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Analysts at Jefferies India Pvt. Ltd have pointed out that return ratios in L&T's non-core businesses have been lower compared to the core engineering business since FY04. (Mint)
Analysts at Jefferies India Pvt. Ltd have pointed out that return ratios in L&T's non-core businesses have been lower compared to the core engineering business since FY04. (Mint)

L&T’s special dividend proposal raises hopes of better capital allocation

  • L&T had announced that it will distribute a part of earnings from its deal with Schneider Electric among shareholders
  • Analysts' estimates on how much of this will be paid as special dividend range from 18 to 38 per share

Engineering and construction major Larsen & Toubro (L&T) will announce its September quarter earnings on Wednesday. But investors are more eager about a proposed special dividend than the quarterly result. The stock was up around 5% since the company said it will consider a special dividend on 28 October.

A part of the 14,000 crore from L&T recently concluded deal with Schneider Electric would be distributed to shareholders. Adjusted for tax, analysts estimate net sale proceeds to be around 12,000 crore or around 86 on a per share basis.

Analysts' estimates on how much of this will be paid as special dividend range from 18 to 38 per share. It’s also important that the remainder of the funds are used to retire debt and make the balance sheet lean, rather than reinvesting them in non-core businesses.

“Post-tax, the company would get around 12,000 crore, we are expecting the special dividend to be around 36 per share. For the stock to rise further, the special dividend has to be significant. We may see some correction in the stock, if they announce anything below 10 per share. However, valuation re-rating will depend on its capital allocation strategy and outlook on core business. The company is taking steps to reduce its focus in non-core business to allay investors’ concerns but it will take more time for these concerns to completely ease," said an analyst with a multinational brokerage house requesting anonymity.

It should be noted that L&T had last distributed a special dividend of 15 per share in 2008. A special dividend coming after more than a decade encourages a positive sentiment. A niggling worry for L&T’s investors has been the management decision to deploy cash in non-core assets. Analysts at Jefferies India Pvt. Ltd have pointed out that return ratios in non-core businesses have been lower compared to the core engineering business since FY04.

So, in that sense, this move does send a positive signal. “The proposed decision of the management to distribute part of the E&A divestment proceeds showcases L&T walking the talk, on returning part of the sales funds to shareholders. Though most investors would have preferred a buyback, we believe a special dividend of 30-38/share (40-50% pay-out) may be at the anvil, implying attractive dividend yield in addition to the absolute stock returns," analysts at IIFL Securities Ltd said in a note on 27 October.

But at the same time, it is a short-term distraction from its underlying fundamental concerns, analysts said. The spotlight would soon be back on order inflows and execution, which are more important from a valuations perspective.

With improving labour availability and easing supply-chain, L&T’s execution is expected to have improved in the September quarter. Analysts at Kotak Institutional Equities expect L&T’s core engineering and construction business operating margin to improve sequentially to around 7.8% in Q2FY21. Margins are expected to be aided by operating leverage benefits and cost-rationalization measures. However, the decline in its core EPC revenues is expected to continue in the second quarter as well, they said in their earnings preview report. Meanwhile, L&T’s recent high-speed rail order win could prompt analysts to revise their FY21 order inflow estimates upwards.

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