Orient Refractories - The heat is on.

Orient Refractories has a interesting past and a interesting future. It was born by demerging itself from Orient Abrasives which is a part of the Rajgarhia group. Orient Abrasives initiated a scheme of demerger through which for every one share of Orient Abrasives the shareholder received one share of Orient Refractories. The company got listed in March 2012 and had a interesting first few weeks in terms of price movements.

It was a demerger that I had tracked but didn’t see any potential value unlocking by virtue of the demerger transaction. What however piqued my interest was trying to understand the potential driving variable behind the demerger process. The refractories business was a great business with high ROE versus the Abrasives business which had poor financial ratios. The thought that crossed my mind was that the management was looking at selling off one of the businesses though it was tough to ascertain which one.

Fast forwarding in the month of May 12 there was a news article in the economic times talking about German group RHI being interested in buying Orient Refractories, The link is attached here. The stock of course rose on the back of this news and started trading in the 32 – 38 trading band as there were periodic news of this takeover. This made it interesting to dig deep into the company.

Some reading up on RHI and the concall + presentation for the June 12 quarter mentioned the fact that they were looking at a acquisition in India and the same would be closed by the end of the year. Parallely, Orient Refractories also initiated a VRS scheme, expenses for which were booked in the June 12 quarter. With the resultant time delay the market lost interest in the stock and stock drifted down to the 29- 30 levels where the position was built into the counter. 

The month of Oct and Nov saw flurry of activity again as the news of the takeover started surfacing again. Here’s a link to a new story in the Economic times.

Though there were standard denials from the company, what is really interesting is the current investor concall of RHI for Sept 12 - Link. The CFO  in the concall in response to a question explicitly mentions that they are talking to Orient Refractories and of course a few other players :-). Of course the deal horizon has got pushed back. The market in the meantime has pushed up the stock in the 38-40 range.

The market has anchored itself to the price point mentioned in the ET article of Rs 42 for the deal though I would be surprised if the deal was to happen at this price point. Factoring in valuations and precedents on some global deals coupled with control premium my expectation would be that the deal ( if it takes place :-)) should happen in the Rs 55-60 price range.  It would be a interesting next couple of months to check if things are heating up.

Disclaimer

1)      The articles that are posted on this blog either stock specific or otherwise should not be construed as investment advice to buy/ sell stocks. These are sharing of my thoughts for discussions.

2)      As a analyst and investor I may have positions in stocks discussed on the blog and may exit these positions without intimation.

3)      Please do not base your buy/sell decision purely based on the articles in the blog. Do carry out your own diligence before your base your decisions.

Thinking about Thinking

The brain has a amazing ability to contemplate based on the sensory stimuli that it receives which it then matches with the memories that it has stored to arrive at a suitable response to the stimuli. This is common across all species and with us homo sapiens. The human mind however differentiates itself with other species in its ability to contemplate itself contemplating over something. This particular repetitive quality or as we popularly call it second order thinking, is to quote Prof Ramchandran’s talk on Ted the “Holy grail of  Neuroscience”

One of the interesting aspects of second order thinking is its ability to have a slightly more rational approach as it analyses the relatively emotional reaction of the first order thinking.  But to quote Yogi Berra “In theory there is no difference between theory and practise. In practise there is”.

So let me come to a practical experience that I went through last month. I had bought Hero Honda about a year and half back at around Rs 1400 . This was the phase post the break up with its erstwhile partner Honda and the market had turned bearish on the stock with the outlook for the company appearing bleak. I had at that point tried to sit back through the clutter, think through what were the key success variables in the two wheeler business and what value did Hero bring to the table. Though the market was focussing on the technology front, my thoughts led me to believe that the key differentiator ( beyond the brand/ positioning etc) that Hero bought on the table was the distribution strength that it had and the associated mindshare. Having looked at the past instances and examples of Bajaj  & TVS, technology was available off the shelf, maybe costing 400-500 crores which could be acquired and a product portfolio built in 2-3 year horizon. But building distribution especially rural distribution was a challenging task.

Fast forwarding and having collected about Rs 150 ( 70+35+45) of dividend along the way and missed opportunities to sell the stock at 2200 ( I got greedy :-)), I started pondering last month over how the business environment had evolved over the last one year. The company had moved forward on executing the technology gap by acquisition/ tie-ups and has progressed on taping the export markets. Couple of things have happened which made me start looking at a exit. The domestic market had slowed down and Hero was finding it difficult to grow on the large base that it had, coupled with slowdown in the export markets resulting in a relatively delayed launch in the export markets. But most importantly its erstwhile partner Honda has been making progress and gaining marketshare at a pace which to be honest I had not anticipated. 

This is where something interesting happened. As my brain started formulating this line of thought, I began to notice from my comforts of my car that more and more newer bikes and scooters that appeared on the road were largely from Honda and to a certain extent Bajaj. My scanning eyes would rarely notice a Hero bike or scooter.

My second order thinking was telling me that this was clearly availability bias coupled with reinforcement bias playing out where the brain was scanning for data to confirm a decision that was already taking shape in my mind. It knew that Hero’s strength was largely in 100 cc segment and it never had a strong foothold in the urban landscape where the competition was stronger. So logically the second order thinking should have prevented the first order thinking from garnering any fresh data points. But to the surprise of my second order brain, I was still not able to stop looking out of the car window trying to notice the increasing number of Honda vehicles on the road. Though I was rationally able to think that I was being irrational, it didn’t help take away the irrationality.

I did finally sell Hero Motocorp around the 1950 levels and exited the position. Till date my third order thinking is not able to reconcile the inability of the first and the second order thinking to merge together. If all this sounds confusing, well it reflects the confused state of my mind :-).

Rahul Dravid - The role model

To my biased mind Rahul Dravid who announced his retirement today, has been one of the greatest cricketer that this country has produced and unfortunately will get the least credit for his contribution to the game. I had put out a post in 2008 which I felt deserves a repost as a dedication to Dravid. 

Sachin Tendulkar, Rahul Dravid, Rakesh Jhunjhunwala
What does Sachin Tendulkar have to do with Investing? I think a lot and to me forms the basis of how I approach investing.

Sachin Tendulkar is a phenomenonal batsman and a thinking cricketer. He clearly the best batsman this country has produced if the not the world. I think he was born gifted and has a amazing sense of timing and hand eye co-ordination. He showed it, way early in his career and progressed by building on it. He is, as I would say a “natural”.
Every single Indian who picks up a bat aspires to be like Sachin Tendulkar. Mother pray and fathers bray in coaxing their litters into wielding the willow. But for every Tendulkar, there are a million who fall by the wayside and are left selling credit cards and writing blogs :-).

Let me examine another cricketer - Rahul Dravid. I wouldn’t by any stretch of imagination call him a natural. Dravid is the hard working, technically correct cricketer who puts in a lot of effort and displays tenacity. He unfortunately is not gifted with the raw natural talent that Sachin has ( This is true for 99.99% of us ). So he has made that up with sheer hard work and getting down to the basics. I would put Anil Kumble in a similar bracket as Dravid.
Dravid will not be as great as Sachin but he has left his indelible mark on Indian cricket.

The problem is that all of us aspire to be like Sachin when we are as talented as Dravid, if not worse. We walk in believing that we are potential god’s gift to mankind and leave the field with dreams shattered and egos hurt.

The key to success is to realise whether you have the natural talent of Sachin and if not, to change tack and become like the hardworking Dravid. Strategy No 2 clearly has a higher probability of success.

So what does this have to do with stockmarkets?
I think most people behave very similar when it comes to the stockmarkets. We all believe that we are the Sachin Tendulkars of the market with inborn insights and natural stock picking abilities.

There are people who have those abilities and I have met people like that. People who have the right instincts in terms of timing the market or the ability to look at a trading screen and see patterns. I have met people who can look at a balance sheet’s and come up with amazing insights.

Unfortunately these people constitute just 0.01 % of the population that exists in the stockmarkets. The remaining 99.99 % of us are not born with natural instincts. And a significant chunk of this population enters the market believing that they are the next Rakesh Jhunjhunwala’s of the world.

They leave disheartened and disillusioned by the experience and unfortunately some a lot poorer.
The way I look at the markets for myself is to position myself as a Dravid ( Knowing fairly well that I m not a Sachin). Nudging here and there, scoring those singles and twos and hopefully a few fours and sixes along the way.

The key to scoring runs is to retain your wicket or your portfolio to play the next day.

Bipolar Disorder

Bipolar disorder is a condition in which people go back and forth between periods of a very good or irritable mood and depression. The "mood swings" between mania and depression can be very quick. People suffering from bipolar disorder tend to toggle between going out spending all their money and feeling at the top of the world and slip in maniacally depressive state couple of weeks later feeling that the world is coming to an end.

I have a friend who has been suffering from this ailment for the last few months. He is called Mr Market. Mr Market was going through this really depressive phase in the months of Nov and Dec where everything on this planet appeared to be going wrong. Greece was going under, Anna Hazare was fasting, Power sector was in doldrums, government was twiddling their thumbs, corruption was everywhere-  telecom, mining etc.  Of course Mr Market's friend's, Mr Economic Times and Mr CNBC who as opposed to cheering Mr Market up seem to have aided this state of mind by wallowing in the same depressive state. After-all what are friends for if they cant stick together and wallow in misery. 

As the bells tolled to ring in the new year, Mr Market suddenly came out of his depressive room and walked into sunshine. Was it the drinking on the new years eve or just a cocktail of liquidity and dopamine that he injected, Mr Market felt he was on top of the world.

Buy Buy Buy and he wants to buy everything on this planet. The world has changed, the sun is shinning, Greece might be going down but that’s for the Germans to worry, Anna Hazare has been having hearty meals off late, who needs power when we have hope, and the corrupt have existed for 2000 years of human history so whats the big deal etc.

Mr Markets friends Mr Economic Times and Mr CNBC seem to be coaxing him into pulling those credit cards out and go on a binge. I m told Mr Market and his friends were last seen at the Mid & Small Cap Mall buying everything in sight. Microcap market is next on the cards followed by the TIP market. Mr Market’s old friend Mr Brokerage House who has been suffering with Volume Disorder for the last one year has recovered and is gradually joining in helping Mr Market in his buying binge.

Mr Market’s other close friend Mr Merchant Banker is planning to bring his old sweethearts Ms “IPO 1”, Ms “IPO 2”, Ms “IPO 3”, Ms “IPO 4”, Ms “IPO for Suckers” to the party. Ms IPO’s were on a sabbatical for the last year spending time with Mr SEBI on a workout regime getting in shape. Shape or no shape a women become more attractive when u r drunk which holds true for Ms IPO’s.

In all this, though Mr Market is a close friend and I like to spend a lot of time with him, for some reason our mood swings are inversely correlated. I was in such a ecstatic state in December and am beginning to get morose now.

Gets me to wonder whether it is Mr Market or I who suffers from bipolar disorder.

Here’s a few lines from a nice song by the “Carpenters” dedicated to you my friend Mr Market 

Top of the World

Such a feelin's comin' over me 

There is wonder in 'most ev'ry thing I see
Not a cloud in the sky, got the sun in my eyes

And I won't be surprised if it's a dream

Everything I want the world to be

Is now comin' true especially for me

Nesco Ltd

We value investors are a funny breed. I have over the past couple of years experienced that though we might share the same framework and thought process for some explicable reasons the portfolio of value investors rarely seem to match beyond maybe 20 – 30% of stocks. I regularly compare notes with my fellow friends and value investors Rohit Chauhan and Neeraj Marathe ( and a few more ) and funnily I have found that all of us have different stocks that we are comfortable with.

So it was a interesting that during the last week of December it transpired out of conversations/emails that all three of us have been independently looking at a company - Nesco Ltd. So we decided that post the year end break without discussing individual thought processes or our view on the company, we will put out posts on our blogs with our perspective on this investment opportunity. We thought it would be an interesting exercise for us as well as the readers of our blogs to have a post on the same company at the same time. 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 Neeraj Marathe’s post at  http://neerajmarathe.blogspot.com/  and Rohit Chauhan's post at  http://valueinvestorindia.blogspot.com/ 

So here goes my side of the story 

Nesco Ltd was established in 1939 as New Std Engg and operated in the capital goods business. The company had plants in multiple locations in Mumbai which it finally consolidated at a single location in Goregaon on the Western suburbs of Mumbai with a 70 acre plot.

The company started incurring losses in its capital goods business and gradually shifted to the business to Gujarat and converted the Mumbai land bank into a exhibition and convention centre. The size of the land bank coupled with close proximity to the airports and the national highway has enabled it to become one of the premier exhibition centres in the country and has conducted over 500 exhibitions and events at the location. The closest competitor in Mumbai, Nehru Centre is less than 1/15^th the size in terms of exhibition space.

The company has also converted its old plant sheds into IT parks and is in the process of constructing a large IT park ( IT park 3). IT park III will have nearly 8,00,000 sq feet of space and the company has leased  out a significant chunk of this project which is under construction and should be ready for fit outs in the next couple of months. 

The management has been conservative and has repaid the debt on the books and has used the internal accrual route to fund expansion for the IT park that it is setting up. The management has clearly stated plans for IT park IV and IT park V where it intends to use the cash flow generated out of the exhibition business and rental income to fund construction of the remaining IT parks.

Financials

FY 2011

a) Income

1)       Convention Business -  65.62 crores ( up 21% over previous year)

2)       IT Park ( rent Income ) – 51.61 crores

3)       Capital Goods business -  16.82 crores ( Down from 24.8 crores in the previous year)

4)       Income from investments and other income -  10 crores

b) Cash/ Investments on Balance sheet -  168 crores

c) Net Profit -  68 crores

d) Cashflow from operations -  78 crores

HY -  2011 -2012

a) Income

1) Convention Business -  25 crores ( HY 2011 -  21 crores )

2)       IT Park ( rent Income ) – 51.61 crores

3)       Capital Goods business -  15.29 crores (HY 2011 -  6.61 crores )

4)       Income from investments and other income -  3.15 crores (  HY 2011 -  3.63 crores )

b) Cash/ Investments on Balance sheet -  215 crores

c) Net Profit -  25 crores

Dividend policy

The dividend payout ratio has been poor because the management has chosen to reinvest the cashflow in construction of the new IT building. The management intends to maintain the same as it is averse to taking debt and will use internal accrual to fund further construction over the next four to five years. One can’t argue against this thought process of the management considering the high operating margin and ROCE.

Valuation

The company is currently available at a market cap of Rs 800 crores with no debt on books. Against which we have

Cash / Investment on Books -  215 crores

Net Profit – 68 crores ( Last year) 

IT Park III should start contributing from next year and on a conservative estimate of Rs 80 per sq feet should generate an additional Rs 50 crores of revenue in FY12-13. 

So net cash of the company is available at 5-6 times and which would appear low for a company with high ROE and with steady cashflow and huge entry barrier to the business.

Risks

1)       Though cashflows over the next 4- 5 years are slated to be lined up for construction of IT park IV and V, subsequent to which there is lack of clarity on what the management intends to do with the cashflow going forward. The bladder problem of management either earmarking the cash for its capital good business or blowing it up into unrelated diversifications exists.

2)       The historical low dividend payout ratio though can be argued as logically correct at this stage of the business could however turn out to be a constant thought process for the management.

3)       The biggest risk that I perceive is that the entire business model is constructed around a piece of land in a single location in Mumbai. Mumbai is currently the most expensive city in this country with respect to real estate prices. There is a situation of oversupply of commercial property in Mumbai. The company stands exposed to not just a generic correction in real estate prices ( hence associated rent income )  but more importantly derating of the Mumbai real estate market. There is a increasing trend of companies shifting their IT / ITES operations out of Mumbai to other locations like Bangalore/ Pune/ Gurgaon etc. Case in point is that Intelenet which occupies one of the building did shift a significantly large process of over 2000 ppl to Aurangabad. TCS Eserve which occupies one of the other buildings is expanding its operations in Ahmedabad and other Tier II cities. Considering the 4- 5 year window when shareholders could possibly look at actual cashflow, this is a large risk that the business carries.

 My viewpoint

Prima facie the company appears to be cheap with relatively steady cashflows. I intend to look at company from a different angle.

Is Nesco a cash bargain / holding company and hence should be valued accordingly?

Lets examine the management competency variables

1)       The biggest achievement of NESCO is the piece of land at Goregaon which it fortuitously acquired a long time back.

2)       The current business model and cashflows are dependent on this piece of land.

3)       Can we say the management has competency in the real estate business and can take up more projects beyond this piece of land like any other real estate developer. 

4)       Is the same true about the Convention business? Do we think the management has competency to set up x more convention centres across the country and run it?

5)   The only operating business that management is running which is the capital good business has a chequered past track record.

So lets flip the coin and look at NESCO as a holding company / cash bargain opportunity.  We have a plot of land which on a conservative basis can be valued at RS 2000 crores + 200 crores ( Cash on balance sheet) = Rs 2200 crores.

This piece of land through rent and the convention centre generated about  68 crores of net profit last year . (I m keeping the calculations simple at this point of time without valuing the capital goods business separately) 

Effective yield of 3.4%. This yield should go up to about 5 % with the IT building III coming to play.

The market today values

Holding companies -  25% of intrinsic value

Cash bargains  -  40-50% of cash on balance sheet

 ( One can argue on the merits and demerits of these discounts but if one feels otherwise clearly there are better managements who could  be looked at for cash bargains)

 Considering the relatively lower yield being earned as compared to other cash bargains and management risk we can value the company at about 40% holding value.

 Value of the company -  40%* Rs 2200 crores -  880 crores

Current market cap  - Rs 800 crores.

Conclusion

Considering the lack of visibility of cashflow payout to the shareholders over the next 4- 5 years, I would like to look at this opportunity a couple of years down the line as clarity emerges on the management’s thought process and visibility on dividend payout and deployment of future cashflows.