Judicious use of cash from Schneider deal is key for Larsen & Toubro stock

Larsen and Toubro Ltd (L&T) had announced the sale of its switchgears business to Schneider Electric two years ago. Given the delay in concluding the deal, investors were understandably nervous. Finally, the deal has concluded and the company will receive ₹14,000 crore in cash, but there were no fireworks on the Street. L&T shares have been flat.

While the conclusion of the deal is a positive, what remains to be seen are L&T’s plans with the proceeds of the deal. The company has so far not specified how it will utilize the proceeds. But expectations are that L&T will use this money to cut debt and increase focus on its core business. High exposure to non-core businesses has been a niggling worry for investors, betting on the stock.

“We believe if most of these proceeds are reinvested in the core business and in debt repayment, particularly in Hyderabad Metro to make it a self-sustaining project, confidence should gradually build-back,” analysts at Jefferies India Pvt. Ltd said in a note on 31 August. According to Jefferies, the ₹10,600 crore Mindtree acquisition in 2019 did not go down well with investors. It cast some doubt on capital allocation as it ran contrary to management’s commentary of making its balance sheet leaner, added the note.

L&T’s total debt soared by ₹33,500 crore over the last two years to ₹1.41 trillion at the end of fiscal year 2020. It surged further by ₹14,300 crore in the June quarter of FY21 and stands at ₹1.55 trillion. Cyclical challenges in the engineering and construction business, the commissioning of the Hyderabad Metro project and delays in closure of the Schneider deal added to significant stress on L&T’s balance sheet.

“Sharp increase in debt is mainly led by increase in working capital needs against the backdrop of execution slowdown seen in recent months. In the June quarter, L&T’s working capital as a percentage of its revenues increased to 26.8%. L&T had earlier guided to bring its working capital down to 18% of its revenues. In the absence of private capex, achieving this target is difficult, however, offloading some non-core assets would take some pressure off its working capital cycle,” said Arafat Saiyed, assistant vice president at Reliance Securities Ltd.

For the stock to reclaim its past glory, more divestments of non-core assets are needed, which will improve return ratios.

Also, what could cap near-term gains in the stock is the grim sector outlook. As highlighted, the tight fiscal space would keep government spending on infrastructure muted, and restrict a meaningful inflow of new orders. Compared to its pre-covid highs earlier this year, the stock is still down by about 30%.