Larsen & Toubro Rating| Buy — Capital allocation to invite scrutiny

We believe L&T’s proposed acquisition of MindTree is not material in itself. However, it does increase scrutiny on L&T’s capital allocation, as it is in a phase of monetising non-core investments and receiving over $2 bn in the next
24 months. Management commentary of making its B/S leaner is contrarian to the current move. We believe the acquisition concerns will pass, but incremental questionable capital allocation can lead to a sustained derating.
1-2% FY20-21e negative EPS impact

Pro forma financials with 66% shareholding shows that every 5% lower profit growth rate for MindTree will imply an incremental 0.5% P&L impact for L&T. Net D:E does not change meaningfully and will remain around 1.3x for FY20e-21e. The impact on RoE would be 50-70 bps on 16-18% base in FY20e-21e. L&T’s revenue proportion from services (primarily financial and technology) would rise to 21-22% from 17-18% post acquisition. In its call, management stated that moving this to one-third in the long-term is the broader target.

Move contrarian to commentary

We were looking forward to L&T growing profit on a leaner B/S through monetisation of non-core assets and returning it to shareholders. In the call, management highlighted its aim to take the services (financial and tech) business, which it views as core, to 33% from 20%. But, this acquisition at 18.7x PE FY20e, does dilute returns near term. L&T’s return on investment in MindTree at current prices is comparable with the low sub-5% RoEs of IDPL.

L&T Infotech, L&T

Technology and MindTree will be separate companies for a while, as per management in the call. L&T Infotech acquiring MindTree would have been a better fit but management highlighted the two key reasons for not doing this: (i) to overcome integration issues if L&T Infotech and MindTree are not run independently; (ii) to avoid compromising LTI IN and MTCL IN’s minority shareholders’ interest given the value differential —likely pointing to leverage needed for acquisition and also relatively lower RoEs and margins of MindTree vs L&T InfoTech. This means any acquisition synergies and value creation would be delayed.
Incremental capital allocation prudence key to no de-rating
We believe this event will pass for L&T given the limited impact and also as MindTree is a well-run IT services company. However, we believe any move contrary to having a leaner B/S from now on can lead to a sustained de-rating.

L&T Infotech & Mindtree are well-run

Both companies are over two decades old and have grown relatively faster than large cap IT companies Infosys and Wipro in the past five years. The nature of the takeover has probably played a key role in L&T deciding to keep the companies separate for a few years. Effectively, any synergies are delayed and reduce value accretion for shareholders. Reported FY18 RoE was 32% for LTI and 21% for MTCL.