CategoryCompany analysis

Thesis delayed, but not denied: Cochin shipyard Ltd

By Rohit Chauhan
In Company analysis
October 31, 2022
2 Min read
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The Defense sector has caught investor fancy, with stocks such as GRSE, Hindustan aeronautics and Cochin shipyard, running up in the recent months

The following factors are supposed to be the key drivers for it

  • Increasing defense spend as India raises it spend as % of GDP in view of the changing geopolitical situation
  • Higher spend on capital equipment to modernize the armed forces
  • Focus on Import substitution to reduce reliance on foreign suppliers
  • Support ‘Make in India’ initiative and raise exports of defense equipment

These factors have been in place for the last few years, but are gaining momentum now (achieving critical mass)

We initiated a position in Cochin shipyard in 2020 in the model portfolio which turned out to be early in Hindsight. The main driver was an increasing order book driven by the above factors. As it happens with anything related to the government – You can count on delays inspite of the best intentions. As a result, we exited the position to avoid opportunity loss

This sector continues to be on my radar, though we have no position in it

I am publishing the research report from 2020, as the thesis is unchanged. You can download it from here

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Negative free cash flow is (often) a good thing

By Rohit Chauhan
In Business, Company analysis
September 16, 2020
4 Min read
1 comment
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I tweeted the following half-jokingly

This is in response to comments from investors and analysts where they raise a red flag on a company with negative free cash flow, without further analysis.

What’s free cash flow

Let’s define free cash flow for a business

Free cash flow = Operating cash flow (including depreciation) – Maintenance capex

Maintenance capex is defined as capital required by a business to maintain its unit volume and competitive position. This capex would be in the form of working capital and fixed assets.

Let’s take a simplified example to illustrate it. Let’s say you own a house on your own piece of land (a rarity but go with me on this one). After a few years, you decide to get the house repainted as the old paint is peeling off and there are cracks in the wall. Let’s say you spend 5 lacs on the whole thing.

After the house is painted and repaired, you feel good about it. Keep in mind that the value of the house hasn’t gone up. If you were to list the house it would not sell for more (though it could have sold for less if the repairs had not been done).

Let’s fast forward a few years. You decide to extend your house and build a new room. The square footage of the house goes up by 15%. If you decide to sell the house now, you will be able to get a higher price for the house as the area of the house has increased.

The first scenario is that of maintenance capex – money spent to maintain value of the asset. The second is the case of growth capex – money spent to increase the value of the asset.

No published numbers

The same point holds true for a business/ company. The only difference is that a company will rarely break out the annual investment into maintenance and growth capex. This is something an investor has to figure out based on a study of the business.

Investors look at the cash flow statement with the following math

Operating cash flow + depreciation – working capital investment – fixed asset investment

If the above number is negative, they flag it as an issue. The problem here is that the investor is not distinguishing between growth and maintenance capex.

Any money spent on maintenance capex does not increase the value of the business. If all the investment in the above equation is maintenance capex and the resulting number is negative, then it is a red flag.

A lot of businesses, especially in the commodity space, have to keep investing just to stay in the same place from a competitive position. That’s the main reason why these businesses do not create value for their investors over a business cycle.

A company in growth phase and investing into growth capex, will also have negative free cash flow which could create value down the road.

How to evaluate growth capex

This requires a detailed understanding of the business and competence of the management.

There are businesses which requires very little maintenance capex (almost equal to depreciation) and re-invest all their free cash flow for growth and at high rates of return. Such businesses create a lot of wealth for their shareholders in the long run.

The key point to evaluate is whether the investment is being above the cost of capital (including debt). If yes, then you want the management to invest as much as it can (within reasonable limits) as these incremental investments will create value for us down the road.

The main job of the analyst is to figure out whether the management is truly investing above the cost of capital. That unfortunately cannot be accurately estimated to a decimal point, though there are indicators which can help you make an educated guess. You need to ask questions on the attractiveness of the industry, the opportunity size and capability of the management (based on past performance) and come up with a rough guess.

The next time you hear someone talk of negative free cash flow without an analysis of growth v/s maintenance capex – you can recall my tweet above. Such a person is implying that spending on education is a red flag as there no free cash flow being generated in the present.

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Cheap and durable (price matters !)

By Rohit Chauhan
In Company analysis, Competitive advantage, Investment process
April 10, 2015
14 Min read
11 comments
C

Starting note: This is a long post and I am going to cover a lot of ground. I have tried to cover a vast topic in a few pages, which is usually the subject of entire books. As a result, I have tried to simplify and generalize in several cases to make a point.

In the previous post, I tried to make the point that it is not enough to say that a company has a moat and then rush to your broker to put in an order. One needs to answer a couple of questions

  • Does the company really have a sustainable competitive advantage or a durable moat? A high return on capital is a necessary but not a sufficient condition to demonstrate the presence of a moat
  • It is also important to judge the depth and durability of the moat. Deeper the moat and longer it survives, more valuable is the company

 Do not focus too much on the math

I received a few emails asking me about the calculations on how I arrived at the PE ratios. As I said in my previous post, the math is not important for the point I am making – longer a company earns above its cost of capital, higher is its intrinsic value.

I would suggest that you use the standard DCF model and apply whatever assumptions you like for growth, ROE, free cash flow etc and just play around with the duration of the moat or the period for which the company can earn above the cost of capital. It should be quite obvious that longer the duration, higher is the value of the company.

For the really curious, I have uploaded my calculations here. Prepare to be underwhelmed!

 Market implied duration

The other point i would like to make is by turning around the equation – If the company has a high PE ratio, the market is telling you that it expects the company to earn above its cost of capital for a long time.

For illustration, let’s take the example of Page industries (past numbers from money control, future numbers are my guess).

Future expected ROE = 50% (roughly 53% in 2014)

Future growth rate = 30% (40% growth in 2010-2014)

Terminal PE = 15

Current price = 14000 (approximately)

If I put in these numbers into DCF formulae, I get a Moat period of around 10 years.

So the market expects the company to grow its profit by 30% per annum for the next 10 years and maintain its current return on capital. This means that the company will earn a profit of  2000 crs by 2025.

So do I think that page industries will maintain its moat for 10 years or longer and grow at 30%?

I don’t know !

However if I did own the stock or planned to buy it, my next step would be to analyze the competitive strength of the company and see if the moat would survive 10 years and beyond, because if it didn’t I would be in trouble as a long term investor.

 Precision not possible

In the previous example I used a fancy formulae and a long list of assumptions to suggest that the market considers page industries to have a competitive advantage period or moat (CAP for short) of 10 years.

Once you put a number to some of these fuzzy concepts, it appears that you have solved the problem and are ready to execute.

Nothing could be farther from the truth.

Anytime someone tries to give you a precise number on intrinsic value of a company, look for the assumptions behind it. As you may have read, the best tool for fiction is the spreadsheet.

The above calculation should be the starting and not the end point of your thinking. I typically do the above kind of analysis to look at what the market is assuming and put it into three broad buckets

2-5 years : Market assumes a short duration moat

5-8 years : Market assumes a medium duration moat

8+ years : Market assumes a long duration moat (bullet proof franchise)

Let’s look at some way to analyze the moat and bucket it in some cases

 Measuring the moat

A substantial part of my post has been picked up from this note by Michael Mauboussin. The first version of this note was published in around 2002 and the revised one in 2013 (download from here)

If you are truly interested in learning how to discover and measure moats, I cannot stress this note enough (some important parts in the note have been highlighted by me) . Read it and then re-read it a couple of times. The only point missing from this note is the application of the concepts – Michael mauboussion does not provide any detailed examples of applying the concepts to a real life example.

 Model 1: Porter’s five forces analysis

I am not going to write a detailed explanation of this model – you can find this here. I have used this model to analyze IT companies in the past – see here. A few more posts on the same topic can be found hereand here.

Let me try to explain my approach using an example from the past. Lakshmi machine works was an old position for me (I no longer hold it). As part of the analysis, I did the five forces review of the company/ industry which can be downloaded from here

A few key points about the analysis

  • The entry barriers were quite high in the textile machinery industry. Once a company like LMW has established itself and achieved a market share in excess of 50%, it was difficult for a new competitor to achieve scale. A textile mill with only LMW machines finds it easy to maintain and repair these machines (due to accumulated learning) or get this done from LMW which has a large service network. LMW, due to a large install base, is able to provide a high level of service (network effect) at a low cost (due to scale of operations). So we have a case of positive loop here–  Largest company is able to provide a cost effective solution and high levels of service and still earn a good return on capital
  • The other factors such as Supplier power, substitute products etc are not critical to evaluate the industry
  • There is a certain level of buyer concentration, but the machinery segment has far higher concentration and hence the balance of power is still with LMW
  • Finally rivalry is muted as LMW has a level of customer lockin . A satisfied customer will prefer to continue with the same supplier (Who is also cost effective) as it allows it to achieve a higher uptime in operations and lower cost of maintenance (maintenance team needs to maintain only one brand of machines)

The above is also visible in the form of a very high return on capital for LMW – The company  had a negative working capital for 10+ years and earned 100% + on invested capital at the time of this analysis

As I analyzed the company in 2008, I felt strongly that the company had a medium (5-8) or a long duration moat. It was not important to arrive at a precise number then, as the company was selling at close to cash on books and the business was available for free. Surely a business with a medium term moat was worth more than 0 !

 Model 2: Sources of added value

The second mental model i frequently use is the sources of added value – production advantages, customer advantages and government (pages 34-41 of the note)

I have uploaded the analysis for CERA sanitary ware (current holding), I had done in 2011. Look at the rows 14-19 for the details.

A few points to note

  • The company enjoys scale advantages from demand, distribution, advertising etc. As the company gets bigger, these cost advantages would increase ensuring that the company will be able to price its product at the same level as its competitors and still earn a good profit
  • The company also enjoys customer side advantages from brand/ trademarks and availability
  • As you run through this checklist/ template, you will notice that a company could have either production or customer advantages due to various factors. However a company which has both has a powerful combination. If these two sources of value are working together and growing, then we may be able to say that the company has a medium or long duration moat
  • In case you are curious, I thought that CERA had a small to medium moat in 2011. This has expanded since then and the company most likely has a long duration moat now.

 Model 3: High pricing power

Another key indicator of competitive advantage is the presence of pricing power. The following comment from warren buffett encapsulates it

 “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price 10 percent, then you’ve got a terrible business.”

How do you evaluate this ? Look for clues in the annual report or management responses to questions in conference calls. Does the management talk of margins being impacted severely due to cost pressures ?

For example – Companies like Page industries or asian paints are generally able to pass through cost increases to customer without losing volumes. When the input costs drop they can either increase their margins or use this excess profit in advertising and promotions and thus strengthen their competitive position. Can steel or cement companies do the same ?

 Other miscellaneous models

  1. Is the competitive advantage structural (based on the business) or the management. An advantage based on the management is a weak moat and can change overnight if the same team is not in charge
  2. Industry structure : A duopoly or an industry with limited competition is more likely to have companies with competitive advantage. Look at batteries, two wheelers or sanitaryware for example. One is likely to find companies with medium or long duration moats in such industry structures.
  3. Govt regulation : This can be due to special ‘connections’. If you find a moat due to this factor, be very careful as this can disappear overnight

A brief synthesis

I have laid out various models of evaluating the competitive advantage of a company. Once you go through this exercise, you can arrive at a few broad conclusions

No moat: A majority of the companies do not have a moat. As you go through the above models and are hard pressed to find anything positive, it is an indicator that the company has no competitive advantage. Even if the company has been earning a high  return on capital in the recent past, it could be a cyclical or temporary phenomenon. Look at several commodity companies which did well in the 2006-2008 time frame, only to go down after that.

Weak moats : If the moat depends on single a production side advantage such as access to key raw material or government regulation, it’s a weak moat (think mining or telecom companies). The company can lose the advantage at the stroke of a pen, law or whims and fancy of our politicians. In addition the pricing power of such companies is very low. I would categorize such a moat as a weak one and not give it a duration of more than 2-3 years.

Strong, but not quite : If the moat depends on customer advantages such as brands or distribution network, the moat is much stronger. A company with a new brand which is either no.1 or no.2 has a much stronger moat. I tend to give the moat a medium duration (5-8 years). The reason for being cautious at this stage is that the company clearly has a competitive advantage, but the strength has not been tested over multiple business cycle. In addition, in some case the business environment is subject to change and one cannot be too confident of the durability of the moat. The example of LMW or CERA in the past is a good one for this bucket

The bullet proof franchise :These are companies with multiple customer and production (scale related) advantages. These companies are able to command high margins, can raise prices and at the same time have a very competitive cost structures due to economies of scale. These companies have demonstrated high returns of capital over 10+ years and continue to do so. In such cases, one can assume that duration of the moat is 10+ years. These cases are actually quite easy to identify – asian paints, nestle, Unilevers, pidilite, HDFC twins and so on.

Moats are not static

A key point to keep in mind is that moats are not static, but changing constantly. In some cases the moat can disappear overnight if it depends on the government regulation (such as mine licenses), but usually the change is slow and imperceptible and hence easy to miss.

If you can identify the key drivers of a company’s moat, then you can track those driver to evaluate if the management is strengthening or weakening the moat. For example, the moat of an FMCG company is driven by its brands and distribution network. As a result, it is important to track if the management is investing in the brand and deepening/ widening the distribution network.

In the case of LMW, I think the moat has slowly shrunk due to the entry of Reiter ltd. Reiter was the technology partner and equity holder in LMW. The two companies have since parted ways and Reiter is now competing aggressively in the same space.

LMW has repeatedly indicated that they are now facing a higher level of competition in India and consequently there has been a slow drop in operating profit margins. In addition one can see an increase in the working capital usage too. I cannot precisely state that the moat duration has shrunk from 10.7 years to 6.3 years, but there is increasing evidence that the moat is under pressure. As a result, I exited the stock a few years back.

Putting it all together

Let’s assume that you have done a lot of work and figured out that company has moderate moat possibly 5-8 years. At this point, you can plug in the required variables into a DCF model and analyze the market implied duration of the moat (the way we did for Page industries)

If the market thinks that the company has no moat or a minimal moat, than you have a probable buy. If however the market implied moat is 10+ years, then the decision would be to avoid buying the stock, not matter how good the company

The above sounds simple in theory, but is far more difficult in practice – I never promised that I will be giving you a neat, fool proof formulae of making a lot of money by doing minimal work 🙂

The moat of a long term investor

If the all of the above sounds too fuzzy and cannot be laid out in a neat formulae, you should actually feel very happy about it. Think about it for a moment – if something is fuzzy and requires a combination of a wide experience, insight and some thinking, it is unlikely to be done successfully by a computer or fresh out of college analysts.

Can a research analyst go and present this fuzzy thinking to his head of research, who wants a precise target price for the next month ?

So any investor who has a long term horizon and is ready to invest the time and effort to do this type of analysis will find very little competition. It is a general rule of business that lower competition leads to higher returns – the same is true for investing too.

If you buys stocks, the way most people buy shoes, TV or fridges – after due research on features, durability (how long the consumer durable will last) and then compare with price, the result will be much better than average

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

 

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Analysis: Globus spirits

By Rohit Chauhan
In Company analysis, Uncategorized
March 28, 2012
7 Min read
9 comments
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Globus spirit is a 500 Cr spirits company with four divisions. IMIL (India made India liquor) accounts for 50% of the revenue of the company. The company enjoys a dominant market share in this segment in the states of Haryana, Rajasthan and Delhi.
Franchise IMFL (bottling operations for other companies) is the second largest segment with a revenue share of around 20%.  The company has bottling ties up with companies such as Jagajit industries, ABD etc. This segment allows the company to utilize its manufacturing facility fully and thus earn additional return on its fixed assets
The bulk alcohol and IMFL are the other two segments with revenue share of around 10-12%. IMFL is premium alcohol business with brands such as Country club and Hannibal rum. The bulk alcohol business sells ENA to other companies including the fuel companies and is a lower return, commodity business
Financials
The company has grown its sales from around 68 Crs in 2005 to around 700 Crs by 2012. This translates into a CAGR of around 40%. The net profits have grown during the same period at around 50% per annum, starting from a low base of 5 Crs in 2006. The company has been able to improve its net margins from 6% level to around 8-10% in 2012.
The company has been able to achieve an ROE of around 18% on average with a low debt equity ratio of under 0.3. The company has been adding to its capacity, which has gone up from 28.8 Million liters to around 84.4 Mn liters in the current year. This capacity addition has resulted in the fixed turns dropping from around 5 to around 1.8 in 2011, as the entire capacity is not being utilized yet.
Positives
The company is a consumer products company where the demand for the product is on the rise. In addition, the company has a fairly high market share in the IMIL segment which is a rapidly growing segment with lesser competition. This segment, though price sensitive, is not completely a commodity business.  The company has an established distribution network in the states of Haryana, Rajasthan and Delhi which can leveraged for future launches.
The company has now started expanding in the IMFL segment too with launch of several new brands and is also planning to expand into new states. This segment is however competitive and will require substantial investment in building the brand and distribution network.
Finally the company has added substantial capacity in the last few years which is being used for the franchise bottling (bottling other brands) or for bulk alcohol sale. The company can easily reduce the bulk and franchise bottling sales as the sale of its brands increase (which generate higher margins)
Risks
This industry is worse than the sugar, tobacco and possibly real estate in terms of regulations. The government considers alcohol as an evil and over time has had a love hate relationship with the industry. The love part with the industry is due to the high level of taxes (highest after sales tax) and the amount of black money which can be generated via the grant of licenses for manufacturing and distribution. Needles to say, the industry is quite murky in its operations.
In addition to the regulatory risks, the industry has very poor corporate governance standards (think UB group). As a result, it is not easy to trust the published numbers in this sector.
At the company level, Globus is comparatively a new player and hence faces the uphill task of building a distribution network and brands from scratch which is quite an expensive proposition. In addition there is quite a bit of competition, especially in the premium and super premium segment.
Competitor analysis
The industry is dominated by united breweries and united spirits, both owned by the UB group. These two companies account for more than 50% of the entire industry. Inspite of such a dominance, the group has a net margin in the range of 4-5% and measly 10-12% ROE with high debt levels.
 I am not able to understand why the profitability is so poor, inspite of the dominance. The comparable company for United spirits is Diageo, which makes close to 15% margins and has 40% ROE. Clearly alcoholic beverages are a very profitable business globally. Anyway i am not interested in these two companies, due to their corporate governance.
The other player in the industry – Radico khaitan has similar net margins, but a much lower debt equity ratio (0.7) and an average ROE of around 12%.  The fourth largest player which is listed, is tilaknagar industries. The company has a margin in the region of 7-8% and  a similar ROE of 12%. The company had a much higher debt in the past, but has been able to reduce it in 2011 by raising some equity.
You may notice that I have hardly discussed about the brands of the above companies. There are two reasons for it. The first reason is that strong and well known brands are often a necessary, but not a sufficient condition for high returns on capital. Clearly in the case of the above companies, brands such as kingfisher or Bagpiper  though well know, have not added to the profitability. As an investor, I am more concerned about the profitability of the business
The second reason is that I don’t drink now (used to in the past) and hence am not abreast of the latest brands. At the same I don’t think that is a disadvantage to me as an investor, as I also have never used  a textile machine (LMW) or tiller (VST industries) to be able a informed decision on these companies
In conclusion, one would expect the industry to have remarkable economics in a product which is addictive and has brand loyalty, but unfortunately the numbers are even worse than the cement or steel industry (where atleast the leaders are quite profitable)
Valuation
The valuation in the case of globus is more of a subjective exercise. The company sells at around 6 times earnings and appears cheap by quantitative measures. The  company is cheap only if you believe that the company’s expansion into IMIL and IMFL segment will be successful and the company will do better than the industry (which has lousy economics for varied reasons). If the company can maintain the current margins and continue growing at 20% rate, then it is cheap.
The margins could dip due to higher expenditure in marketing and distribution and the asset turn could drop due to additional capacities for the franchise bottling and bulk alcohol. If the returns trend towards the industry averages, then the company appears to be fairly valued (which is what the market is assuming)
Conclusion
As you can see, I do not have a specific view point on the company.  Although the company operates in an industry with very poor profitability, it has been able to deliver above average performance with low amounts of debt. I am not completely sure if the company will be able to sustain this performance as it is usually quite difficult for companies to rise above the industry economics.
I plan to analyze the performance of the company and track it for sometime before I become more comfortable with it. In the meantime the price could always run up, which is a risk I can live with.
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.
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A bet on china : MOIL

By Rohit Chauhan
In Company analysis, Uncategorized
January 28, 2012
4 Min read
3 comments
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This title must have made you wonder – now what leap of logic is this guy having here ?
Let me walk through the logic to prove to you that I have not lost my marbles (not yet !)
An IPO and frenzy
MOIL came out with an IPO in late 2010 and there was quite a bit of frenzy around it. I think the IPO got oversubscribed by 25 times which shows the level of investor enthusiasm. In my case, I have a personal rule – I never invest in an IPO ( I have written the reason here). As 80% of the IPOs are overpriced and quite a few are junk anyway, I would rather miss a few good chances than be stuck with a lot of duds.
I was asked about MOIL then by a lot of readers on the blog, and due to the above reason I did not look closely at the company.
So why now ? The simple reason is that the stock has dropped quite a bit since then and investor sentiment is a bit negative now. Any time a stock drops or almost everyone gets negative on something, you will find me fishing in that area.
Why the drop ?
MOIL is a mining company and derives almost 80-90% topline and profit from manganese ore. Manganese is a key input in steel making and hence the demand and price for manganese depends on the demand outlook for steel.
MOIL has very high operating leverage. The PBT/ sales ratio has fluctuated between 48% in 2007 to as high as 78% in 2009. The profitability in case of MOIL is highly correlated to manganese prices and due to low levels of operating costs (minimal raw material and manpower cost) in proportion to the sales, any rise in manganese price flows directly to the net profit.
In times of high demand and lower supplies of manganese, the international price for the same has gone up by 30-40% and driven up the profitability for the company. The company was coming off such a peak at the time of the IPO.
In a commodity business, high prices result in capacity addition which in turn drives down the price of the commodity. In case of manganese, South Africa and Australia are big producers  and have increased supply in the recent past. India imports manganese ore as the domestic supply is inadequate for the steel making and for making Ferro alloys (which are exported). As a result, the price of manganese in India is dependent on the international price.
The international prices for Manganese has dropped from their peak levels and so has the profit level for MOIL. Hence the drop in the stock price
So where does china come in ?
I hope you have followed my logic till now – manganese is used in steel making, South Africa and Australia are big producers, India imports manganese and hence manganese prices in india are dependent on international prices, which have dropped in the recent months
So what drives international prices for manganese ? China !
 China account for 50%+ of steel demand globally and is largest consumer of manganese. If china grows, demand and price for manganese goes up. If china slows down or has a hard landing (as some are suspecting), then steel and manganese demand will drop and so will the prices
Sooooo…the profitability in case of MOIL is tied closely to what happens in china
Should you buy MOIL?
If you have a view on what will happen in china in the next 1-2 years, then you may be able to make a decision. In my case, I cannot predict what will happen to the Chinese economy, Indian economy and Indian cricket team (maybe Indian cricket team !) and so I will stay away.
At the same time in the longer run as the company adds more mining capacity and acquires new mines (using the 2000 Crs cash on the book), it will become more valuable. At a certain price, the market may discount a further drop in manganese price and more . I will definitely start looking at the company more closely when everyone thinks it is the worst possible stock.

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.

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One stock, three viewpoints

By Rohit Chauhan
In Company analysis, Uncategorized
January 8, 2012
7 Min read
15 comments
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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.

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