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BW Businessworld

Quantum Leap

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As BW was going to print, senior management at Larsen & Toubro (L&T), the country's largest engineering and construction firm, were waiting for confirmation of a particularly large order - two major offshore platform contracts from state-owned ONGC, aggregating over Rs 5,300 crore. One was for the Mumbai High North (MHN) process platform, and the other for the supply of three process gas compression modules for the same complex.

The previous Sunday, L&T's association with the launch of India's first nuclear submarine made headlines. L&T had done most of the construction of the submarine, including the hull casing, based on the design supplied by the Indian Navy and the Defence Research and Development Organisation (DRDO). It was, in some ways, a triumph for L&T's engineering capabilities. The submarine project may not have made L&T any money, but it was an opportunity to showcase its capabilities in an area - defence - that the company plans to exploit in the coming years. For foreign defence contractors looking to get into the country, it was also a demonstration of the readiness of the company as a potential partner in any defence business that they might get from the armed services. The joint venture (JV) with US defence contractor EADS is an early signal.

L&T is also making huge capital expenditure - nearly Rs 6,000 crore in a two-year period from 2008-10. "It is the most we have ever done in so short a time-frame," says A.M. Naik, chairman and managing director of L&T. There is Rs 1,800 crore in the shipbuilding facility and port at Kathupalli, near Ennore in Tamil Nadu; another Rs 1,700 crore is for factories to make supercritical boilers and turbines - for large-scale power generation units of at least 500 MW each - and yet another Rs 1,600 crore in building a forgings (for nuclear reactors) manufacturing facility near Hariza in Gujarat.

Click here to view enlarged imageHowever, the investments made are not just about growth opportunities. They also signify a strategic shift - from being an engineering and construction services company to becoming a hi-tech, high-end engineering-driven conglomerate that will enlarge scope for an already-leading player in infrastructure-building and heavy industry, with a diverse portfolio of activities that takes on projects of scale in areas where entry barriers are high.

"One interpretation is that they want to be a global multinational, or at least be as competitive," says Krishnakant Thakur, an analyst at Quant Capital, a securities firm in Mumbai. "They have expanded into other geographies such as the Gulf countries, building a new heavy-engineering and manufacturing facility in Oman, for example." When asked about that, Naik smiles, and says that his company does not like making money the easy way.

But the shift draws attention to the challenges the company faces - that of maintaining or looking for new growth avenues, of moving up the engineering and technology value chain, of diversifying the business portfolio and of finding or creating the bandwidth to successfully manage the growing complexities that come with this expansion of activity. The L&T of the next few years will probably look very different from the current one.

Where Will Future Growth Come From?
The infrastructure business - roads, ports, airports and railways - has a large amount of construction services, and currently accounts for 35 per cent of revenues. Process engineering - manufacturing oil and gas platforms, and processing plants for the metals, mining and fertiliser manufacturers - accounts for another 35 per cent. Power - substations, transmission and distribution and boilers for smaller generating plants - accounts for about 13 per cent. Others - mainly industrial products such as valves and switchgear - account for the remaining 17 per cent.

"Most of the growth will come from new initiatives in areas such as shipbuilding, power and some of our geographical expansions," says Y.M. Deosthalee, chief financial officer (CFO) of L&T. "Many of our investments are in heavy engineering and manufacturing, not projects. Power alone could account for 20-25 per cent of that."

CORE COMPETENCY: Infrastructure business — roads, ports and railways — accounts for 35 per cent of L&T's total revenues (Pic by Amit Verma)Power has four components - generation, equipment, total end-to-end solutions, which includes engineering, design, procurement, construction and commissioning, something Nayak considers very promising - and transmission and distribution that includes building sub-stations and balancing equipment.

The first stage is the facility for supercritical boilers, reactors and turbines, for power generation capacity of 1,000 MW or more. For this L&T has two JVs with Mitsubishi Heavy Industries and has set up a plant at Hazira for making them. Also Jaiprakash Associates has stated its intention to have L&T supply boilers and turbines for its ultra mega power plant in Uttar Pradesh. That order - the contract for which is expected to be signed in mid-August - will add over Rs 4,100 crore to L&T's order book. In addition, a contract with Russian firm AtomStroyExport for a nuclear project may also kick in this year.

In their guidance at the announcement of the company's annual results for FY09, company officials had said that the order book (about Rs 71,000 crore) would grow by 20-25 per cent this year (FY10). Just the ONGC and Jaiprakash Associates orders will account for about 13 per cent, on top of the roughly Rs 2,500 crore that came in the first quarter.

"On the infrastructure side, you can add orders that will come from the Indian Railways for building track infrastructure and signalling equipment," says Vaibhav Jain, analyst at Brics Securities in Mumbai. "The government's public expenditure programme will ensure that there is a lot of infrastructure spending, and L&T is well-placed for exploiting that." But Jain also acknowledges that the competitive landscape in infrastructure development is quite crowded.

This level of performance, in a downturn year, illustrates a principle that characterises great firms - while exploiting existing assets and exploring developing new ones, they do not lose sight of the priority, which is exploitation. Initiatives in the other thrust areas such as defence and nuclear power will take longer to fructify, as regulation and government policy change slowly in 'sensitive' sectors.

 Managing Complexity
The organisational structure of L&T - 12 operating companies between five and six divisions, many JVs and wholly owned subsidiaries - could be a nightmare for risk management. It also raises an important question: is L&T a diversified conglomerate or an integrated one?

"The businesses we are in are inherently complex," says J.P. Nayak, president, machinery and industrial products at L&T, who also oversees the company's strategy. "As you would have seen, we have moved away from the commodities businesses, and from businesses that have low-entry barriers. We are an engineering powerhouse, which seeks the kind of complex projects that test our engineering mettle." Nayak says businesses having a national interest element in them are also complex by nature, pointing out that L&T has been part of such activity - from nuclear power to defence - even before now; L&T is returning to something it knows, though in a very different landscape.

Company officials prefer to look at the operating company structure as a portfolio of businesses, rather than a vertical division of activity and labour. The restructuring of the firm got rid of the cement and other non-engineering-related businesses. The moves into defence, power and nuclear power are a readjustment of the business portfolio. L&T not only builds roads, but owns eight of them under a build, operate and transfer arrangement. "It gives L&T a way of participating in the project either as an owner or as a contractor," says the head of infrastructure practice at a consulting firm in Mumbai. "A shift in either position just means a readjustment of the business portfolio."

A similar arrangement worked for a captive power plant for Haldia Petrochemicals, though it was a small one. L&T took a stake of approximately Rs 100 crore in the project as it undertook the construction of the power plant, and exited after delivery at a profit. This approach also works with L&T's cash-strapped clients.

In 2007, Dubai Aluminum announced a project for building an aluminum-processing plant in Orissa. It invited L&T to take a 26 per cent stake in the project for about Rs 3,000 crore. The contract for building and commissioning the plant is worth Rs 7,000 crore to L&T. The project is currently being reviewed and awaits environmental clearances.

Senior management sees the parts of the portfolio as an extension of scope, rather than as changes in scale, which already exists. "Take the oil and gas business," says Deosthalee. "If you plot the evolution of this business, we started with just building offshore platforms. From there we have gone to process platforms. From there we have gone to integration of platforms, installation of new platforms, modernisation of the existing platforms, and having power stations on the platforms." For L&T, it means they are still an integrated, but adaptive, player.

Click here to view enlarged imageA Hiccup On The Way
But L&T Infotech, the information technology (IT) business, and the non-bank financial services company L&T Finance do not seem to fit this frame. Many see the attempted acquisition of Satyam Computers as a strategic error. "Satyam was an opportunity to scale up the existing IT services business," says Nayak. "That business has always been profitable and growing at 40 per cent year-on-year."

The error, it appears, was in the way L&T went about the acquisition. Perhaps, analysts say, buying 4 per cent of Satyam was OK, but the acquisition of another 8 per cent made the deal an untenable one: L&T would have ended up owning 63 per cent of the company instead of the 51 per cent they would have preferred had their bid succeeded. Errors were also made in communication with the government, and not working with the authorities after Ramalinga Raju's confession was made public and Satyam became a takeover target. "It was a misreading of the situation that led to the strategic hiccups," says an investment banker who wished to remain anonymous.

Since then, the prospects of having to write off the investment have receded into the background. L&T is still a strategic investor in Satyam. But what will L&T Infotech do now, or L&T Finance, whose businesses included initial public offering financing when the stockmarket was booming? There are other JVs and subsidiaries in which L&T holds 74 per cent, such as L&T Infrastructure Development, in which JPMorgan and IDFC are private equity partners, and some 100 per cent subsidiaries too.

"When it becomes apparent that there is no strategic fit, we will sell them," says Naik. "There are no holy cows." This much seems certain: the story of L&T's mistakes over the Satyam acquisition will be told and retold within the company. L&T will not fall into the same trap twice.

Some also express doubts about the payback period for the entry into defence and nuclear power, where the public sector holds sway. "It will take a lot of easing of regulations - which are quite hazy - for private sector companies to be able to get into it," says Misal Singh, analyst with Edelweiss Capital, a Mumbai-based securities firm.

But that does not faze Naik, who has gone ahead to set up a forgings plant in Hazira for the nuclear power business, and another facility in Talegaon near Pune in Maharashtra for weap-ons systems such as short and long-range multi-barrel launchers. The shipyard near Ennore will build frigates and destroyers for the Navy. A facility to make composites - engineering plastics - has been set up in Baroda in Gujarat, and another for precision assemblies and sub-components in Coimbatore in Tamil Nadu.

When asked how he was so confident that the private sector would be allowed in, Naik talks about his experience with the first oil platform L&T made for ONGC. "We created the facility to build those platforms despite not getting the licence," he says. "It took us over 10 years from when we first approached the government." When Mazgaon Dock and Hindustan Shipyard fell way behind on delivery deadlines, ONGC went to L&T in 1992. The first platform was delivered in 1994. "That is how we built our credibility," Naik adds."Given our engineering excellence and commitment to the nation, can they refuse us?" But Naik may not be around when L&T delivers on its first new defence contract.

Finding The Organisation Men
In March 2010, Naik will present his blueprint for L&T's strategy for 2011-15 (see interview on page 38). When he steps down in September 2012, someone else will have to fulfil his vision. Most of his current senior management is also well over 60 and nearing retirement, with some of them having to stay beyond their tenure. Even as Naik remakes the company, he faces the enormous challenge of finding the management bandwidth to implement the 2015 strategic vision of making L&T a Rs 75,000-crore company. Being a conservative firm, L&T will be conservative about change. Most great companies make radical change rarely and do so cautiously.

Click here to view enlarged imageWhat will the new L&T look like? "The company we are today is not the company it was five years ago," says J.P. Nayak. "We adapt to changing environment. Our activities will be in line with what the environment demands." Which is all very well, but there is no second line of management to take over. "The absence of a succession plan is a real concern," says Edelweiss Capital's Singh. "Naik will have to find replacements for himself and his entire team all at once."

Naik acknowledges the problem, but points to his ongoing efforts to put in place the team that will take over. An L&T man all his working life - he joined the company in 1963 - he wants to groom the insiders, rather than go outside. "McKinsey & Co. is working with us to identify the new management team," he says. "We are doing everything, from intensive executive development programmes to operationally grooming the next generation for the job."

"Two levels of leadership are being created at the same time," adds Deosthalee. "The first is senior management - those who will replace us - and a second rung to keep a reservoir of leaders ready. It is a continuous exercise, and will go on for about 18 months, of which we have about a year left." That does not mean that others will not be recruited from outside. Some analysts believe that if the new leadership is not ready before Naik steps down, there may be a transitional chairman for three years.

For the power business, Naik brought in Ravi Uppal from global engineering firm ABB. L&T Power may even become a separate company, such as L&T Infotech or L&T Finance. By 2015, today's standalone L&T will also become more complex and much bigger. The operating companies could become scale players in their own right. Many analysts believe that today's L&T will become more like a holding company that holds very few assets, such as the defence and aerospace businesses. Will that mean each of the companies could be listed separately?

It is possible, but may perhaps not be practical from an investor's standpoint. There is a conglomerate premium L&T carries that would be lost if the various businesses were broken up into separate standalone companies governed by a holding company. L&T's people see themselves as engineers, and that comes with a culture of excellence that has been nurtured over eight decades. It would be a pity if that were lost as a result of financial engineering.


EADS was referred to as an American company; it is European. The error is regretted.