January 8, 2012

One stock, three viewpoints

Confirmation bias is the tendency to look for confirming evidence to support an idea. As an investor, one of the risks is that once you like or fall in love with an idea, it is easy to ignore all the negatives and risks associated with the company.  In order to avoid this trap, I typically compare notes with my friends and fellow investors Ninad kunder and Neeraj marathe ( and a few more ).
We are all value investors who share the same philosophy and similar thought process. You would assume that if we look at an idea, we would come up with similar conclusions and more or less agree with each other thus re-enforcing the confirmation bias. 
The reality is much different. I have routinely found that we look at the same facts and arrive at very different conclusions. I consider this difference of opinion as a good thing as it helps me in avoiding confirmation bias when I bounce my idea with other investors.
Let’s look at a live example. In the last 2-3 months I have been analyzing one such company – NESCO. Both ninad and Neeraj have been looking at the same company independently and have arrived at their own conclusions.  I am posting my analysis of nesco below. You can read ninad kunder’s analysis here and neeraj marathe’s analysis here . We have decided to do a joint post to highlight the difference in our conclusions inspite of looking at the same company at the same time.
Moral of the story : Share you analysis with other smart investors who share your philosophy but are not your clones :)
About
NESCO is a real estate and capital goods company. The company has a parcel of land in Mumbai on which it has developed an exhibition centre (BEC- Bombay exhibition centre) and an IT park. In addition the company has a capital goods business – Indabrator group which has plants in Gujarat.
The company was originally a capital good company, but started incurring losses in the late 90s. The company res-structured its operations and moved the plants to Gujarat. In addition the company has a large piece of land in goregaon, Mumbai where it has developed one of the largest convention centres in India and is now developing an IT park on the same land
Financials
The revenue of the company increased from 16 crs in 2001 to around 145 Crs in 2011. This revenue growth although good, does not highlight the change in the quality of the revenue.
The company had a net margin of around 3% in 2001 and was equal parts a capital goods and Services Company (convention centre). Since then the capital good segment has more or less stagnated and the service segment has expanded with expansion in the convention centre and addition of buildings in the IT Park. The company earned a net margin of 48% in 2011.
The profits of the company, especially from the services business is entirely free cash and has been used to pay off debt. The company now has almost 200 Crs cash which is around 20% of the company’s market cap. The ROE of the company is now 35% and if one excludes the surplus cash, it is in excess of 100%.
The company is able to earn such high margins as the services business (convention centre and IT Park) involve upfront investment and very low operating expenses. In addition the company’s business is now working capital negative due to minimal inventory (only in capital goods business) and low accounts receivables (due to customer advances for the services business).
Positives
The financial positives are listed in the previous section. The company is able to earn such high margins and high ROE due to the competitive advantage of the business. The company has been able to develop one of the largest convention centres in Mumbai which is not easy to develop considering the cost of land. In addition the company is developing additional buildings in the IT Park with the surplus cash (without incurring any debt).
The company thus enjoys a form of local monopoly (large piece of land at negligible cost on the books) and has used this advantage to develop an increasing stream of income. The company plans to re-invest the surplus cash into new buildings in the IT Park (building IV) which are high IRR projects.
The company has also re-structured its capital good business in the last 5-6 years and although this business is not generating attractive returns, it is not a big drain on the company.
Risks
The company has a large number of advantages and a steady cash flow. The business risk comes from a slowdown in the economy, which could impact the utilization of the convention centre and lower tenancy in the IT parks.
I personally feel the above risks are low and would be temporary in nature (will not impact the long term cash flow of the company).
The bigger risk is the re-investment risk. The company has developed 30-40% of the land and will continue developing the rest using the cash flow from the existing properties. In a period of 4-5 years, the company will be done with the development and could be generating 150-200 Crs of free cash flow with no clear avenues for re-investment in the business. At that point of time, the risk is that the management may re-invest the cash in all kinds of poor businesses.
Management quality checklist
Management compensation: The management compensation is around 3% of net profits which seems reasonable.
Capital allocation record: The management has allocated capital intelligently for the last 10 years and may do so for the next 3-4 years. It remains to be seen what will happen after that.
Shareholder communication: Management provides the mandated disclosure through its annual reports and details of the business are available on the website. The communication is adequate, though not extensive.
Accounting practice: The company has followed a bit of aggressive accounting in the past . During the period of 2000-2005, the company was re-structuring the capital goods business and also had accumulated losses. The company capitalized the VRS expenses and other costs and wrote them off till 2006 as it became profitable. The company has however followed conservative accounting since then.
Conflict of interest: None as yet
Performance track record: Above average in the last 10 years. The company has re-structured the capital goods business and expanded the real estate business which is a very high IRR business.

Valuation
The company is currently valued at around 800 Crs and has around 200 Crs on it balance sheet (which is likely to be used partly for IT Park IV). Net of cash the company sells for around 600 crs which is around 7-8 times the expected earnings for 2012. This valuation is low for a company which has an ROE in excess of 100% and can grow at 20%+ for the next 4-5 years with small amounts of added capital.
The above valuation appears low from a cash flow standpoint and the company can be conservatively be valued at 1600-1700 crs (twice the current market cap).
Another view point can be based on the assets of the company. The company has around 70 acres which itself can be valued at a minimum of 2000 crs (if not more). This does not include the value of the BEC business or the IT Park, which enhance the value of the land bank.
Conclusion
The company possess close to a local monopoly due to a large piece of land in a prime location. The management has re-structured its capital goods business and shifted focus to the real estate (exhibition and IT Park) business which has high profitability. The company is developing new projects (at high IRR) which should increase its profitability in the near future. In view the above the company appears to be undervalued as of writing this note.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer at the bottom of blog.

15 comments:

Anonymous said...

I went through last few months' news items. On Nov 11, they canceled the plan to split face value of share from Rs 10 to Rs 1. Although there is no material benefit out of splits, I am not able tyo understand why they first decided to go for it and later canceled it. Do they have any internal conflicts?

Anonymous said...

Even I saw the point above. Add to that they announced the stock split just before very good Q3 results which had one time license fee (component) which was not present in normal quarterly results sent to exchanges. I had to get hold of a motilal oswal report to get this information.
Also, I do not like in FY12 they started clubbing some revenues together (from IT park and realty part) in the quarterly results. They may use this to siphon off cash from IT park especially in FY12 their new buildings will start contributing to revenues handsomely. I don't understand where they are doing realty business either.
Also, a couple of years back they spent lot of money on maintenance of their buildings. We need to understand what is the cost of maintaining these buildings etc.

Regards,
Ananth

Ashwini Damani said...

Another good post. Since I stay close to the NEC exhibition centre, I know just how famous and useful this centre is. It is a huge parcel of land, and at the most opportune place in Mumbai.

Most of the top corporates are building their satellite office around the NEC (offices of E&Y, Oracle, TCS, JM Financials etc ) are quite nearby. Their plan of building IT Office augurs well to me.

Plus the realty market of the suburban mumbai is unlikely to slowdon especially in the areas of Andheri to Goregaon which will always be in demand with the Mumbai Middleclass

Have started nibbling into the stock

Regards
Ashwini
http://goldensilt.blogspot.com

Dhwanil said...

Hi Rohit,

A very interesting concept where same stock is reviewed by three different value investors.

My take on NESCO is that it can be considered as pure asset play considering the fact that major revenue for NESCO is derived from convention center and IT park lease (which is incidental for NESCO) while actually real estate is not core business for NESCO. Hence lack of clarity on long term sustainable business model is a key dampner. Moreover, I have been to BEC 3 times and have visited many other convetion center in India, my opinion on BEC is that it is just about average in terms of infrastructure and amenities. Hence, the only real plus for the company is land bank.

Rohit Chauhan said...

Hi anon
I think splitting stock is generally a gimmick and i would really not care for it. Its like cutting a pizza into 12 instead of 6 pieces. the size of the pizza is the same ...only more pieces

rgds
rohit

Rohit Chauhan said...

Hi ananth
the realty group is basically the IT buildings and possibly hotels when they come up. I am not sure if i understand your concerns on this classification

On the point of siphoning off the cash ..that risk is there in all companies ..nesco is not unique. when you invest in a stock, you trust the management to be fair to you. at the same time, i have not seen any actions on the part of the management to siphon off cash for last 10 yrs. on the contrary they have taken lesser compensation than they can

so in absence of any such action, do you declare them guilty ?

in terms of maintenance cost ..they have to upgrade and maintain the convention centre which is generally more than a usual structure

rgds
rohit

Rohit Chauhan said...

Hi ashwini
the stock is priced on the assumption that the company will not grow, the management will sit on the cash and do nothing with the excess land.
due to the low dividend everyone fears that they will siphon the cash. I am able to understand that fear - management has not done anything to show that they are dishonest. on the contrary they allocating capital to high IRR projects.

so even if the realestate slows down, the company should do fine

rgds
rohit

Rohit Chauhan said...

Hi dhwanil
the convention centre maybe average ..but it is quite profitable for the company. the issue is that the alternatives are even worse
I am from mumbai and have lived here for 25+ yrs. local trains are not good ...but if you have travel from borivali to churchgate ..whats the other option ?

on long term outlook ...we have visibility for 4-5 yrs. true we dont know after that , but then in my case thats true for most companies i hold. how many companies can one have visibility beyond 5-6 yrs ?

in 5+ yrs the market dynamics change, competition changes ..and so even if you think there is visibility ..its just a gut feel

anyway i am biased to the stock ..so bound to make +ve arguments

rgds
rohit

Dhwanil said...

Hi Rohit,

I agree that convention center located in the center of a city like Mumbai definitely gives "moat" for the company, however, I wanted to allude to the fact that running convention center does not seem to be the "core business" of the company as there are much better and professionally developed and managed convention centers in other parts of the country.

With regards to the visibility, if someone like me who wants to invest in a company for 10 years, I would like to see that company is involved in a business that will have sustained earnings with reasonable growth for investment horizon. In my view, in case of NESCO, company's revenue generation largely depends upon monetization potential of assets (land bank) and hence may be a good case for asset play.

Indrajeet Singh said...

Hi Rohit

For last few months I have been following Anant Raj Industries in my comments. It is very much similar to that idea. Maybe someone in Delhi will better appreciate this. I believe it is highly undervalued with good management

Regards

Indrajeet Singh

Manish said...

Hi Rohit,

Nice Analysis...

This reminds me of the borosil glass story.

Company sold its land and is having net cash of @ Rs. 700 Cr.
Company,s Total market capitalization @ 350 Cr.

Classical Value case of buying $1 for 50 cents.

Management announced share buyback ( Still going on)

Market cap still remains sub 350 Cr.

Retail investor don,t have any option but to sell as company neither gives out money as dividend but thinks itself as Buffett II invests in share/MF and plans to delist company after completing buyback.

Classic Value Trap...

Market values most of the holding companies at 50% of asset value since company do,t plan to monetize assets, retail investor don,t have any say on how assets should be used...

Rohit Chauhan said...

hi dhwanil
agree with you ..this company does not have a 10yr visibility like an ITC or GAIL or nestle where you the nature of business is likely to be the same as now

at the same time a 3-4 year bet is not a short term bet either and we can see value created in this period too

rgds
rohit

Rohit Chauhan said...

Hi indrajeet
have not read on anant raj industries. what is the story behind it ?

rgds
rohit

Rohit Chauhan said...

Hi manish
NESCO can become a borosil in 5+ year, but we dont know that yet

i have invested in such companies in a small way in the past ..cash bargains which were value traps

i dont think nesco is a value trap yet. to call it that now even as it is investing its capital at high rates of return is to declare a suspect guilty without any evidence

it may turn out ..but there is no evidence to support that argument as yet

rgds
rohit

vpp8311 said...

No, it does not look like a value trap. The biggest advantage in this case is the healthy cash flow generation.