road assets through an infrastructure investment trust and expects to raise more than 2,000 crore through this process.

“Today we have a critical mass of toll road assets, which we are trying to work on a format to monetize. We did try a year ago through overseas listing but India came up with its own version of investment trust and there are still some issues to be ironed out with this. I do believe that over the long term it’s a good platform that India should nurture," said Raman.

L&T IDPL had in November 2013 said it was considering an initial public offering (IPO) in Singapore as well as listing certain road assets of the unit through a business trust in Singapore.

The plan was shelved.

In June 2014, L&T IDPL received a commitment of 2,000 crore of investment from the Canada Pension Plan Investment Board (CPPIB), Canada’s largest pension fund manager. CPPIB said it will invest the amount in two tranches with a gap of 12 months. The first tranche of the investment was made in December 2014 through CPPIB’s subsidiary CPP Investment Board Singaporean Holdings. L&T has reiterated that the remaining investment will come in by December this year.

According to two investment bankers who spoke on condition of anonymity, CPPIB and L&T IDPL are in negotiations to alter some of the terms of investment ahead of the second tranche of investment.

CPPIB, however, says it remains committed to the investment.

“CPPIB remains happy with the partnership with L&T IDPL in India and looks forward to continuing the relationship," the board said in an email response to a query from Mint.

Up to Tuesday’s close, L&T’s shares have fallen 9.55% from the beginning of the calendar year while the benchmark Sensex has lost 5.95%. The BSE Capital Goods index declined 7.16% in the same period.

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