Sunday, January 8, 2012

Nesco Ltd - A good exhibit!

I often talk with a few value-based investor friends and discuss products, industries and ideas. Its quite amazing that usually there are very few common ideas between us. Almost everyone has portfolios consisting of different stocks. So it was quite a surprise that a coupla weeks ago, me and my good friends Ninad and Rohit discovered that all of us have been independently looking at Nesco Ltd. 
So we decided that without discussing our individual thought processes, all three will write about Nesco on our individual blogs and post it at the same time. We thought that it would be an interesting exercise for the three of us as well as the many readers of Ninad's and Rohit's blogs and the few readers of my blog to see how three different investors, though value-based, will look at the same company from different angles. (I hope the angles will be different!)  The idea is not to see who is right or who is wrong. All three of us know that even if we reach a consensus, all three of us could be very wrong and even if all of us have different conclusions, all three could be very right! Well thats the best thing about investing, there is no one way of doing things!


You can check out Ninad Kunder's post on Nesco here.
You can check out Rohit Chauhan's post on Nesco here.


After reading the two posts, if you are still left with some patience, here goes mine!


Nesco is a BSE, NSE listed company. Market cap stands at Rs.780 cr (at CMP Rs.555), with promoter holding of 62%. Not the most liquid stock! CMD is Mr.Sumant Patel. His son Krishna Patel joined the Board in FY08 and is now an ED.

The company has three divisions:
  • Exhibition centre (BEC): The Company owns and lends out the Bombay Exhibition Centre. Its a 4.5 lakh sq ft centre at Goregaon on Western Express Highway.
  • IT buildings: The company has constructed and leases out buildings to IT, ITES companies in the same complex at Goregaon (65 acre complex). Currently, there are 3 buildings with a combined area of 10.4 lakh sq ft. 4th IT building has also been announced. This will be a 9 lakh sq ft building entailing a cost of Rs.200 cr. About half of the total land asset has been used up till now.
  • Engineering business: Indabrator supplies surface preparation treatment plants to various industries. The business is quite lumpy, to say the least.


I am not looking at valuing the company based on its ‘existing land asset’, which will be a few times more than the market cap. I do not think that’s the right approach, since the company is pretty clear about not monetising the land asset.

Prof Bakshi's report gives a very detailed view of the business; there’s nothing much I can add about the business and its working, it’s extremely well explained in the report. I strongly request you to please go through the Prof's report.

Now that the details of the business are understood, what I will do is put up my thoughts on Nesco, as an investment opportunity.

Positive arguments:
  • The company’s strategy would appeal to any conservative person. Construct a building, lease it out, milk it for a coupla years and with the cash accumulated, build one more! Quite averse to debt. (This may be taken as a negative, but they never stretched themselves because of this policy.)
  • New buildings are built only after proper feasibility study to ascertain whether the supply can be absorbed. This ensures that buildings don’t remain empty. Also, time intervals between buildings means that the company can generate enough cash for constructing new buildings.
  • Fantastic payback period on incremental assets created, because of absence of land cost. (IT Building 3 was constructed at a cost of Rs.150 cr. Yearly rentals, at full capacity, should be at least Rs.70 cr. About 2 years payback!!)
  • Decent management: The conservative actions of the management have helped it negotiate the twists and turns of the sector. On the flip side, one may argue that they haven’t been aggressive enough. I am in the former camp. I did not find anything blatant in the ARs of the company to raise doubts about their integrity. Here, I should clarify that I have never interacted with the management or attended the AGM. The management does not even take the full remuneration they are entitled to, even though there is approval for the same. Also, their whole professional approach while going in for a new building appeals to me.
  • I read about a lot of corporate offices moving from South Mumbai to Goregaon-Andheri area. (One can counter this argument by talking about healthy supply in Nesco’s area. I believe Nirlon also has land there)


A base-case valuation:
Since this is an annuity business, I have valued it using DCF as follows. (PAT is almost equal to cashflow, since there depreciation is less and 'working capital' is not required.) Please check the assumptions behind this DCF. You will find them to be 'conservative', to say the least! :-)

Click to enlarge

Assumptions:
1) There will be no additions to existing buildings, there will be no increase in rentals of BEC and IT buildings. (Basically, zero growth scenario)
2) Additionally, I have taken the lease rentals for IT buildings at about 10% lower than existing rentals.
3) The entire infrastructure will last for 30 years. Hence, only 30 years DCF done. No terminal value considered.
4) Total expenses (including depreciation) taken at 30% of revenue.
5) 'Other income' has not been considered. (Although this was Rs.17 cr in FY10 and Rs.10 cr in FY11)
6) Full 35% tax on PBT taken.
7) Cash on books taken at Rs.130 cr. (Deducting capex left for IT Bldg 3)
8) Engineering business not considered (although it has been performing well at present.)
9) Discounting rate taken: 15%





The DCF gives us an IV of Rs.460/- per share. (Changing assumptions, discounting rate, etc will, of course, change the IV.) So, it seems that at Rs.460, the market will be valuing Nesco as a zero-growth stock. Whether there will be zero growth in the company? Well the management has disclosed intentions to gradually go for IT building 4, 5, 6 and 7, double BEC capacity to 9 lakh sq ft and also construct a five star hotel. Specifics for IT building 4 have already been announced (9 lakh sq ft, Rs.200 cr capex). That’s not exactly ‘zero growth’! So, at Rs.460, Mr.Market will be (irrationally?) valuing the stock as a zero-growth stock. (This approach I have used is actually Mauboussin's Expectations Investing approach, which can be used to find out what the current price of a stock implies. Basically, we try to find out what Mr.Market expects from the stock at current market price and then check whether Mr.Market's expectations are justified or are they toooo pessimistic or optimistic. As Munger says, invert, always invert!)

Negative arguments (of course!)
  • The company’s business is very susceptible to macro slowdown. BEC revenues will be especially hit and IT building rentals will come under pressure. This is more of a systematic risk and will affect equities as an asset class on the whole, not just Nesco. Also, slowdown fears in Mumbai real estate market are being talked about. This can affect the IT buildings part of the business.
  • The company pays pathetic dividend of Rs.2.5 per share. Payout is about 7%. If one wants to hold on to this stock for extended periods of time (8-10 years or so), absence of meaningful dividend payout will be a deterrent for any investor. However, in my view, it is criminal to ask this company for dividend! The cash is better left in the company’s hands! Payback period in incremental IT buildings is 2-3 years! How much will a shareholder earn out of the money he receives as dividend? Surely not as high! However, I think that absence of large dividend payout has been depressing the valuations of the stock (irrationality of Mr.Market?) Over a period of time, the sheer quantum of earnings and cashflow should be so large, that Rs.750 cr market cap would appear just too less. (upon completion of IT building 4, PAT, which is effectively cash earnings could be as high as Rs.150 cr)
  • I think that the biggest risk against investing in this company is capital misallocation. Until now, the management has not done any hanky-panky in the business. They do not even take remuneration which they are legally entitled to! However, risk of capital misallocation exists in following cases:
-      The company proposes to construct a 5-star hotel on part of its land. If the company decides to operate it on its own, without going for the fixed income/leasing model, I think it would be a massive misallocation of capital.
-      The management seems to be sentimentally attached to the engineering business, which has not exactly been doing great, struggling to break even. The management also expressed its ambition to be no.1 in India and among the top 5 in the world. With ample cash available, if they decide to put a greater part of it into engineering business, the returns on the same will not be as attractive as the lease-out business.
-      The company has been dabbling a bit in equity mutual funds. (Rs.10.5 cr in equity funds against Rs.150 cr in debt funds as on 31st March 2011). However, if the management feels that they are Buffett part-2 and decide to get a lot into equity (directly or through MF route), there would be much additional risk. I believe that they should leave the act of making losses in equities to us professionals! ;-)
-   The company is currently in a rolling phase. Cash earned from existing assets is ploughed back to create new assets, which are substantially cheaper due to almost zero land cost. However, the question remains.. let’s say after 10-12 years when they completely exhaust all their land, what will they do with the cash they generate. Family managed companies have the tendency to neither disclose their intentions, nor to treat other shareholders as ‘owners’.
  • During real-estate-craze-times, the stock gets bundled up with all the other land bank stories and runs pretty wild. (Some may not take this as a negative point!)


Overall opinion

In my view, Nesco presents a decent opportunity where a high quality business and a conservative management is combined with a first-class asset base, which is being exploited slowly. Intrinsic value in this case would be more like a moving target (based on the mgmt plan), hence I have not gone into the same. What I wanted to look at more is what the current valuations accorded by the market imply? I think that below Rs.500, the market starts giving it a zero growth valuation, which seems to be more on the irrational side, presenting an opportunity. 


Cheers and happy investing!!





Disclaimer(s)!!
1) All the posts on this blog, including this one, are for educational and discussion purposes only.
2) I post articles on individual stocks as well as varied topics like behavioural finance, industry analysis etc. None of the material posted should be regarded as advice to buy/sell any stock. My articles are not recommendations to buy/sell individual stocks, and should not be construed as any form of investment advice.
3) I may have positions in stocks discussed. As a professional advisor, I advise clients regarding investments. They also may or may not have positions in stocks discussed, depending on their decision. 
4) PLEASE DO NOT TAKE BUY/SELL OR ANY INVESTMENT DECISION BASED ON ARTICLES YOU READ ON THE BLOG. These are only meant to provide information and initiate discussion. Final decision is and always should be, yours and only yours!

25 comments:

Guru, the life kahani... said...

Really Good Post. I have still not read Ninad's and Rohit's post but have gone through Prof Bakshi's post.

Few points which a dumb investor like can think about is -

- Inflation adjustment in rental income on conservative basis to be considered for cash flow in future
- As you mentioned they have additional land for construction so obviously in future they would monetise this based on market demand. So, some opportunity income can be considered in my opinion.
- Additional income from exhibition activities.

I am sure you had thought about it and you being a conservative investor would like to look at present state rather than what can happen.

Nevertheless, a wonderful analysis and I would increase my stake slowly and steady below Rs. 500...

Thanks,

Guru

Neeraj Marathe said...

Absolutely agree Guru..the assumptions are really pathetic, to say the least. but thats the point. at 450-460, Mr.Market starts giving the stock a zero-growth valuation, in which my assumptions hold true. BUT, it will not b a zero-growth scenario right? so, is Mr.Market being irrational?
cheers!
Neeraj

Anonymous said...

Nesco is on my radar since last couple of months.

Earlier, the low payout turned me off, but as you said, expecting them to increase the payout ratio doesnt make sense as the money is best reinvested in the business.

Couple of questions:

1) The focus seems to be shifting to real estate business from the capital goods. Do you know of any plans to get rid of the capital goods business altogether?

2) Any plans to grow beyond Mumbai ?

Regards,
Rahul

Neeraj Marathe said...

Hi anonymous,
1. About the engineering business, I do not think they will want to get rid of it, going by their comments in recent interviews.
2. They have not talked about expanding out of Mumbai at all.
Cheers!
Neeraj

sagar said...

Great post Neeraj..i liked your way of invert analysis and coming to zero growth expectations at price of 460.

company donates some amount everyyear. AR-2011 they donated 15,505,000 Rs. Any idea to whom this amount goes to ?

Neeraj Marathe said...

Hi Sagar,
Nope, no idea as to whom the donations are given.
cheers!
Neeraj

Anonymous said...

nice piece of work, Neeraj!

as an aside, keep a watch on the Pune Intl Exhibition & Convention centre coming up @ Moshi. phase 1 expected to commence within a year or so. I'm told they are planning 7 exhibition halls of 1.1 lakh sq ft each + the other stuff- 3500 car park, 3 hotels etc on a total development of about
260 acres.

If they bid aggressively for business, rates will be under pressure. Currently there is no alternative for Bombay Exhibition centre.

On the positive side for nesco, pune airport has limited direct intl connectivity .

jayendra

Neeraj Marathe said...

thnx a lot for the info Jayendra..
cheers!
Neeraj

Tarun Talwar said...

Hi Neeraj,

I have been watching Nesco for past 2 months now after reading its annual report and no matter which way I look at it, it's a great story. A lot will depend on how the management decides to share this wealth with minority shareholders in future. If that happens, value investors will benefit. If not, it will be a value trap.

Regards,

Tarun

Neeraj Marathe said...

Yup..Agreed Tarun..
cheers!
Neeraj

Guru, the life kahani... said...

Professor,

Agreed. You are dot in terms of zero growth story and how Mr. Market behaves irrationally.

As usual, admire your views and rational approach which is the mark of great investors.

Cheers,

Guru

Neeraj Marathe said...

Well thank you Guruji.. but being a great investor is a long long time away. Learning still..
Cheers!
Neeraj

Kisan said...

http://www.youtube.com/watch?v=SgPmAYJ7aBI

Neeraj Marathe said...

Hi Kisan,,
I suppose u hated my post, right dude?
Yaar, plz post relevant stuff..wat shud i do wid Kolaveri Di video????
Neeraj

Anonymous said...

Hi Neeraj, how do you go about estimating excess cash in a business?
regards

Neeraj Marathe said...

Hi anonymous,
Very sorry, but i didnt understand your question..
wud you plz elaborate a bit?
thnx
Neeraj

Anonymous said...

Sorry Neeraj this is not related to Nesco. As such in valuation we normally remove excess cash and then add back separately. Some estimate it based on benchmark industry terms (say % of sales). Any thing excess of industry benchmark % is excess cash. Just wanted to know your thoughts.Thanks.

Anonymous said...

sorry Neeraj for not making the question clear on excess cash in business.

Neeraj Marathe said...

Arey no probs anonymous..why the sorry n all?
cheers!
Neeraj

Anonymous said...

Hi Neeraj
Just going through your blog. I have a couple of questions:
1) Why have you used 15% discount rate - any justification?
2) Prof Bakshi has used 9% (aaa bond rate) for capitalization; however he has used 12% for bringing back to present value. Do you see any reason for this? He has not mentioned any reason for using 12%. I can understand 9% but not 12%.
Your response for the above separately for each query would be helpful.
regards

Neeraj Marathe said...

Hello Anon,
1) I have used 15% discounting coz thats what i am comfortable with, in case of Nesco..usually, i use 18-20% discounting..but in Nesco, the cash flow is more predictable, hence lower rate. (although one can argue that this is high too)..the purpose of taking a bit higher rate is to make the results of the calculation more conservative.
2) I cannot comment on Prof's logic..
cheers!
Neeraj

Anonymous said...

I just thought as well regarding your logic which is the right thing to do.
But I wonder what would have caused Bakshi to use different rates.
Thanks Neeraj

Neeraj Marathe said...

Well Anon,
Valuation is soooo relative..given the same data, no two people will come out with the same conclusions..so cant really comment on the Prof's thought process..
cheers!
Neeraj

Anonymous said...

You are absolutely right Neeraj. No two persons would come up with similar value for any asset. Same goes for the discount rate used: it is for the investor to see the riskiness and use the rate that is comfortable in terms of expectation.
My 2 questions were actually unrelated. The first one was regarding your rate of 15% which you answered already.
The other one was regarding Bakshi's two rates instead of one: 9% for capitalization and then 12% for discounting. Probably 9% is for cash flow growth and 12% for investor's expectation. But as you rightly said we can't get into his thought process unless we pose this to him directly.
Thanks anyways.

vpp8311 said...

Taking into consideration the cash on books which management is using wisely, I came to a fair value of Rs.592. So I think if it comes around Rs.600 it will be a good buy.
In any of the previous annual reports they have not mentioned anything about 5 star hotel. Where did you get that info from? Thanks.