LARSEN & TOUBRO (L&T) chairman A.M. NAIK wasn’t pleased. On Feb. 22, 2012, a leading business daily carried a front-page story titled ‘L&T chief A.M. Naik still a hero at 70, has long to-do list’. While the article generally lauded Naik’s near-half-a-century stint at the company, it carried a suggestion from Kavil Ramachandran, a professor from the Indian School of Business, that Naik shouldn’t be allowed to continue further, even in a non-executive position. (He is scheduled to step down in September). Ramachandran then pointed out that.
M.V. Subbiah, the former chairman of the Chennai-based Murugappa Group, went to study at the Kellogg School of Management after his retirement, and Naik could do the same. When Naik spoke to his PR minders, he is said to have thundered, “How can they compare me with him? He will hand over his business to his clan and I run a professional company here.”
Naik’s passion for L&T is well known. He still works 18-hour days, talks straight (sometimes to the despair of his spin doctors), and often thumps the table violently when he wants to make a point. He describes his job as a patriotic calling, building all things from turbines to highways to submarines for the nation. Though employees cower in his presence, they acknowledge that he made them many times richer, thanks to the L&T shares they own. Since Naik moved into the corner office in 1999, L&T’s scrip has been on fire. An investment of Rs 10,000 in January 2001 in L&T is worth Rs 1.5 lakh today. Naik is believed to be India’s richest non-family, professional CEO, holding over Rs 250 crore of L&T’s stock. All these details have come together to build his legend. Though not conventionally charismatic, those who meet him walk away admitting there’s something riveting about him. Indeed, his personality may have played a huge role in L&T becoming one of India’s most admired companies.
But now, as the Naik era perhaps draws to a close—‘perhaps’ because Naik may still seek an extension and much will depend on how the domestic financial institutions, which collectively own 38%, respond—is it time to rethink L&T’s business mix?
L&T’s main business is executing turnkey projects including power plants, oil rigs, highways, and construction, dubbed engineering, procurement, and construction (EPC) in the trade; it also has a manufacturing arm that makes power switch gears, mining equipment, electric meters, and the like. Then there are its subsidiaries, a clutch of new businesses that Naik pushed L&T into—software, power, and financial services. These new enterprises aren’t leaders in any of the sectors and, in some sense, they are mere distractions. But the more crucial question for L&T is whether the over-reliance on the EPC business is placing it at risk.
DOUBTING L&T ISN’T EASY IF ONLY because, overall, it continues to prosper and awe analysts and competitors alike. Amitabh Mundhra, managing director of Kolkata-headquartered Simplex Infrastructure, which competes with L&T in port and transport projects, and large civil works, says, “L&T is a mammoth, and in a different league altogether.” Ashish Damania, head, institutional equity, at Emkay Global Financial Services, one of India’s leading brokerage firms, says L&T is one of the most-owned stocks in the capital goods sector across most Indian or India-focussed foreign portfolios.
Over the last two years, Naik has begun positioning L&T as a very complex company which is difficult to understand. Though he wasn’t available for this story despite repeated requests, he had once told me that L&T wasn’t just any company. “It is many companies and businesses rolled into one. And that makes it extremely difficult for anyone to understand.” More recently, on the sidelines of a Mumbai banking conference, Y.M. Deosthalee, ex-chief financial officer and currently the head of L&T Finance, reiterated that line in conversation with journalists.
When Naik began building today’s L&T, his objective, as G.D. Sharma, the former human resource head at L&T’s engineering, construction, and contract division recalls, was to make the elephant dance. “L&T had all the attributes associated with an elephant—a size that commands respect from peers, the strength or a sense of power in the marketplace, and intelligence courtesy some of the country’s brightest engineering minds working for the company.” But speed or nimblefootedness isn’t something one immediately associates with pachyderms. For L&T, that was a big drawback in post-reforms India where opportunities came with heightened competition and greater stock market scrutiny, says Sharma, currently a principal at Chennai-based Beeline HR Advisory.
To inspire his managers, Naik offered several incentives—quicker promotions, better pay, employee stock options, etc. He also began piecing together a strategy that would give L&T a greater share of India’s growth story. As chief financial officer R. Shankar Raman, who also sits on L&T’s board, recounts, “Sometime in the mid-1990s, we realised that L&T only operated in the manufacturing or industrial spaces that accounted for just a third of the economy.” L&T wanted more. Besides entering services (financial, IT), it also plunged deeper into infrastructure development (build-own-operate). But most significantly, it enlarged its EPC portfolio.
Back in the late 1990s, EPC accounted for half of L&T’s revenues while cement and capital goods manufacturing (essentially making machines for diverse industries from tyres to dairy) accounted for a quarter each. (Danish founders Henning Holck-Larsen and Soren Kristian Toubro, both engineers, had envisaged L&T as an engineering company when they started out in 1938 in Mumbai; among their early successes was making dairy machinery in India when Hitler’s 1940 invasion of Denmark stopped imports.) Today, L&T’s EPC portfolio has ballooned to 85%, and capital goods has come down to 11%; dividends, etc. from its subsidiaries, joint ventures, and the like account for the rest. It sold the cement business in 2004. With revenues of around Rs 40,000 crore at the end of FY11, L&T’s EPC division is India’s largest and nearly four times that of the No. 2 player, Punj Lloyd.
The markets have so far cheered L&T’s EPC tilt. L&T remains one of the most popular and expensive stocks in the entire capital goods and construction and engineering pantheon. Its Rs 80,000 crore market capitalisation is more than its key competitor in power, Bharat Heavy Electricals’ (BHEL) Rs 73,000 crore. L&T’s price/earnings ratio multiple is nearly double that of BHEL, despite BHEL being far more profitable and distributing double in dividends. In FY11, BHEL, India’s largest capital goods maker, reported a net profit of Rs 6,046 crore (Rs 4,464 crore for L&T) and handed out dividends worth Rs 1,524 crore (Rs 882.84 crore for L&T).
L&T’s model has been to leverage its balance sheet and its triple-A credit rating, which only the best companies get. This has not faced any headwinds so far because its funding cost is among the lowest in India Inc. despite a gradual deterioration in its key financial ratios over the past five years. (See chart). According to Shankar Raman, L&T’s interest cost was a comfortable 7.5% during the December 2011 quarter. In comparison, the Government of India’s cost of funds is currently over 8% for a 10-year bond. This gives L&T a huge competitive advantage over its peers, most of whom have taken a hit on profitability due to the rising cost of borrowing. But for how long can L&T retain this advantage given the increasing share of riskier businesses in its portfolio?
AJAY SRIVASTAVA, CEO, DIMENSIONs CONSULTING, a boutique corporate and financial consultancy out of Gurgaon, is one of the few who has begun questioning L&T’s approach. “It was a unique company because it married a strong manufacturing footprint in capital goods with the country’s most competent EPC team. But in its rush to grow, it has ended up becoming just another EPC company with few competitive advantages of its own and a pile of working capital liabilities.”
The trouble with any EPC business is that it’s a cash guzzler, even though margins may be attractive. The way it works is you spend out of your pocket to build, say, a road for a client, who then pays you back. The number of days it takes to be paid back depends on the financial health of the client, which is often determined by the overall state of the economy. Obviously, the larger your EPC business becomes, the more you have to pay from your pocket to keep it going. This stretches the company’s working capital cycle. In plain terms, working capital is the cash or funds required to pay for a firm’s operational costs until customers start paying their dues. A longer working capital cycle may force a firm to borrow more to sustain operations or cut down on capital expenditure and diminish long-term growth prospects.
L&T reported a 10% increase in its working capital cycle to 110 days during the first nine months of the current financial year, as projects were deferred and customers stretched their payment schedules. This meant L&T had to foot the 110 days of operational expenses from its own pocket. It also borrowed more. L&T ended the third fiscal quarter with a gross debt of around Rs 9,600 crore compared with Rs 7,100 crore at the beginning of the financial year. Over this period, L&T’s debt-to-equity ratio increased from 0.33 to 0.4. The debt piled up despite the company spending just around Rs 1,000 crore on capital expenditure during April to December last year against a budgeted amount of Rs 2,500 crore for the whole of FY12.
This does not surprise experts. Shobhit Agarwal, director, Protiviti Consulting, says when a slowdown hits the economy, the payment schedule gets affected as companies face a demand slowdown and pressure on margins. “If an EPC company enters the down cycle with debt on the books, then, as customers delay payment, it may have to raise fresh debt to service the existing debt. This leads to a double whammy and the company may fall into a debt trap.”
Shankar Raman says the deterioration in financial ratios is cyclical and not a cause for worry. “This is in line with the historical trends in our EPC business, where the working capital cycles fluctuate from a low of 90 days in good times to around 125 days in bad times.” But think of this. Paying for a 110-day working capital cycle translates into as much as Rs 14,000 crore in the whole of FY12, based on L&T’s estimated revenue for its EPC division; this money could potentially be better spent on long-term capital expenditure.
L&T doesn’t share a segment-wise breakup of revenues of its EPC division. However, it does provide a breakup of its outstanding order book. This provides a glimpse into the changing mix of its bread-and-butter business. The order book is broken into five broad areas: infrastructure, which includes roads and bridges, ports and airports, industrial and commercial buildings, water, and other urban infrastructure; hydrocarbons, which includes rigs, platform pipelines, oil refineries, fertiliser factories, etc.; power, which includes generation, equipment, industrial electrification and transmission and distribution; process, which include minerals, metals, and bulk material handling; and finally, ‘others’, which includes shipbuilding, defence, etc.
Over the years, L&T’s order book mix has tilted in favour of infrastructure and power. At the end of FY11, for instance, infrastructure accounted for 36% of the outstanding order book valued at around Rs 1.3 lakh crore and power projects accounted for another 32%. Six years ago, in FY06, the corresponding figures were 30% and 17%. During the same period, the share of the ‘others’ segment has declined from 17% to 4%. This is significant, as the ‘others’ segment utilised some of L&T’s in-house manufacturing divisions such as electrical, electronics, construction, and mining equipment.
In the absence of segment-wise reporting, it’s tough to make a firm guess about the profitability of the various EPC heads. However, a comparison of the profit before interest and taxes margins of L&T’s EPC peers suggests that profitability is highest in hydroelectric projects and hydrocarbons, and lowest in infrastructure.
Blame the infrastructure boom for deteriorating margins. Given that there are very few entry barriers to EPC, plenty of firms have mushroomed in the last decade. Indeed, many companies that today compete against L&T were once its subcontractors. “In highway projects, the competitive intensity has increased substantially as more companies fight for the same pie. This has thinned the margins,” says Devang Mehta, vice president and head of equity sales at Anand Rathi Financial Services, a brokerage.
Worse, most infrastructure developers are facing a cash crunch. Thanks to high interest rates, they are finding it difficult to raise debt; neither can they raise equity. As a result, projects as well as payments get delayed. Shankar Raman says various banks are currently hawking around 46 different build-operate-transfer (BOT) projects to potential buyers as their original promoters have either backed out or are unable to bring their part of the equity to the table. This has had a cascading effect on their EPC contractors.
L&T IS IN NO DEBT trap. Far from it actually. Thanks to its high market valuation, periodical capital raising by selling shares to new investors, and shedding of manufacturing businesses, money has been flowing in nicely. In the past six years, the company has sold its glass container business, dairy equipment business, ready-mix concrete division, and fuel dispensing unit.
Next on the block is its medical equipment business, and the management has announced plans to spin off the electrical and electronics division—its biggest manufacturing asset—into an independent company. Word on the street is this is a precursor to its eventual selloff to a multinational. That means the share of the EPC business as a part of overall revenues will rise further. At a group level, EPC accounts for three-fourths of revenues, slightly lower than its 85% share of L&T on a standalone basis. In contrast, L&T’s manufacturing businesses, such as electrical and electronics and machinery and industrial products, accounted for just 6% and 5%, respectively, of the parent company’s revenues during the December 2011 quarter.
It wasn’t always like this. Some years ago, in FY07, the EPC business accounted for 74% of L&T’s revenues while electrical and electronics, and machinery and industrial products, accounted for 10% and 11%. Manufacturers, of course, face a different set of challenges. According to Protiviti Consulting’s Agarwal, manufacturing requires upfront capital in plant and equipment and periodic top-ups to create fresh capacity or replenish old assets. “These companies also need to continuously invest in new products and technology or else run the risk of losing out to new entrants or technologically superior competitors. There is no such risk in service-oriented businesses such as EPC,” he says.
This makes manufacturing a tough and messy business in the short to medium term. But the assets get amortised through depreciation benefits, the company masters the knowhow and fills the market with a portfolio of products supported by a strong brand, which creates a formidable entry barrier for new entrants, and the business becomes a cash cow. Thus, manufacturing yields more profit for every rupee of investment, or return on assets is higher, compared to EPC, financial services, and BOT projects.
The decline of manufacturing is beginning to show on L&T’s return on assets (RoA) over the years. In FY11, the RoA for the entire L&T group (on consolidated basis) was 9%: five years earlier it was 13.8%. This also means L&T needs to deploy more capital in its businesses either by injecting fresh equity or raising more debt to maintain a similar level of profitability.
Meanwhile, most of L&T’s peers in capital goods, including BHEL, Thermax, Siemens, and ABB, who don’t have as large an EPC business, have entered the bad times with insignificant or zero debt on their books. Their financials and balance sheet ratios are superior to L&T’s. “This provides these companies with greater staying power if the macroeconomic environment turns nastier going forward,” says Emkay Global’s Damania.
It follows, then, that if the economy continues to deteriorate, L&T’s balance sheet will worsen further. Equally, as the EPC business grows, during the next cyclical downturn, L&T will be stressed even more. Then, it’ll need to fork out even more of its own money to keep an even bigger EPC business going.
SHANKAR RAMAN SEES IT differently. “Far from being a risk, the EPC business is, in fact, our strength as it de-risks us from the growth volatility in any particular sector or industry. Many times, the contribution of EPC and non-EPC (manufacturing) depends on the investment cycle and so contributions keep fluctuating from quarter to quarter,” he says.
As for the risk of becoming just another EPC company, L&T claims that unlike its peers, it does projects which entail a lot of manufacturing. “Up to 40% of the value of a typical L&T project is accounted for by manufactured goods and systems that go into that project, many of which are manufactured in-house. We have a global sourcing policy and in many projects we supply or use third-party equipment or systems depending on customers’ requirements,” says K. Venkataramanan, whole-time director and president, hydrocarbon, L&T. Too much dependence on third-party equipment, however, precludes L&T from reaping long-term gains from a robust in-house manufacturing setup.
Dimensions Consulting’s Srivastava makes another point. He says if L&T’s management saw so much potential in the infrastructure space, it should have fully leveraged the parent company’s balance sheet and become India’s premier infrastructure developer like GVK, the GMR Group, Jaypee Group, or the Adani Group. “Given the high upfront cost of building infrastructure assets such as highways, airports, ports, or metros, the only raw material that you require to succeed in this industry is capital. And L&T had one of the best balance sheets [low debt] in the industry to begin with. But, then, it lost out to these newbies and ended up becoming just another EPC company.”
According to him, ownership of infrastructure projects would have provided L&T with a steady stream of annuity income over the next 25 to 30 years and, thus, de-risked the volatility of the EPC business.
The company concedes the missed opportunity in the infrastructure sector, but says that it was deliberate. “I concede that L&T could have been a much bigger player in the BOT space than it is right now, but I have always been sceptical about the return ratios of these capital-intensive and long-gestation projects. L&T has an internal threshold of 18% internal rate of return for bidding for a project and I could not allow this threshold to be diluted just to build a portfolio of BOT projects,” says Shankar Raman. “I don’t want shareholders’ money to get stuck with a specific project for a long time. Capital is best circulated; that’s why we sold our stake in the Bangalore airport project as well. Many international infrastructure investors such as Macquarie or even Siemens do the same. This frees up capital for other projects.”
But keeping those same shareholders happy may get difficult. “L&T is one of the priciest stocks from its sector and investors are willing to give it a premium. But then it increases investors’ expectation of the company, and to meet that, it needs to demonstrate superior growth metrics. It will be a little challenging to maintain the historical growth trajectory, given a slowing order book and a worsening balance sheet,” says a senior analyst with a leading brokerage who didn’t want to be named.
There is no doubt that Naik has built L&T into an institution. But as he prepares to redefine his role, he may want to take another look at one part of that institution—EPC. If anything, it’ll only cement his legacy further.
