When a company like Larsen and Toubro shouts about economic conditions being a matter of concern and is put forth as the reason for a poor financial performance, it is time to pause. A company’s poor performance can be on two counts- Poor economic environment or poor company circumstances. Why I worry is because the company has an order book that is getting executed. So, to put up a poor show, it would imply that either the customers have called off their orders or are unable to pick up their bills.

If orders are getting executed as planned, but not getting picked up, it should mean a working capital tightness but should not impact the EBITDA margins. If EBITDA margins are poor the reasons are not the same. It could be pricing pressure (which means that poor profitability was written in the day the order was booked) or rise in input prices. To my knowledge, there has not been any appreciable rise in input prices over last two or three years. In fact, if we take commodity prices, they have been trending down.

In his 1987 letter to investors, Warren Buffet made the following observation: “the heads of many companies are not skilled in capital allocation, and … it is not surprising because most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.”

Read the sentence and see how many companies seem to so easily fit the description above.

L&T is a conglomerate with multiple businesses. Unfortunately, in bull markets there are ‘strategic’ diversifications that become white elephants sooner or later and then the company uses jargon like ‘retain core focus’ or ‘shed non-core’ businesses. The businesses that are set up in bull markets, become a millstone round the neck and in bear markets, even the realisation of that business cannot be great. A strategy that seems fluid in a bull market, unchallenged by analysts too, becomes a bane during hard times.

I am using L&T as an example. I do not know the company enough to say whether it is a good company or not, from an investment perspective. All I know is that the ROCE and ROE is nowhere near what good companies earn.

Companies with long working capital and long lead times for execution, generally deliver below average returns, over a long term. Unrelated diversifications are also a big sin. It is what is classically referred to as poor ‘Capital Allocation”. How do we identify poor capital allocation? When a company seeks to enter in to a new business, the first test one should apply is whether the new business will deliver a superior return as opposed to the existing business? If not, then the diversification should not happen. Alternately, it should help to protect or preserve margins in an existing business.

Thus, if we the diversifications of companies like ITC or L&T in to businesses that are of poor quality and profitability, that the management quality becomes a matter of concern. If a company management cannot find enough profitable uses for the capital, it should either buy back shares or return the money to the shareholder as dividends. Shareholder money should not be used to justify expansion or waste in to unrelated areas which dilute shareholder returns. As a shareholder, I invest in a tobacco company because it is a highly profitable business. If I wanted FMCG, I would buy that company. I do not want a tobacco company to get in to selling soaps and agarbattis without MY permission. These are decisions which the shareholder has not agreed to. A company like ITC has multiple poor capital allocations- FMCG, Hotels, Paper,etc etc . None of them stand to any logic other than a fear that the tobacco business will vanish. If so, let it. As a shareholder, I have good choices from these industries, should I want it.

If ITC had put the same money they put in to FMCG business, in to buying shares of HUL, Marico, Godrej Consumer etc, the value of that would have been several times the value of ITC as a company, today! If the tobacco business dies down, let it. Shareholders buy different businesses with different goals. Do not take the decision for them, without their permission, before the fact.

The word called ‘diversification’ hides a lot of sins by the executives and the Board of Directors is answerable for this. But, who will question a ‘great’ company like L&T or ITC? Financial institutions? Mutual Funds?

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12 thoughts on “CAPITAL ALLOCATION- ITC, L&T – VALUE DESTRUCTION?

  1. Well said Bala. Indian promoters are notorious in doing it. Earlier it used to be restricted to family run businesses where the only skill promoter had was off gaming the system. In last couple of decades that mindset has moved into non family businesses as well – whether government (NMDC) or private & not held by a core families as highlighted by you. Unfortunate part is that investors have very short memory. So sins will be forgotten come next bull markets.

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  2. I thought you would go a little further down memory lane! Remember shipping, cement, glass, leather,….? The permanent CEO has conveniently forgotten this. Now he is hoping for some ‘value’ by the listing of the technology company, next he will list the Infra company, and then….something else. It is losing people, contracts, etc. Clearly a Has Been. There has to be a dramatic turnaround. I am wondering what the “professional” board is doing in both these companies run by soon to be octogenarians!!

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    1. Going back to past, L&T started sliding down from the day you had jokers like DN Ghosh heading it. GOI intervention, the sick diversification in to cement, then the aborted RIL takeover, then the Birla _Khalnayak game.. Every where it is one sad story

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  3. Roce won’t happen overnight….by your logic startups will never make sense. Even assuming roce is low ..as long as its higher than cost of capital …if revenue growth is good and there is a clear plan to growth it further then roce will only improve. whether its l&t getting into it or ITC getting into fmcg I can’t blame them just because their immediate roce is low. Your assessment is valid only if the prospects in the new business aren’t worth taking the roce hit or their execution in a new area is shoddy

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    1. Hotel, Paper are businesses that ITC has been doing for donkey’s years. FMCG – ITC has zero background, no skills, different selling outlets// Very poor choice. They should have returned money to shareholders, instead of burning it.

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  4. By that logic, no company will ever expand or diversify. I agree that uncalled diversification is definitely wrong. But an ITC venturing into selling of FMCG – I don’t think any thing superbly wrong in it. Many companies who stuck to their core business or core competence, also lost their money and market. For example, RIL into E&P and Refining (leave aside telecom foray for a moment), still RIL has been losing for the last 7 to 8 years on marginal profitability or value added basis.

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  5. We should always differentiate between Investments & Business . ITC & L T are in business . Investor value business differently in Cycles. But one thing we have to admit both are making strong foundation for future.

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    1. Any new venture will some day will be “new business” into undefined / unchartered territory. A business which does not take risk, will vanish sooner than later. Businesses undergo reincarnation only by constructive destruction and for that constructive destruction to happen, you have to venture into “new, undefined / unchartered businesses some day. I agree that investments and businesses are two different games and cannot be evaluated on the same footing.

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  6. A company didn’t work for a SINGLE or A SMALL GROUP of shortholders (who themselves call shareholders). One side it was said that promoters must not think shortterm and had to look at longterm prospects of company and the other side there is this lobbying of more dividends. After 10 years, if the tobacco division get into more trouble (like more govt intervention)., ppl will happily sell shares and move on but it is the RESPONSIBILITY of PROMOTER to make sure the company doesn’t go into oblivion

    ROE & ROCE are for shortholders., if a promoter/owner runs a business on ROE then even a paanwala on roadside can’t establish a business bcoz in initial years he can’t make it

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    1. Valid point. But an investor chooses a company for its core competence. Not for playing to the personal missions of a director or executive. And if you see the diversifications done by these two companies, you will understand what I say

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  7. Is company a facade of brick & mortar of its registered office. Is any nation a piece of land on global map. No way. Any company is represented by its leadership. Leadership can be good or bad. Leadership’s vision and missions can’t be segregated from the company. And that’s why leadership team is not employee team. Leadership team comprises of owners/promoters/director and top management team. Should we say that Narendra Modi’s personal mission is different than India’s mission as a nation. Should we say that Ratan Tata or Kumar Birla or Anand Mahindra’s personal mission is different than that of their companies. If that’s the case, then, you see second or third rate companies who then go into oblivion sooner than later. Look at Yash Birla’s companies ( from the same famous Birla clan). Definitely an ITC or L&T is not a second or third rate company.
    A company is always represented by its top owners and management team. They only carry forward their vision to the next level.

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  8. A very healthy debate in which both sides have really strong & appealing views. I agree partially with Bala that companies should return capital to its stakeholders & for unrelated diversification the company should try to raise fresh capital in a new entity & which in such cases shall not be difficult for companies like ITC or L&T considering its impeccable track record. In this way all those stakeholders like Bala have the option of or not participating in unrelated business & investors thus have the choice of investing in companies who are focussed on specific businesses. Of course, in companies like ITC the Tax implications could be compelling to go for diversifications in the same company as Otherwise profits from Cigarettes business shall continue to be taxed on one hand & on the other hand new businesses like FMCG that usually take 5-7 years to become profitable shall only continue to amass losses. Difficult call to convince everybody.

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