A man walks through a slum outside the L&T factory in Mumbai
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MARGIN CALL

The Mindtree bid may land L&T in a tight spot

By Durba Ghosh

After weeks of high-voltage drama over a hostile takeover bid, Larsen & Toubro (L&T) may finally be close to successfully acquiring a majority stake in mid-sized IT firm Mindtree.

The Mindtree management, vehemently opposed to the Mumbai-based engineering major’s offer till a few days ago, took a conciliatory note on March 26 by setting up a committee to look into the bid. This is expected to pave the way for L&T to smoothly buyout an asset that would add great value as it looks to diversify into non-core areas.

However, this also portends several risks, and at least some experts are questioning the wisdom behind L&T’s move.

For one, the acquisition goes against the L&T management’s earlier commitment to making its balance sheet leaner by letting go of non-core businesses. The deal is “not material in itself” for L&T, brokerage firm Jefferies India said in a March 27 note to investors. It “does increase scrutiny on L&T’s capital allocation,” Lavina Quadros, equity analyst at Jefferies India wrote.

In addition, there are also concerns over how L&T plans to run Mindtree in the future.

It has said that Mindtree won’t be immediately merged with its two other IT businesses—L&T Infotech and L&T Technology. The rationale behind this decision is that it would help avoid integration issues between the three companies and also protect minority shareholders of each firm, given the difference in valuations of the companies.

“This means any acquisition synergies and value creation (for L&T) would be delayed,” Quadros said. “Three listed IT companies reduce shareholder value accretion… L&T Infotech acquiring Mindtree would have been a better fit.”

Who’s paying?

On March 26, L&T announced it will make an open offer to acquire an additional 31% of Mindtree shares for Rs3,050 crore, at Rs980 apiece. The company on March 18, had bought a 20.32% stake in Mindtree from VG Siddhartha, owner of the country’s largest coffee shop chain, Café Coffee Day (CCD). L&T also has plans to pick up some additional shares from the open market.

Eventually, L&T hopes to have a controlling stake of over 66% in Mindtree for Rs10,700 crore.

The engineering and construction major is funding the buyout through its own cash reserves, as its IT arms do not have enough funds in hand.

But funding the deal would weigh heavy on L&T’s balance sheet.

The company was on track to meet its target of delivering an 18% return on equity to shareholders by the end of March 2021 by divesting its non-core assets, according to Amit Shah, a research analyst at Motilal Oswal. Now if there is an increase in the cost of acquiring Mindtree, that may not happen.

Also, the acquisition of Mindtree could take away a chunk of the cash reserves L&T has gathered, which is contrary to the management’s earlier target of making the company leaner, Quadros added.

Cash wise

As of December 2018, L&T had cash and cash equivalents of Rs15,000 crore, according to Motilal Oswal. Additionally, it generates free cash of Rs1,500 crore every quarter.

The company had last year said it will buy back Rs9,000 crore worth of shares. Shareholders would have preferred this, said Shah of Motilal Oswal. But the plan ran into trouble with the market regulator, the securities and exchange board of India (SEBI), and has been in limbo since.

If the Mindtree acquisition goes through, the plan would be pushed until additional cash is generated from the business.

“Since it has initiated the (acquisition) move, it would be in L&T’s interest to consummate this buyout quickly so that it can hold on to as many key customer relationships and employees—both of which could see a flight if there is prolonged uncertainty,” Girish Pai, head of research at Nirmal Bang said.

But a quick turnaround seems unlikely now. The L&T management has indicated it will merge Mindtree with L&T Infotech only after the businesses reach $5 billion in revenue each, which is a few years away.

“Even if L&T Infotech and Mindtree merge today, both the companies will see de-rating. There will be management instability, attrition, client instability. The integration will go for a year or more because it is not a smooth acquisition,” Sanjeev Hota, an analyst at brokerage firm Sharekhan, said.