L&T wanted to Buy Back Shares but Where Is the Cash?

Capital allocation decisions taken by the management of the company have far-reaching impact on the returns to the shareholders.
The management basically has two options of what to do with the cash generated out of profits every year :-

  1. Reinvest profits in the business (R&D, add more plants, more spends on marketing/branding, expand markets etc.)
    OR
  2. Return money to shareholders through dividends or share buybacks.

Recently, in Aug-18, L&T announced a massive share buyback proposal worth Rs 9,000 Crs. The market regulator SEBI dis-approved the proposal citing Regulation 4(ii) of the SEBI (Buyback Regulations) 2018 and Companies Act 2013.

 

This article was originally published in Moneylife Magazine.

 

SEBI has disapproved the share buyback proposal of L&T. I am sure, several investors, especially retail investors, are perplexed. L&T has followed due procedure; taken shareholder approval. So why is the Securities Exchange Board of India (SEBI) not allowing it?
The legalese used by SEBI in its order also does not help. “The buyback offer is not in compliance with Section 68(2)(d) of Companies Act 2013 and Regulation 4(ii) of SEBI (Buyback of Securities) Regulations 2018.”

In this article, we analyse what has gone wrong and why it is important for the existing shareholders to pay careful attention to the entire episode.

L&T is one of the pillars of Indian industry. It is run by professionals and the non-executive chairman, AM Naik, is considered a stalwart of Indian industry. In several Indian B-schools, L&T is taught as an example of what entrepreneurship, hard work, discipline and professionalism can achieve.
L&T announced the buyback of 60 million shares on 23 Aug 2018.The buyback price of Rs1,475 per share was at a premium of 11% to the closing price of Rs 1,322 on the previous day. L&T had proposed to buy back about 4.3% of the total outstanding shares and the expected cash outgo was Rs 9,000 crore.
In the past two years, since the government levied additional taxes on dividends received, several companies have resorted to buyback of shares to reward shareholders instead of giving dividends. Buyback is a very common and a routine procedure and usually takes a few months to execute. Infosys, Wipro and TCS, which have huge cash piles, have executed generous buybacks in the past two years.

However, the buyback announced by L&T is a little unusual. Let us look at the 10-year consolidated financials of L&T.

L&T 1

L&T 2

In the past 10 years, sales at L&T have tripled and profits have almost doubled.  In fact, L&T has paid almost Rs11,824 crore as dividend to its shareholders over the past nine years.

L&T 3

This is good financial performance for a company of the size of L&T. In fact, the share price has increased from Rs 390/share in April 2009 to about Rs1,324 in January 2019. Most shareholders have little to complain about.

But, as the saying goes: “Cash is real; profit is an opinion.”

Let us look at the cash flow from operation (CFO) and the Free Cash Flow (FCF) that the business has generated.
Since one of the subsidiaries – L&T Finance Holdings Ltd operates in the lending business, given the nature of accounting for a lending business, the cash flow from operations is distorted.
We must eliminate the effect of cash flow from operations that L&T Finance Holdings has on the parent, to get the true picture of the state of the business.

L&T 4Note – Figures for 2009 are not comparable as finance business of L&T was not completely segregated.

We observe that L&T went through a difficult period between 2012 to 2014 when the cash flow from operations were negative in 2 out of the 3 years. The company has recovered in the last few years and has generated a cumulative CFO of Rs 39,620 in the last 9 years.
Now let us look at the cash spent by L&T group in purchase of fixed assets After eliminating the numbers for L&T Finance Holdings, the figures look like this

L&T 5

What we observe from the above data is that L&T group has not generated any cumulative free cash flow (FCF) over the last 9 years. Whatever cash was earned from operations has been completely invested in the business for purchase of fixed assets and a bit more.
This additional cash required has come from additional borrowings which have increased from Rs 14,880 Cr in Mar-2010 to Rs 35,947 Cr in Mar-2018
After accounting for the debt in the lending business ie L&T Finance Holdings, the debt profile of the rest of L&T business looks something like this on a consolidated basis.

L&T 6

L&T 7

Thus, the cash for the dividend paid by L&T over the last 9 years (cumulative Rs 11,824 Cr) has actually come from additional borrowings.
It also means that the money for the proposed Rs 9,000 Cr buyback of shares would have to come in the form additional borrowings from banks.
Though borrowing from the market to fund share buybacks may be a good capital allocation decision in the US markets where absolute and real interest rates are just a tad above zero, in India this may not be a prudent decision right now. With inflation below 4% and cost of borrowing around 9% (for corporates like L&T), real interest rate is 5% in India.
Now let’s go back to what SEBI has invoked. What do Section 68(2)(d) of Companies Act 2013 and Regulation 4(ii) of SEBI (Buyback of Securities) Regulations 2018 say?

“A company is prohibited from buying-back its shares if the debt/equity ratio of the company exceeds 2. “

Based on the audited financial results of March 2018, the consolidated debt:equity ratio of L&T, which was already 1.9, would have gone above two after the proposed buyback. This is the reason why SEBI has ‘advised’ L&T to not go ahead with the proposed buyback.
By definition, L&T Finance Holdings being a NBFC operating in the business of lending has to resort to external borrowings so as to be able to lend it further to its customers.
If we eliminate the impact of the borrowings of L&T Finance holdings on the parent, then L&T has a debt:equity ratio of only 0.8

In my opinion, it is unfair to club the borrowings of the lending arm of the company (L&T Finance Holdings) when deciding on whether L&T is eligible to go ahead with the share buyback under the relevant provisions of the Companies Act 2013 and SEBI (Buyback of Securities) Regulations.
Though, I maintain my opinion as articulated above that borrowing additional money to fund the share buyback especially with real interest rates so high may not be the most prudent use of the company’s financial resources.

 

 

Disclaimer: Amey Kulkarni is a SEBI-registered investment adviser. The article has been written with the sole purpose of provoking a thoughtful discussion amongst the investor community.

 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s