L&T goes for funding amid declining ratios

Plan to raise Rs 9,600 cr through a mix of equity and debt might lower its return on equity

Earlier this week, Larsen & Toubro (L&T) sought its shareholders' nod to raise a fresh round of capital — $600 million (Rs 3,600 crore) in equity and another Rs 6,000 crore through private placement of non-convertible debentures. The fund-raising looks sensible from the company’s point of view, given the rally in its stock price and a strong appetite among foreign institutional investors for Indian papers; but the gain to L&T shareholders looks doubtful, given the firm’s low return ratios.

L&T has been aggressively expanding its balance sheet in search of new growth engines since it was forced to sell off its cement division to Grasim Industries in 2003. The result has been a 21-fold rise in its assets (on a consolidated basis) in the past 10 years — from Rs 5,470 crore in FY04 to Rs 1.15-lakh crore at end-FY14. The bulge has, however, failed to fire up its growth engines with revenues and profit growth failing to match up with the rise in liabilities. During the period, consolidated revenue was up 7.3x and net profit jumped by a little over six times. The effect has been a steady decline in L&T's return-on-equity (RoE) to 12.9 per cent in FY14 from 29.4 per cent in FY04. The decline in return on capital employed has been even sharper at 9.2 per cent in FY14 from 24.1 per cent in FY04.

A historically-low RoE signals low capacity utilisation and poor demand environment. This calls for a strategy of either balance-sheet shrinkage, as L&T had done with the divestment of its low earning cement assets in 2003 or increasing assets utilisation rate by tapping new demand. "Companies raise capital if either RoE is rising or it has settled at a high threshold level indicating faster demand growth that requires capacity expansion. This doesn't seem be the case right now," says Dhananjay Sinha, head (institutional equity) at Emkay Global Financial Services.

A fresh round of asset expansion could lead to a further decline in L&T's return ratios and hit share price if profits growth fails to catch up in the next few years. The company has already raised around Rs 5,500 crore worth of equity capital since FY06, but faster earnings growth has eluded shareholders so far.

The market has overlooked this so far and the stock made a new all-time high early this month. But if the expected earnings growth fails to materialise in the next few quarters, bears will come knocking at the doors.