The Hindu Business Line : Haunted by legacy orders

It was not high price or excessive leverage that marred Punj Lloyd’s acquisition story. Little could the company have predicted that legacy orders of a subsidiary of the acquired business would come back to haunt it and drag down the entire group’s profitability.

Punj Lloyd’s acquisition of Singapore-based Sembcorp Engineers and Constructors (Sembcorp) in June 2006 appeared to be a good strategy then — the acquired business would supplement and expand Punj Lloyd’s area of operations, and provide access to new geographies. The acquisition price of S$40 million, which valued the target at 0.7 times its book value, looked attractive enough for Punj Lloyd, with scope for acquiring a portfolio that would make it a complete infrastructure player, beyond its traditional areas of oil and gas pipeline projects.

Limited gains

Punj Lloyd had also charted out its funding plan well; raising FCCBs even before the offer with the intention of using such funds for buyouts. Sembcorp brought in qualification for a range of infrastructure services that were not Punj Lloyd’s forte, and its UK-based subsidiary Simon Carves provided capabilities in refinery process, supplementing Punj Lloyd’s strength in oil and gas.

The acquisition did help Punj Lloyd expand its operations in South-East Asia, besides Europe, China and Iran, and it did bid for more infrastructure projects, leveraging the subsidiary’s strength. These subsidiaries have been generating about one-third of the revenues of the consolidated entity.

However, as Punj Lloyd had expected, the subsidiaries also pulled down its operating profit margins (OPM) as Sembcorp’s model of sub-contracting projects made for a high-volume, low-margin business. Immediately after the acquisition the standalone OPM of Punj was about 9.2 per cent, while its consolidated OPM was a good 3 percentage points lower. A year later, profit margins appeared to be stabilising with legacy orders coming down. However, the first sign of trouble came in the form of Punj Lloyd’s auditors pointing out that the company had underprovided for losses from a contract under the acquired UK subsidiary Simon Carves.

Into the red

Punj Lloyd appeared to be sorting out this issue when it entered into an interim settlement with Simon Carves’ client in June 2008. Revenue and profit growth, nevertheless, continued uninterrupted, until December 2008, when the client called off the contract on the grounds of delay and poor work quality and invoked a bank guarantee. A sum of about Rs 450 crore were provided for in FY-09 towards the cost overruns in the subsidiary as well as the guarantees, dragging Punj’s financials into the red over the December and March quarters.

Whether the acquired business has further legacy orders that feature cost overruns, and litigation costs if Punj is forced to take recourse to the Courts continue to be key uncertainties still dogging the acquired business.

Note that Sembcorp was on the block for over three years before the deal with Punj Lloyd was clinched; perhaps why Punj could buy the company at an attractive valuation.

While Punj Lloyd has been successful with the primary acquisition — Sembcorp (the company’s operating profit margin of 1 per cent in 2006 has been scaled up to over 7 per cent), the UK subsidiary has become a sore point. This instance highlights that it is better to tread with caution when an acquisition comes at a bargain price.