Under new leadership, Larsen & Toubro is getting leaner and stronger
Larsen and Toubro Ltd (L&T) is getting rid of its electrical and automation (E&A) business, as part of its strategy to exit non-core businesses. It has agreed to sell the business to Schneider Electric at an enterprise valuation of Rs14,000 crore. As the chart alongside shows, non-core businesses have been a drag, and the sale of the E&A business can well be seen as a tacit admission that the company had spread itself too thin in the past.
Of course, this division has been on the block for almost five years, even under the previous leadership. But it so happens that the final decision to sell it has only been taken now. Under S.N. Subrahmanyan, who took over as chief executive and managing director less than a year ago, the mantra is to steer the ship back to its core, which would largely include infrastructure, power, heavy engineering and hydrocarbons.
To be sure, there have been successful attempts in the past to sell stakes in non-core businesses such as financial services and information technology as part of the overall strategy to raise cash. But the company remains a majority owner in these businesses, which are now listed, and the decision to sell the E&A business lock, stock and barrel appears to be a first.
While the funds from this all-cash deal will come into L&T’s coffers only 18 months from now, it would unlock shareholder value by improving return ratios.
L&T’s return on capital employed (ROCE) had peaked at 26% in fiscal year 2007 (FY07), after which it started steadily running downhill after the global recession impacted domestic economic growth. Both private and public sector capex took a hit and orders from its core business of engineering and construction, dwindled. The conglomerate looked to soften the blow by growing other businesses such as financial services, realty, information technology and other miscellaneous activities.
No doubt, the decision helped keep the ship afloat during the stormy weather. But then, return ratios have not been able to scale the FY07 peak in a decade. On the other hand, slow movement of existing infrastructure projects, delayed payments and hefty working capital requirements led to ballooning of debt on its books. The net debt-to-equity ratio doubled to 2 in FY17. Interest costs as a percentage of sales also rose over the years. In other words, the many diversification attempts worsened balance-sheet health.
In that backdrop, the inflow from the E&A sale will help reduce debt and fund strategic acquisitions that strengthen the core. The sale also makes sense because the E&A division is largely a products business, quite different from L&T’s intent to stay mainly in the projects business. Besides, electrical automation is rife with competition.
For investors, the sale is a big positive and lifts confidence in the company’s intent and ability to monetize assets. While the net debt-to-equity ratio is likely to come down to 0.7-0.9 by FY20, ROCE will also rise as a result of the smaller balance- sheet size and on the back of strong operating cash flows. A report from Jefferies India Pvt. Ltd says that apart from macro recovery, a gradual balance-sheet strengthening will lead to a rerating of the stock.
Yet, investors must note that the conglomerate’s diversification had sheltered it to some extent from risks in capex cycles—something that it may again be exposed to.