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L&T storms Mindtree gates, but its own investors feel the heat

If L&T can pull off the Mindtree takeover, it stands to gain from higher scale in some key verticals, which will give access to some clients and projects, which L&T Infotech couldn’t target on its own. (Vipul Sharma/Mint)Premium
If L&T can pull off the Mindtree takeover, it stands to gain from higher scale in some key verticals, which will give access to some clients and projects, which L&T Infotech couldn’t target on its own. (Vipul Sharma/Mint)

  • Larsen and Toubro's (L&T's) hostile takeover provides a nice exit window for Mindtree investors at 980/share
  • The worry is for L&T investors, since the engineering conglomerate is increasing exposure to non-core businesses

"Be assured that the Barbarians are out there just beyond the gate, licking their wounds, biding their time, waiting for their next chance to storm the gates," wrote Bryan Burrough and John Helyar in their classic book Barbarians at the Gate.

It is well over 30 years since the events in the book took place, when private equity firm Kohlberg Kravis Roberts (KKR) acquired RJR Nabisco for $25 billion. But for company boards, especially those with low promoter shareholding, the lurking danger of a hostile takeover remains.

Mindtree Ltd’s founders and management had thought they had fended off Larsen and Toubro Ltd (L&T), when the latter tried talking them into a friendly merger and acquisition deal. But L&T is back and how. It has set aside 10,700 crore to buy up to 67% in Mindtree in a hostile takeover. At 980 per share, it is also paying top dollar for the acquisition.

In fact, L&T’s entry provides a nice exit opportunity for Mindtree shareholders, with valuations at the top end among Midcap IT stocks (see chart). If anything, the worry is for L&T shareholders, since the engineering and construction (E&C) conglomerate is increasing exposure to non-core businesses. A conglomerate with multiple arms is typically valued at a discount by investors. It is also taking a fair amount of risk related to integration of Mindtree, without the support of the latter’s founders.

The company’s decision to use its cash for an acquisition in a non-core business raises pertinent questions about capital allocation as well, say analysts. “We believe it will not be in line with L&T’s core focus of listing (cashing on) non-core businesses and enhancing shareholder value," says a report by Jefferies India Pvt. Ltd.

Indeed, just a few months ago, L&T had plans to return cash to shareholders through a 9,000-crore share buyback. The plan was oddly blocked by the Securities and Exchange Board of India (Sebi), on the grounds that L&T’s debt-equity position doesn’t allow a reduction in its equity. But high leverage isn’t really L&T’s problem. Its net debt-equity ratio could rise marginally from 1.3 times to 1.5 times after the Mindtree deal, adds the Jefferies report.

As pointed out earlier, the larger worry is that of capital allocation. Shareholders would rather have the company return cash in some form, than be adventurous with its use. The Mindtree acquisition is fraught with risks.

According to analysts at Motilal Oswal Financial Services Ltd, some of Mindtree’s top clients have had long-standing relationships with the company and its founding leaders have been the face of these. “The top 10 clients contribute about 44% to revenues. The risk to growth and/or relationships in one or multiple accounts cannot be completely ruled out," they said in a note. Also, as pointed out earlier in this column, integration risks are high in businesses where people are the biggest assets.

If L&T can pull it off, it stands to gain from higher scale in some key verticals, which will give access to some clients and projects, which subsidiary, L&T Infotech Ltd, couldn’t target on its own.

“We think the combined entity will be in a sweet spot with scale in almost all major verticals, barring healthcare," analysts at Elara Securities (India) Pvt. Ltd said in a note to clients.

L&T is also banking on the de-risking narrative to soothe its shareholders’ nerves.

According to R. Shankar Raman, chief financial officer at L&T, “A strong presence in IT will de-risk the E&C business, where margins are low and projects are long-drawn. While financial services business is counter-cyclical to E&C, the IT services business brings in relatively stable cash flows."

The 1.5% drop in L&T shares on Tuesday shows investors are not particularly worried about the acquisition, but aren’t very convinced with Raman’s reasoning either. They would have clearly preferred an outcome where their company didn’t storm the gates, but waited to be asked in.

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