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MOSL: LARSEN & TOUBRO (Buy)- Proposed amendment on share buyback a bit late

LARSEN & TOUBRO:  Proposed amendment on share buyback a bit late

(LT IN, Mkt Cap USD25.3b, CMP INR1294, TP INR1800, 39% Upside, Buy)

 

The latest union budget removed the tax arbitrage between dividend payout and buyback of shares, thus, limiting the extent of benefits.

• To start with, there is no major tax arbitrage on share buyback v/s the dividend payout option now. The latest union budget proposed 20% tax on buyback of shares, thus doing away with the tax arbitrage between dividend payout and buyback of shares. Therefore, it does not make any difference to L&T whether it chooses the share buyback or the dividend payout route to return excess cash to its shareholders. Interestingly, L&T’s earlier decision was based on tax arbitrage (to opt for buyback) as it was considered to be a better way to reward shareholders.
• SEBI’s proposal for relaxation of buyback norms: SEBI has proposed that (a) If post buy-back, debt to equity ratio does not exceed 2:1 (on standalone and consolidated basis), it will continue to allow buybacks; (b) for the calculation of the same, it has proposed permitting the exclusion of subsidiaries that are NBFCs/HFCs and are regulated by the RBI/NHB; and (c) for all such excluded subsidiaries, the debt to equity ratio should not exceed 6:1 on standalone basis – a key criteria.
• L&T’s earlier buyback proposal was rejected on concerns over consolidated leverage: To recall, SEBI had rejected L&T’s proposed buyback of INR90b on the grounds that consolidated leverage post buyback would exceed 2:1. L&T’s core business leverage is just 0.2x; the reason for the high leverage on consolidated basis was due to its NBFC arm, L&T Finance Holdings.
• We still analyze buyback option for L&T: We note that the consolidated leverage for L&T Finance Holdings stood at 6.8x at FY19-end. However, SEBI’s amendments suggest that for the excluded subsidiaries, the leverage has to be considered on standalone basis. At this point, we are unclear if a step-down subsidiary may be considered for exclusion. Assuming it may be considered, the buyback option opens up for the company under the new proposal (Refer our synopsis of leverage across key entities on next page).
• Any announcement on higher dividend payout/dividend may lead to re-rating: In light of the changes in the budget and SEBI’s amendments, the buyback option doesn’t seem as lucrative as envisaged earlier. However, given L&T’s focus to be a pure-play EPC company and aversion to asset business, we expect the company to either opt for higher dividend or buyback to return excess cash to shareholders. This is also important considering that the company expects to garner gross proceeds of INR140b from the sale of its E&A business. Any announcement to increase payout by dividends or buyback may be a re-rating catalyst for the stock. At CMP, the stock trades at FY20/FY21E P/E multiple of 18x/15x for core E&C business, which is at discount to its long- term trading average multiple of 23x. L&T is our top pick in the capital goods space. We maintain our Buy rating with unchanged TP of INR1,800.