How L&T’s buy-back could correct its faulty capital allocation & reward shareholders

Jitendra Kumar Gupta Moneycontrol Research

Unlike many astute global investors like Warrant Buffett who have been able to deploy additional capital at far superior rate than the cost of capital, most owners and business managers fail. In such cases, returning money back to investors or shareholders is typically a tough choice. Many corporates instead end up deploying cash in unrelated and less remunerative activities. India’s engineering giant, Larsen & Toubro (L&T), has made one such difficult choice and has announced a Rs 9,000 crore buy-back for the first time.

Rationalising capital Over the last 10 years, the company has generated a cumulative consolidated net profit of about Rs 53,385 crore. Of this, about Rs 11,350 crore, or 21 percent, has been paid out in the form of dividends and the rest (about Rs 42,000 crore) has been retained in the business. Over the last 10 years, it has added close to Rs 45,000 crore to shareholders funds, which stood at Rs 55,340 crore at FY18-end.

Where has this money been deployed? Back in FY08, the company had 81 subsidiaries, which has grown to 123 by FY17-end. Moreover, their contribution has been meagre. As against a cumulative net worth of Rs 5,468 crore in FY08, these subsidiaries had a net worth of Rs 53,000 crore in FY17, but recorded a profit after tax of Rs 2,724 crore. Close to 47 of these subsidiaries incurred losses of about Rs 2,175 crore. No wonder, the last 10 years average return on equity stood at 18.7 percent and an average of 14 percent in the last five years.

Cash correction Over the last couple of years, probably to rectify the same, the management has listed several of its subsidiaries, divested non-core businesses and sold or divested few capital intensive assets like roads, ports etc. This happened at a time when its core infrastructure and engineering business was generating a lot of cash. At present, the company is sitting on cash and cash equivalents of about Rs 8,500 crore on a standalone basis, generating treasury income. The latter may not be the purpose of a sound businesses and part of the internal cash has already been used to reduce its standalone debt-to-equity from 0.35 in FY15 to 0.21 times in FY18.

Buy back: Earnings accretive As the cash cycle is improving and burden of those capital intensive businesses is reducing, the share buy-back could turn out to be better strategy. Moreover, this aligns well with its long term objective of offering an 18 percent return on equity by FY21-end as against 16.04 percent in FY18.

How would a buy-back improve returns?