L&T’s Buyback – The Curious Case Of Rejection Of The Behemoth’s Proposal

Source – wise-owl.com

L&T’s buyback proposal was recently rejected by SEBI on the grounds that the capital gearing ratio would exceed 2x, thereby breaching SEBIs buyback regulations. The marked difference in debt levels between the standalone and consolidated business’ is mainly due to the debt levels of L&T Finance, which by its very inherent nature of business requires a high level of debt. This capital gearing ratio clause effectively precludes any NBFC or Bank from going for a buyback. We do feel that such a blanket ban might have to be done away with in the future. Time and again we see banks buying back shares in the developed markets.

There could be one, if not many, reasons for a company to undertake a buyback. The most frequently cited reason is that buybacks serve as a tax-efficient route of return excess money to the shareholders in lieu of a dividend. As opposed to buybacks, dividends are subject to a dividend distribution tax. Another scenario when management might propose a buyback is if it feels the share is undervalued. In that case, a buyback would be an appropriate way to invest back in the company.

In L&T both the cases don’t seem to be true. L&T is neither cash-rich nor is it trading at valuations which can be considered cheap. The cash & cash equivalent as of March 31st, 2018 was about 8000 crs (the proposed L&T’s buyback was for 9000 crs) which is about 7% of sales at the consolidated level. The company also had about 9000 crores invested in liquid financial instruments. There does not seem to be an obvious case of undervaluation as the stock is trading at 22 times earnings and 3.3 times book value.

The Company stated in its objective for the buyback that it is currently following an asset-light business model and hence any significant investments which may utilize the cash is not envisaged. However, we are not sure to what extent this is true. L&T raised about 10,000 crs in borrowing in the financial year 2018. The cash flow from operations in FY 18 was a negative 10,000 crs. In the last seven years, except for one year in 2017, the CFO was negative and the cumulative CFO over this period is a negative 25,000 crs.

Another reason cited for L&T’s buybacks is that they result in an improvement in ROE: post buybacks, ROEs tend to increase merely because of an increased degree of financial leverage, and this seems to be the case in L&T. The company’s first-ever buyback program was approved by the company board on 23rd August 2018. In 2017, the management had set specific operational targets for the itself that included achieving a 12-15% CAGR in sales, expanding margins, reducing working capital intensity amongst other things – all of which would lead to improved ROE (internal target to improve ROE to 18% by FY21 from the then ~14%).

Source : Nighthawk Research