Analysis: Nesco Ltd

Modified: 04-Jul-20

The current section of “Analysis” series covers Nesco Ltd, owner of the largest exhibition and convention center and multiple IT office buildings in Mumbai.

“Analysis” series is an attempt to share with all the readers, our inputs to the company analysis submitted by readers on the “Ask Your Queries” section of our website.

 

Nesco Ltd Research Report by the Reader

 

Business Overview:

New Standard Engineering Company Ltd was founded (now known as Nesco Ltd) by Mr. Jethabhai V Patel in 1939. It was in the business of manufacturing of a number of engineering products. In the early 60s, Nesco Ltd purchased a 65-acre land on the Western Express Highway at Goregaon in Mumbai.

Later in 1986, Nesco Ltd diversified its business into the realty sector by developing and providing customized built-up space on lease for multinational companies and leading corporates at Goregaon. It has also developed an exhibition centre named Bombay Exhibition Centre (BEC), which is the largest private exhibition centre in India.

Until 2015, Nesco Ltd was running its business as a single company. However, in FY2015, It created a subsidiary named ‘Nesco Hospitality Private Limited’, which is in the food and catering business. For this reason, we have used standalone data from 2009 to 2014 & consolidated data from 2015 to 2018 to analyze Nesco Ltd’s financial numbers.

As of today, Nesco Ltd has four verticals:

  1. NESCO IT Park: Lease out built-up space to corporate
  2. Bombay Exhibition Centre: Provides space for trade fairs, exhibitions etc.
  3. Indabrator: Capital goods division
  4. NESCO Hospitality: Food & Catering services

 

Financial Analysis of Nesco Ltd:

1) Top line growth

As mentioned earlier there are four verticals, which contribute to Nesco Ltd’s top line. Along with this, Nesco Ltd has created a sizeable cash reserve or liquid investment in its balance sheet. The return from this investment (other income) has a good contribution to the total revenue.

Nesco Ltd is growing its business at a moderate pace of around 15-18%. The realty sector is a capital-intensive sector, which requires continuous cash for growth. As a result, companies need to raise fund through debt and equity dilution. However, Nesco Ltd’s policy is to grow business with only internal accruals and it has maintained its debt-free status for the past years. As a result, present growth is lower than what it could have achieved with an aggressive expansion.

Hospitality division is started recently and growing at a fast pace. On the other hand, Indabrator is continuously struggling to grow and generate profit.

 

2) Profitability:

Rental income from IT Park and BEC command a high profit margin as there are very little operating expenses from Nesco Ltd’s side. Overall Nesco Ltd has maintained an operating margin of around 70%.

An investor may note that Nesco Ltd has maintained its high OPM at the same level for several years with no/little fluctuation. A steady profit margin indicates that over the years, the company has created a good negotiating position with the customers and is able to pass on the increasing expense costs to its customers. Such kind of situation exists when a company enjoys certain benefits over its competitor so that it can have a pricing power over the customer. We need to dig deeper to find the root cause of Nesco Ltd’s pricing power (moat).

 

3) Cash Flow Analysis of Nesco Ltd.

Cash Flow is one of the key parameters to analyze a business. If the business model does not generate enough cash, then the company needs to borrow money from somewhere else to run the existing business and do the expansion.

Although Nesco Ltd is generating enough cash from its business, over the last 10 years, its cumulative PAT is ₹990 Cr and cumulative CFO is ₹905 Cr. cCFO is a little bit less than cPAT because of Nesco Ltd’s high amount of other income (Income from investment). Other income is not considered in CFO calculation although it will be added in PAT numbers.

From 2009 to 2018, Nesco Ltd has generated a Free Cash Flow of ₹296 Cr, which is 32% of its cCFO. FCF is the excess cash company has from its operation after fulfilling its capital expenditure (Capex) requirement. In the case of Nesco Ltd, it is able to generate excess cash, which is being accumulated in its balance sheet. As a result, Nesco Ltd is able to create a liquid investment of around ₹505 Cr as of FY2018.

This cash can be used for any future expansion, which is why Nesco Ltd has not taken any debt or equity dilution in recent past to do CAPEX. As communicated by management on Annual Report 2017, it will maintain its debt-free status in future also.

One of the reasons for Nesco Ltd’s strong cash flow position is an improvement in receivable days. Nesco Ltd has reduced its receivable days from 42days to 15days in last 10 years.

In IT park, it rents out to reputed corporate and MNCs which generally pay the rent on time. In the case of BEC, it collects payments upfront. If a client wants to rent Bombay Exhibition Centre, it has to pay a percentage of total money up front in advance. An upfront payment covers a major part of Nesco Ltd’s operating expenses. As a result, Nesco Ltd’s working capital requirement is low.

 

4) Balance sheet:

The balance sheet shows a company’s fund flow. It shows the source of its funds and the manner in which the company is utilizing the funds. As mentioned earlier Nesco Ltd is a debt-free company so that its business is mainly funded by shareholders’ equity.

Nesco Ltd has created a strong and clean balance sheet. Half of its asset is in liquid investment (equivalent to cash) and rest is fixed asset (building and lands) which is its core business. 30% of the asset is in CWIP, which is the current ongoing expansion.

Although Nesco Ltd has created a strong balance sheet over the years, keeping money in liquid asset does not generate a significant return. In FY2018 ‘other income’ generated from the investment is ₹36 Cr, which is around 7.2% of its investment amount.

 

Competitive Advantage (Moat) of Nesco Ltd:

One of the biggest strengths of Nesco Ltd is the location of the exhibition centre. The Bombay Exhibition Centre, close to Western Express Highway, is located in a prominent location, allowing better footfall.

Nesco Ltd purchased the land more than 50 years back at a throwaway price. For any other player to set-up a similar large IT park/exhibition centre on a prime location in Bombay, he has to pay a huge amount of money to acquire land as well as it may also take a good amount of time to get clearance from different Govt. authorities. This situation has created a great entry barrier for others. For this reason, Nesco Ltd has a better pricing power.

Apart from this, the amenities provided by the company such as food court, and other hospitality services within the venue not only add value to the business but also provide another source of revenue for the company.

 

Management analysis of Nesco Ltd:

Nesco Ltd is run by a conservative management. As mentioned earlier, management has decided not to take any debt for future expansion. As per 2017 Annual Report, the estimated cost of future expansion is ₹1,500 Cr. However Nesco Ltd’s present balance sheet size is ₹1,183 Cr. Therefore, the company needs a good amount of time (10-15years) to complete this expansion. If it had raised fund from outside, it would be able to complete the project in less time and would create a higher growth for its shareholders.

Similarly, for a long time company is holding liquid investment, which generates 7-8% return. With a little bit of calculated risk, it would have generated far better return.

 

1) Management succession plan

Mr. Sumant J. Patel, son of founder promoter Mr. Jethabhai V Patel, is the Executive Chairman of the board. Mr. Krishna S. Patel, son of Mr. Sumant J. Patel, is already associated with Nesco Ltd for more than 10 years. He is presently working as Managing Director of the company. Therefore, there is a proper management succession plan.

 

2) Promoter holding

There is an increase in promoter holding for the last couple of years. Involvement of next generation from promoter’s family and an increasing promoter holding suggests that promoter has skin in the game and has faith in the business in the long run.

 

3) Management salary

Total remuneration to promoters is ₹6.59 Cr, which is 3.6% of FY18 PAT. Although it is well within the regulation limit of 5%, the investor may consider it as a little on the higher side. Going forward investor should keep track on salary drawn by promoters.

 

Future Expansion Plans of Nesco Ltd:

Nesco Ltd has created a long-term project plan, which consists of significant remodeling of present NESCO centre. At present construct of IT building 4 is going on and management expects the building to be ready by the Q3FY19. The total cost of constructing the IT building no. 4 is about ₹500 crores (the majority of it is shown in FY17 & FY18 CWIP), and Nesco Ltd expects to generate a revenue of ₹200 crores per year from this building.

In the case of Bombay Exhibition Centre, it has decided a 4-phase plan. This project is named as New Business Exhibition Center (NBEC)

  • Phase 1 – Convention hall + Hotel
  • Phase 2 – Exhibition
  • Phase 3 – Support + Hotels
  • Phase 4 – Exhibition

Since the complete capex will be funded internally, Nesco Ltd’s liquid investment will get used. Therefore, there is a chance of a drop in income from investment in the near future. However, the future expansion plans provide a long-term re-investment visibility in a high return business with an efficient way of capital utilization.

In the case of IT Park, the next project is IT Building-5. As well as the company is considering to build a commercial tower. As per Chairman’s speech in 2018 AGM, by Q2FY19 Nesco Ltd will finalize its next project.

 

Risk involved in the business of Nesco Ltd:

1) Reliance is constructing an exhibition and convention centre at BKC. The completion of this center has been delayed by a number of years and the timelines of construction completion and commencement of operation by Reliance Convention Center are not yet clear. However once it is launched, it will be a competitor to Nesco Ltd’s BEC and will hamper Nesco Ltd’s pricing power as well as the number of customers. Management has also pointed out this concern in 2013 annual report.

2) Govt. regulation: Any kind of Govt. regulation, which affects Nesco Ltd’s profitability, is a threat to business. As per the below news on TOI, traffic department asked Nesco Ltd not to accept booking of more than 50% of BEC capacity due to traffic congestion. Mumbai traffic police issue directions to convention centre (Times of India)

3) Terrorist attack or act of God: As Nesco Ltd’s business depends on a single physical location, any kind of terrorist attack or act of God (earthquake, tsunami etc.) in Mumbai can severely damage Nesco Ltd’s revenue. As happened in case of 26/11 Mumbai attack.

4) Once Nesco Ltd fully utilizes its present 65-acre land, it has to move to some other location (buy new land) for future expansion and growth. In that case, it will lose its competitive advantage over its peers. However considering the size of present freehold land and company’s future expansion plan (NBEC is a more than 10 years project), it looks like that it will take quite a long time to fully utilize the present land.

5) As future expansion solely depends on internal funds, the liquid investment may get affected in future. As a result, the income from investment will also be hampered. So for a short to medium term topline may get affected negatively until the new projects start generating revenue.

 

Valuation Analysis of Nesco Ltd:

At present price, Nesco Ltd is available at P/E of 21. As per Nesco Ltd’s past track record of 15-18% growth, present valuation is a little bit expensive. Along with it, there is a chance of a drop in revenue in the near term.

 

Dr Vijay Malik’s Response

Hi Kunal,

Thanks for sharing the analysis of Nesco Ltd Limited with us! We appreciate the time & effort put in by you in the analysis by going through the past annual reports and company filings. Your hard work provides good insights about Nesco Ltd.

Let us analyse the performance of Nesco Ltd over the last 10 years.

While analyzing the past financial performance data of the company, an investor would notice that until FY2014, Nesco Ltd used to disclose only standalone financials. This is because; the company did not have any subsidiary until then and in FY2015, it formed it subsidiary Nesco Hospitality Private Ltd. Since the FY2015, the company has been preparing both standalone as well as consolidated financials.

We believe that while analysing any company, the investor should always look at the company as a whole and focus on financials, which represent the business picture of the entire group. Therefore, while analysing Nesco Ltd, we have analysed standalone financials until FY2014 and consolidated financials from FY2015 onwards.

Further advised reading: Standalone vs Consolidated Financials: A Complete Guide

Nesco Financials

 

Financial Analysis of Nesco Ltd:

While analyzing the financials of Nesco Ltd, an investor would note that in the past (FY2009-18), the company has been able to grow its sales at a rate of 16-18% year on year. Sales of the company increased from ₹85 cr. in FY2009 to ₹321 cr in FY2018.

An investor would notice that throughout the last decade, the operating profit margin (OPM) of Nesco Ltd has been in the range of 64%-72% except in FY2009 when the OPM was 47%. Such sustained high profit margin of the company indicate that it enjoys good pricing power over its customers. Nesco Ltd enjoys its superior position in terms of business negotiations from the location of its IT Park and the exhibition cum convention center at the key location adjoining Western Expressway in Goregaon, Mumbai. The absence of any competing exhibition center in Mumbai adds to the business strengths of the company.

Further advised reading: How to do Financial Analysis of Companies

In FY2009, the company reported lower profits because of the global slowdown and Mumbai terrorist attacks in 2008. The company highlighted its challenges in its FY2009 annual report, page 4:

Indian economy, one of the fastest growing economy in the world, grew well in 2007-08 and in the beginning of 2008-09. Around August 2008, in response to rising inflation, monetary policy was tightened with the result interest rates went up and there was a liquidity crunch. Then in September 2008, the bankruptcy of Lehman Brothers and the sub prime crisis led to the deterioration of the USA and European economies, unparalled in history. All this led to decline in GDP and IIP growth.

These developments had an impact on further investments and expansions, which were slowed down or stopped. This affected both our Industrial Capital Goods Group and Bombay Convention & Exhibition Centre. Several leading companies deferred their capital equipment purchases, particularly in the automotive & steel segments. The economic slowdown in India and worldwide combined with 26/11 Mumbai blasts resulted in downsizing or cancellations of several exhibitions. With the result, growth we had envisaged in 2008-09 did not take place.

The company witnessed cancellation of exhibitions in FY2009. However, the business recovered soon thereafter and the company could report growth in sales with improved operating profit margins in future.

The company enjoys high profit margins on account of the nature of its business of a landlord where the company rents out its assets and has to spend only a nominal amount on the running its business operations. Investors may note that under most common leasing contracts, the occupants/lessees pay the expenses for maintaining the building separately in addition to their monthly lease rentals. Therefore, the financial burden of the property owner reduces further, which results in the high profit margins.

The net profit margin (NPM) of Nesco Ltd has been with about 55% over the years and has been following the trend of OPM.

When an investor analyses the tax payout ratio of Nesco Ltd, then she notices that the company has been paying taxes in line with the standard corporate tax rate in India except in FY2018. In FY2018, Nesco Ltd had a tax payout ratio of 25%, which is less than the standard corporate tax rate.

When an investor analyses the details of computation of tax provided by the company in its FY2018 annual report, page 140, then she notices that the primary reason for the lower tax rate is the implementation of new accounting standards (IndAS):

Nesco FY2018 Reasons For Lower Tax Payout Ratio

Further advised reading: Understanding the Annual Report of a Company

An investor would note that as per IndAS, the company had to show the unrealized gains in the value of investments like mutual funds etc. under non-operating income (other income). The inclusion of unrealized gains on investments has increased the profit before tax of the company for FY2018 in the profit & loss statement. However, the company will have to pay taxes to the income tax department only when it sells the investments and realizes these gains.

Moreover, in such situations, the tax liability of the company will depend on multiple factors like the period of holding of the investments, which may be short-term capital gains tax or long-term capital gains tax. Even in the computation of the long-term capital gains tax, the amount of tax may differ depending upon the date when the company bought the investments and the date when the company sells these investments. This is because one of the key influencing factor of the final tax liability: the value of inflation index may differ significantly over the periods. The applicable tax on long-term holdings in the debt mutual funds of domestic companies is 20% with indexation + applicable cess & surcharge.

Another important factor leading to lower tax payout is the IT park rental income considered under “Income from House Property” as per income tax act. Under income from house property, the owner gets a benefit of 30% standard deduction on the net rental income. As a result, if a property owner earns ₹100 as rental income, then she can take benefit of 30% standard deduction and pay tax only on remaining ₹70 of the rental income. At a tax rate of 30%, the tax payable by the owner will be ₹21 (70 * 30%) + cess & surcharges. An investor would notice that in such cases, the overall tax payout of the property owner would be lower than the standard corporate tax rate.

Investors would appreciate that this new addition to the annual reports of the company under IndAS, reconciling the income tax is a good feature, which clarifies many queries of investors.

Further advised reading: How to do Financial Analysis of Companies

 

Operating Efficiency Analysis of Nesco Ltd:

When an investor analyses the net fixed asset turnover (NFAT) of Nesco Ltd, then she notices that the NFAT of the company initially declined from 3.65 in FY2010 to 1.01 in FY2014. Later on, the NFAT improved to 1.77 in FY2017. However, once again the NFAT declined to 1.54 in FY2018.

Investors may relate the decline in NFAT with the investments done by the company in IT buildings 3 and 4 respectively. The NFAT declined in FY2014 when the company invested in IT building no. 3. It took some time for the company to find lessees for building 3. Therefore, the NFAT remained low for 2-3 years and thereafter, as the leasing of building 3 increased, the NFAT started increasing. In FY2018, the company has done significant investments in the construction of building no. 4, which is yet to be ready. Therefore, the NFAT has declined in FY2018. If Nesco Ltd is able to complete the building and find lessees soon, then investors may witness an increase in NFAT.

Read on: How to Assess Operating Efficiency of Companies

The primary business of Nesco Ltd is renting out its space of IT buildings and exhibition center. Most of the clients of these businesses pay their rental due in advance. As a result, Nesco Ltd does not need to give high credit period to customers. The business segment of capital goods (Indabrator) would need to give a credit period to its customers. However, the contribution of Indabrator to the overall sales of the company is small. Therefore, investors would notice that the company has a very low amount of receivables when compared to its sales resulting in low receivables days of about 15 days.

Investors would notice that over the years, the receivables days for the company have witnessed a continuous decline from 42 days in FY2009 to 15 days in FY2018. This significant improvement seems to be due to the increasing contribution of rental income from IT parks in the overall sales of the company. The contribution of rental income in the total sales has increased significantly after completion of building 3. Similarly, if the company is able to complete and lease out building 4 soon, then investors may expect the contribution of rental income from IT parks in the total sales to increase further.

While comparing the cumulative net profit after tax (cPAT) and cumulative cash flow from operations (cCFO) of the company for FY2009-18, an investor would notice that the cCFO of the company has been less than cPAT during this period. Over FY2009-18, Nesco Ltd Limited reported a total cumulative net profit after tax (cPAT) of ₹991 cr. whereas during the same period, it reported a cumulative cash flow from operations (cCFO) of ₹905 cr.

However, the investor would notice that over the years, other non-operating income has contributed significantly to the net profits. Over FY2009-18, Nesco Ltd reported a total non-operating (other) income of ₹249 cr. Investors would appreciate that while calculating cash flow from operations, we remove the impact of other income because the other income is primarily from non-operating activities like investments in mutual funds.

Therefore, the removal of a large component contributing to net profits (non-operating income), while calculating CFO has led to the cCFO over FY2009-18 becoming less than cPAT. Investors would appreciate that the lower amount of cCFO when compared to cPAT is not a result of money being stuck in working capital.

An investor may refer to the following article to understand more about the situations in which a company may be able to report a lower cCFO when compared to its cPAT and vice versa:

Further advised reading: Understanding Cash Flow from Operations (CFO)

An investor would appreciate that the significant part of Nesco Ltd’s revenue comes from rental/leasing activities of its IT buildings and the exhibition/convention center. As a result, it does not need to keep a large amount of inventory like manufacturing companies. The divisions of the company like the capital goods division (Indabrator) and the food kitchen division (Nesco Hospitality Pvt. Ltd) need to keep inventory. However, the contribution of these divisions in the overall asset base of the company is small. Therefore, an investor would notice that at any point in time, Nesco Ltd carries only a small amount of inventory in comparison to its total sales. As a result, the company has been able to demonstrate very high inventory turnover ratios (ITR) of 25 or more over the years.

Read on: How to Assess Operating Efficiency of Companies

 

Margin of Safety in the Business of Nesco Ltd:

i) Self-Sustainable Growth Rate (SSGR):

Further advised reading: Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company

Upon reading the SSGR article, an investor would appreciate that if a company is growing at a rate equal to or less than the SSGR and it is able to convert its profits into cash flow from operations, then it would be able to fund its growth from its internal resources without the need of external sources of funds.

Conversely, if any company attempts to grow its sales at a rate higher than its SSGR, then its internal resources would not be sufficient to fund its growth aspirations. As a result, the company would have to rely on additional sources of funds like debt or equity dilution to meet the cash requirements to generate its target growth.

While analysing the SSGR of Nesco Ltd, an investor would notice that the SSGR of the company has consistently been above 50% over the years. The primary reason for such high SSGR is the significantly high profit margins enjoyed by the company on its rental income from IT parks and exhibition center.

Because of the high SSGR, the company could grow its sales at about 16% per annum from ₹85 cr. in FY2009 to ₹321 cr. in FY2018 without the need for external capital. The company could repay its debt of ₹17 cr. in FY2010 and become debt free.

 

ii) Free Cash Flow Analysis of Nesco Ltd:

While looking at the cash flow performance of Nesco Ltd, an investor notices that during FY2009-2018, the company had a cumulative cash flow from operations of ₹905 cr. However, during this period it did a capital expenditure (capex) of ₹608 cr. Nesco Ltd could meet the entire capex from its own sources. As a result, it had a free cash flow (FCF) of ₹297 cr (= 905 – 608) over FY2009-18. In addition, the company had a non-operating/other income of ₹249 cr. over the same period.

As a result, the company did not need to raise any debt for meeting its capital expenditure plans. It could use the free cash available with it to repay its debt, pay dividends to shareholders and still left with surplus funds. At March 31, 2018, the company had ₹509 cr. of cash & investments.

Further advised reading: Free Cash Flow: A Complete Guide to Understanding FCF

Free cash flow (FCF) and SSGR are the main pillars of assessing the margin of safety in the business model of any company.

Further advised reading: 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing

Stock markets have also recognized the ability of Nesco Ltd to produce high surplus cash from its low cost and high profitability business. As a result, the company could generate an increase in market capitalization of ₹3,100 cr. over FY2009-18 when compared to about ₹900 cr. of earnings/profits retained by it. It amounts to a creation of a wealth of ₹3.40 in terms of increase in market capitalization of the stock of the company for every ₹1 of the earnings retained and not distributed to shareholders.

 

Additional aspects of Nesco Ltd:

On analysing Nesco Ltd Limited, an investor comes across certain other aspects of the company:

 

1) Management Succession:

When an investor analyses the annual reports of Nesco Ltd, then she notices that Mr Jethabhai V. Patel founded the company in 1939. Later on his son, Mr. Sumant J. Patel took over the management of the company. In 2003, Krishna S. Patel, son of Mr. Sumant J. Patel, joined the company and he is currently the Managing Director of the company.

Presence of the next generation of the promoter family in active management roles in the company when the earlier generation of the promoters is still active is a sign of good management succession. Such a situation provides sufficient time for the next generation to learn the management skills to run the business under the guidance of senior members of the family. It provides for continuity in the leadership of the company.

 

2) Promoter’s shareholding:

The Shareholding of the promoters in the company has been consistently on increase over last 10 years. However, there was a brief period previously when the shareholding of the promoters declined significantly from 60.49% in December 2001 to 52.22% in June 2004. Nevertheless, increasing promoters’ shareholding thereon until the present is a good sign.

Increase in promoters’ stake in the business along with the presence of next generation of promoters in management, indicates the faith/confidence of the promoters in the company and its business.

Further advised reading: Steps to Assess Management Quality before Buying Stocks

 

3) Capital allocation decisions:

While analysing the business performance of Nesco Ltd over FY2009-18, an investor would notice that the company has taken good capital allocation decisions by investing in new IT buildings and improvements of the exhibition/convention halls. The company has been able to generate good returns from the investments done in IT parks and exhibition center.

However, when an investor comes across the investments done by the company in its capital goods division “Indabrator”, then she finds that the decisions of the company to put additional capital in Indabrator are not equally efficient.

An analysis of the past annual reports of Nesco Ltd indicates that during FY2009-18, the capital goods division, Indabrator, has reported losses in three out of ten years. While analysing the segmental performance section of the past annual reports, an investor would notice that overall, Indabrator reported a cumulative profit before tax (PBT) of ₹14.37 cr. in FY2009-18. Assuming 33% tax rate including cess & surcharge, Indabrator could have reported the cumulative net profit after tax (PAT) of about ₹9.63 cr. (= 14.37 – 33% tax on 14.37). Moreover, the segmental performance sections of past annual reports and the director’s report section indicate that over FY2009-18, Nesco Ltd did an incremental capital expenditure of ₹9.13 cr. in Indabrator.

Nesco Indabrator Capital Goods Segment PBT, PAT, Capex, Losing Money

Therefore, an investor would notice that almost all of the profits generated by Indabrator are in turn, consumed by this division itself as additional capital investments. An investor would note that if Indabrator generated a lower amount of cash flow from operations than its profit after tax over FY2009-18, then it would have proved a net burden on the other divisions of IT parks and exhibition center.

Further advised reading: How to Identify if Management is Misallocating Capital

Upon analysis of past business performance of Nesco Ltd, an investor would notice that the capital goods division has been consistently in troubled times.

FY2008 annual report, page 8: the company discloses that the raw material prices of steel are going up but the final product prices are not increasing due to the intense competition:

Recently there has been an all round increase in prices of steel, cement and other bought out items. It is going to be a challenge to sustain reasonable profit margins in our industrial Capital Goods Group when costs are going up on one hand while on the other hand there is pressure on prices due to increasing competition from local and foreign players.

FY2009 annual report, page 4: Nesco intimated its shareholders that the capital goods division is not doing well because many corporates have deferred their capital expenditure plans.

Industrial Capital Goods Group: Income was almost the same at Rs. 279,608,347 as compared to Rs. 283,782,876 in previous year. Large value of finished/semi finished goods could not be dispatched due to constraints faced by our customers. Due to economic slowdown, several corporates deferred or cancelled their plans for capital investments. The industries particularly affected were automotive, steel and engineering.

Upon further analysis, an investor would notice year after year until FY2015, the company kept on informing the shareholders that the capital goods segment is not doing well:

FY2010 annual report, page 4:

Indabrator-Industrial Capital Goods Group: Income was Rs.248,305,826 as compared to Rs.279,608,347 in previous year. Large value of finished/semi finished goods could not be dispatched due to constraints faced by our customers. Due to economic slowdown, several corporates had deferred or cancelled their plans for capital investments. Now, with the economy improving, orders inflow is improving.

FY2011 annual report, page 8:

Indabrator- Industrial Capital Goods Group: In the year under review, the Industrial Capital Goods segment did not pick up as was expected but in fact showed negative growth in the country as many corporates deferred their plans for capital investment. Besides, several customers could not take delivery of equipment ordered by them. As a result, income was Rs.168,210,331 as compared to Rs.248,305,826 in previous year.

Further advised reading: Understanding the Annual Report of a Company

FY2013 annual report, page 9:

2012-13 was one of the most difficult year for the capital goods industry. A large number of projects were either cancelled or deferred; automotive and other industries faced low demand and went through difficult times.

FY2014 annual report, page 9:

Indabrator- Industrial Capital Goods Group: In the year under review, Indabrator income was Rs.18,38,83,000 (previous year Rs. 25,08,25,178). 2013-14 continued to be extremely difficult year for the capital goods industry. A large number of projects were either cancelled or delayed or deferred; automotive and other industries faced low demand and went through difficult times.

FY2015 annual report, page 5:

Indabrator: In the year under review, Indabrator income was ` 1,790.91 lakhs (previous year ` 1,838.83 lakhs). Year 2014-15 continued to be a difficult year for the capital goods industry. A large number of projects were either cancelled or delayed or deferred; steel, automotive and other industries faced low demand and went through difficult times.

An investor would notice that in FY2011 annual report has acknowledged that the capital goods sector is the first one to get impacted in any slowdown and the last one to recover.

Further advised reading: How to Analyze Companies in Industries new to you?

FY2011 annual report, page 8:

In a slowdown, capital goods are the first to be affected and last to pick up. This segment is now showing positive trend, inflow of orders is increasing, the Company expects good growth in 2011-12 in its Indabrator Division.

However, despite these sustained challenges and resultant poor performance of the capital goods division, Nesco Ltd kept on increasing its investment in Indabrator over the years:

FY2009 annual report, page 4: the company completed construction of unit at Vishnoli:

The Company completed construction of its third unit at Vishnoli, Gujarat which gives it the capacity to manufacture and assemble the largest surface preparation plants.

FY2012 annual report, page 5: the company is constructing a new research and development center at Indabrator:

Your Company has been continuously investing in developing new products and technologies. To accelerate this process your Company is investing in construction of a new building and other capital expenditure to set up a Research and Development Centre for Indabrator, its Industrial Capital Goods Division. Construction of this new building is progressing well, besides several new equipment and facilities will also be installed.

FY2014 annual report, page 9: Nesco is investing in upgrading the abrasive plant:

Your Company is investing in the upgradation of its Abrasives Plant to produce abrasives which has demand from customers using surface preparation equipment.

FY2016 annual report, page 6: Nesco Ltd is upgrading the machine building division at Vishnoli:

2015-16 showed some progress in the capital goods industry. A number of projects which were deferred in the previous year were completed in the current year. Your Company has recently won several large contracts. Company has decided to expand its machine building division at its Visholi Complex, Gujarat, construction for which is expected to start in Q4 of this year.

An investor would notice that the communications from the management in the annual reports from FY2016 onwards have become positive. The management intimates that the division has seen revival and has won some additional orders. However, looking at the segmental performance of Nesco, the capital goods division (Indabrator) is hardly making any money. In FY2018, Indabrator earned a profit before tax (PBT) of ₹0.18 cr. In FY2018, the revenue earned by capital goods division was ₹26.38 cr indicating a PBT margin of 0.68%.

Moreover, an investor would notice that at March 31, 2018, Nesco Ltd has employed a capital of ₹28 cr. in the capital goods division, which has produced a profit before tax of ₹0.18 cr. in FY2018. It turns out to be a return of 0.64% on the capital employed (= 0.18 / 28).

Nesco FY2018 Segmental Performance

A return of 0.64% before tax on any investment is very low. Investors would note that an investment in bank fixed deposits or government securities or debt mutual funds can easily provide a return of 6.50%-7.50% before tax.

Therefore, an investor would appreciate that the decision of the management of Nesco Ltd to put additional money in Indabrator despite low returns and recognition of persistent challenges leave a scope for improvement in the allocation of capital.

Further advised reading: Why Management Assessment is the Most Critical Factor in Stock Investing?

 

4) Audit and compliance issues:

While analysing the audit report section of the FY2018 annual report, an investor notices that Nesco Ltd has not paid an undisputed income tax demand of AY2008 (FY2007).

FY2018 annual report, page 60-61:

Nesco FY2018 Pending Income Tax Undisputed For FY2007

This development comes as a surprise to the investor due to the following reasons:

  • Income tax demand is outstanding for a long period despite being undisputed.
  • The amount of income tax demand is very small when compared to cash balance available with the company.

However, when an investor analyses the annual reports of previous years, then the investor notices that auditors have regularly highlighted issues related to compliance with statutory regulations and payments by the company.

 

i) Delays in depositing service tax and unclaimed dividends to the Govt. accounts:

FY2008 annual report, page 44: Nesco Ltd is not regular in depositing statutory dues:

According to the records of the Company and as per the information and explanations given to us the Company has not been regular in depositing undisputed statutory dues including provident fund, investor education and protection fund, employees state insurance, income tax, sales tax, wealth tax, service tax, custom duty, excise duty, ems and other material statutory dues as applicable with the appropriate authorities during the year. The company has not deposited unclaimed Dividend of Rs.14,835/- to Investor Education and Protection Fund.

The company did not deposit the unclaimed dividend in the Investors Education and Protection Fund (IEPF) even in the years FY2009, FY2010 and FY2011. In many of these years, it continued to have delays in the depositing service tax as well.

FY2011 annual report, page 46:

Except that the company has not deposited unclaimed Dividend of Rs. 14,835/- to Investor Education and Protection fund and the delay in payment of service tax.

The delays in depositing the service tax continued in FY2012 and the company did not deposit the unclaimed dividend to the IEPF.

FY2012 annual report, page 16:

Except that the company has not deposited unclaimed Dividend of 214,835/- to Investor Education and Protection fund and the delay in payment of service tax.

The company finally deposited the unclaimed dividend to IEPF in FY2013. However, it continued to delay the deposit of service tax to the Govt. account.

FY2013 annual report, page 20:

According to the records of the Company and as per the information and explanations given to us the Company has been generally regular in depositing undisputed statutory dues including provident fund, employees state insurance, income tax, sales tax, wealth tax, custom duty, excise duty, cess and other material statutory dues as applicable with the appropriate authorities during the year except the delay in payment of service tax.

Further advised reading: Understanding the Annual Report of a Company

An investor would appreciate that the delays in the timely deposit of statutory dues by a company, which claims to be cash rich do not put the company in a good light. Despite repeated highlights by the auditors, the company kept on delaying the payments of service tax and unclaimed dividends.

 

ii) Inadequate internal audit system:

An analysis of the past annual reports of Nesco Ltd indicates that for a significant period, the company did not have a good internal audit system. The auditor of the company continued to highlight this shortcoming continuously in the audit reports from FY2008 (the earliest audit report available on the company website) to FY2012.

FY2008 annual report, page 44:

In our opinion, the Company has a formal internal audit system, which needs to be strengthened, commen-surate with the size and the nature of its business.

The audit report during FY2008, FY2009, FY2010, FY2011 and FY2012 consistently indicates that the internal audit system of the company needs strengthening.

FY2012 annual report, page 16:

In our opinion, the Company has a formal internal audit system, which needs to be strengthen, commensurate with the size and nature of its business.

Finally, after multiple years of warnings, the company improved its internal audit system in FY2013 and the auditor removed its observation.

An investor would note that probability of issues like frauds, misappropriation of funds etc. is high when the audit systems are insufficient. An investor can only pray that no such negative incident would have happened in the company when its audit system was not sufficient.

Further advised reading: Why Management Assessment is the Most Critical Factor in Stock Investing?

 

iii) Maintaining records of inventory and fixed assets:

While analysing the past annual reports, an investor notices that Nesco Ltd did not update its inventory records/books at least for a couple of years. As a result, the auditor could not provide her opinion whether there is any discrepancy in the actual amount of inventory available with the company when compared to the amount of inventory claimed by the company in its records.

FY2008 annual report, page 43:

We are not in a position to opine whether the discrepancies noticed on physical verification of stocks as compared to book records were material or not as the book records are not updated,

FY2009 annual report, page 42:

We are not in position to opine whether the discrepancies noticed on physical verifications of stocks as compared to book records were material or not as the book records are not updated,

An investor would appreciate that non-updation of inventory records might lead to frauds where the inventory claimed by the company in its records may not exist in its plants/warehouses. It is good that the company started updating its inventory records later on and as per FY2018 annual report; the company has maintained proper records for the inventory.

FY2018 annual report, page 60:

The inventory has been physically verified by the management during the year. In our opinion, the frequency of such verification is reasonable. The Company has maintained proper records of inventory. The discrepancies noticed on verification between the physical stock and the book records were not material and have been dealt with in books of account.

Similarly, the company did not do physical verification of its fixed assets at least for four years: FY2008, FY2009, FY2010 and FY2011. This is because, during all these years, the auditor of Nesco Ltd has pointed out that the company has not carried out the physical verification of its fixed assets as it is in the process of updating its records.

FY2008 annual report, page 43:

(i) (a) The Company is updating records to show particulars of quantitative details and situation of its fixed Assets maintained with effect from 1.4.1970

(b) We are informed that physical verification will be conducted after the records are updated.

FY2011 annual report, page 46:

(a) The Company is updating records to show particulars of quantitative details and situation of its fixed Assets maintained with effect from 1.4.1970

(b) We are informed that physical verification will be conducted after the records are updated.

It seems that the company took at least 4 years (FY2008-2011) to update the fixed assets records. This is because it was in FY2012 that the auditor mentioned that the company has updated its records partially.

FY2012 annual report, page 16:

The Company has updated records showing particulars of quantitative details and situation of its fixed Assets, except for electrical installations, Patterns and Mouldings and Furniture, fixtures and office equipments.

An investor would appreciate that it does not look good on part of any company if it does not maintain proper records of its assets like inventory or fixed assets. When an investor looks at the fact of non-maintenance of records along with the aspect of a weak internal audit system, then she can only pray that the reported results of the company during those periods would have reflected the true picture of the business position of the company.

Further advised reading: Why Management Assessment is the Most Critical Factor in Stock Investing?

As per the audit report of Nesco Ltd for FY2018, the company has been maintaining proper records of fixed assets as well as inventory.

 

5) Delays associated with real estate projects:

An investor would notice that most of the real estate projects witness delays in construction and sales. Most of the times, the developers end up promising very aggressive schedules for construction and sales/leasing only to witness delays later on.

Nesco Ltd informed its shareholders in FY2011 that the construction of IT building 3 is complete and internal finishing work is going on. The company indicated that it would be able to lease part of the building 3 in FY2012 and fully lease it in FY2013.

FY2011 annual report, page 8:

Nesco IT Park’s third building is nearing completion: construction work is over, internal finishing is now in progress. Company expects some revenues from IT building 3 in 2011-12 and full occupancy in 2012-13. A leading American architect firm has been appointed for subsequent IT buildings, designs for IT building 4 are under finalization. We expect to start work on IT building 4 by December 2011.

However, an investor would notice that at the end of FY2013, the leasing was yet to commence.

FY2013 annual report, page 9:

Now that IT building 3 (area 6,60,000 sq ft) is completed and has received occupation certificate, your Company is in the process of finalizing licensing arrangements with well known Indian and multinational companies, and expects to generate revenues from the current year.

Finally, the company could lease building 3 fully in FY2016 instead of earlier indicated date of FY2013:

FY2016 annual report, page 5:

Your Company has started construction of IT building 4, having built up area of approx. 17,00,000 sq. ft. The building is pre-certified Platinum rated under the LEED India for Core & Shell rating system from the Indian Green Building Council. IT buildings 1, 2 and 3 are fully occupied by well renowned companies. Hall 3 provides Incubation Centre and Child Care Centre for children of employees working in Nesco IT Park.

Further advised reading: Understanding the Annual Report of a Company

An investor should appreciate that real estate projects require a coordination of many parties including multiple govt. departments. Delays in real estate projects are a norm instead of the exception. Therefore, investors should always keep this aspect in mind before envisaging the future aspect of any real estate company including Nesco Ltd.

Moreover, due to delays in project completion, many times, the original business situations undergo significant changes. As a result, companies cancel the previously declared plans and launch new plans from scratch.

In FY2009, Nesco Ltd noticed revival in the demand post global slowdown. As a result, it announced plans to increase the area of the exhibition and convention center from the existing 450,000 sqft to 1,000,000 sqft.

FY2009 annual report, page 5:

There are some signs of improvement in demand. We are of the view that future outlook is positive, as the Indian economy will continue to be one of the fastest growing economies in the world since it is driven largely by domestic demand.

In this context, we are considering to increase our Convention & Exhibition Centre hall space from 4,50,000 sq ft to 1,000,000 sq ft.; construct additional IT buildings after IT building no.3 is completed and fully occupied; and, modernize our Industrial Capital Goods Group.

However, the company could not increase the area of its convention center to 1,000,000 sq ft even by present date. As per the FY2018 annual report, the area of exhibition and convention center is 635,000 sq ft (59,000 sq. meters).

FY2018 annual report, page 6:

Bombay Exhibition Centre:……Our Centre continues to bring more visitors to Mumbai than any other venue and now has a total capacity of 59,000 sq. mtrs. of exhibition and convention center spread over six air conditioned halls and has plans of further  expansion.

Therefore, investors should be cautious before taking the proposed expansion plans and the timelines of completion of real estate projects at face value. Investors should always use their own understanding before factoring in future plans of real estate developers in their cash flow projections.

 

6) Risks to the business from expected sources:

The key business strength of Nesco Ltd is that it is the only large exhibition and convention center available in Mumbai. An investor would expect that in such a situation, other competitors would come up with competing convention centers to benefit from the lucrative high profit margin business of hosting exhibitions.

The same is happening in Mumbai where Reliance group is coming up with its convention center in Bandra Kurla Complex in Mumbai. This convention center is currently under construction and has witnessed the delays in completion, which are a norm for real estate projects.

However, as and when this competing convention center is complete, then it will present a serious threat to the business of Nesco Ltd. It might have an impact on Nesco Ltd both in terms of occupancy level of its exhibition and convention halls as well as its profit margins as Nesco Ltd might have to charge lower prices to retain its customers.

An investor can easily anticipate the extent of damage Reliance group can inflict on existing players when it enters any new business segment by looking at the example of the telecom sector. Entry of Reliance group in the telecom sector has forced many existing players out of business and has made many existing strong players to report losses due to a price war.

Therefore, any investor should keep the threat of competitors while assessing the future business potential of Nesco Ltd.

Further advised reading: How to do Business & Industry Analysis of a Company

The company has acknowledged the threat of competition in its FY2013 annual report, page 8:

In case a large exhibition Centre is set up in Mumbai or if there were any unexpected developments, this business could have an adverse effect.

 

7) Risk to the business from unexpected sources:

Businesses always operate in uncertain environments. In many cases, the threat to the business arises from unexpected sources. Moreover, Nesco Ltd has faced such issues multiple times in the recent past.

In Dec 2017, Mumbai police directed Nesco Ltd to limit its bookings only up to 50% of capacity on weekdays in order to avoid traffic congestion at Western Expressway. (Source: Mumbai traffic police issue directions to convention centre to prevent snarls: Times of India)

“Directions have been given to Nesco Ltd. to not accept bookings for more than 50% of the capacity of BEC for events to be conducted on weekdays. Full bookings can be accepted for events to be held on weekends,” highly placed officials in the traffic department said

Similarly, in August 2018, an office of the municipal corporation (BMC) directed Nesco Ltd not to hold any exhibition until the construction work of the Andheri-Dahisar Metro line is complete. (Source: BMC bars events at Goregaon ground till Metro 7 work is over: Times of India)

BMC has told the Bombay Exhibition Centre (Nesco) at Goregaon East not to host any event on its premises from now till the completion of the Andheri-Dahisar Metro construction along the highway.

Later on, as per media reports, BMC withdrew the said order prohibiting exhibitions by Nesco Ltd.

An investor would appreciate that due to the significant problem of traffic management present in Mumbai, many times, Nesco had to face such challenges in its business. Such kind of challenges/risks may arise in future as well and God forbid, any such similar adverse order in future, if the order prevails, then it may hurt the business of Nesco Ltd significantly ensuing long legal battles.

Additionally, the concentration of almost all business activities of Nesco Ltd in a single geographical location increases the impact of such risks.

 

8) Resignation of Chief Executive Officer of Nesco Ltd:

Nesco Ltd intimated its stakeholders on August 1, 2018, by an announcement to stock exchanges that its CEO, Mr. Dibakar Chatterjee has resigned. The company stated that the tenure of the CEO would end on after 2 days i.e. on August 3, 2018.

Exchange Received Time 01-08-2018 17:22:27 Exchange Disseminated Time 01-08-2018 17:22:34 Time Taken 00:00:07

Dear Sir, Pursuant to Regulation 30 of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, we wish to inform you that Mr. Dibakar Chatterjee, Chief Executive Officer of the Company has tendered his resignation and he shall render his services till closure of working hours on 03 August 2018. This is for your information and record.

It seems like an abrupt resignation, as the notice period of 2 days looks very short for an effective handover of the responsibilities of CEO from one person to another.

Investors may seek clarifications from the company about the sudden exit of the CEO. In most of the cases, companies come out with the explanation that the employee has resigned to look for better opportunities outside the company. However, we believe that investors should do their own analysis before making their final opinion.

 

9) Errors in the annual reports:

In the FY2018 annual report, in the section representing the segmental results, the company has not provided a correct description of the parameters that it has listed down in the segmental profits.

The subheading of the section describes it as “Segment profit after tax and finance cost” whereas the label of the total at the end describes it as “Total Operating profit before tax”. As a result, an investor is confused whether the date provided in the annual report in this section is “before tax” or “after tax”.

FY2018 annual report, page 142:

Nesco FY2018 Errors Of PBT And PAT In The Segmental Results

Further advised reading: Understanding the Annual Report of a Company

The company seems to have repeated the same mistake in previous annual reports as well.

FY2017 annual report, page 162:

Nesco FY2017 Errors Of PBT And PAT In The Segmental Results

 

Margin of Safety in the market price of Nesco Ltd:

Currently (Sept 3, 2018), Nesco Ltd is available at a price to earnings (PE) ratio of about 19.50 based on consolidated FY2018 earnings. The PE ratio of 19.50 does not offer any margin of safety in the purchase price as described by Benjamin Graham in his book The Intelligent Investor.

However, we recommend that an investor may read the following articles to assess the PE ratio to be paid for any stock, takes into account the strength of the business model of the company as well. The strength in the business model of any company is measured by way of its self-sustainable growth rate and the free cash flow generating the ability of the company.

In the absence of any strength in the business model of the company, a low PE ratio of the company’s stock may be signs of a value trap where instead of being a bargain; the low valuation of the stock price may represent the poor business dynamics of the company.

 

Analysis Summary

Overall, Nesco Ltd seems like a company, which is currently witnessing a very stable business model with high profitability. It has the only big exhibition and convention center in Mumbai and as a result, it is able to get repeat business from its customers at very attractive prices.

The other key business segment of IT park (office space) benefits from the key location of its premises at one of the main roads in Mumbai, the Western Expressway. The location of its office building has made it an attractive proposition for corporate tenants. The payment of maintenance expenses of the buildings by the tenants over and above rental charges makes it a highly profitable business for the property owner. Moreover, contractual increases in rental charges provide for growth in the sales revenue/rental income.

These factors make the business of Nesco Ltd a stable source of income where the company is reaping the benefits of buying a strategic asset (a large land parcel adjoining one of the key roads in Mumbai) at very attractive prices in distant past.

However, there are certain aspects of the business, which should make investors cautious before they become complacent. One factor is the risk of competitors coming up with better convention centers at premium locations like the convention center built by Reliance group at BKC, Mumbai. It is currently under construction. This convention center poses significant competition to Nesco as and when it becomes functional.

The other factor is the risk from unexpected sources like Govt. departments, regulatory authorities etc., which may issue orders hampering the business of Nesco Ltd. The company has faced such orders in the past and such instances may repeat in future. Any such instance carries the potential of hampering the business of Nesco Ltd in a significant manner.

Another factor, which investors should keep in mind, is the omnipresent delays in the construction and leasing of real estate projects. In the past, Nesco has witnessed such delays due to which a few plans did not commence like the expansion of exhibition center to 1,000,000 sq ft and other plans were delayed like leasing of IT building 3 by almost three years. Therefore, an investor should always be cautious before taking the plans and projections of real estate developers on face value. They should always use their own views about such projections instead of relying completely on the plans provided by the real estate developers. There have been many instances where nearly complete buildings could not get completion certificates from the govt. authorities for years due to pending compliance with many of the regulations.

The promoters of Nesco Ltd seem to have good faith/confidence in the business of the company. As a result, the promoters have been increasing their stake in the company in the last decade. Additionally, the younger generation of the promoters has joined the company and is playing an active role in the management.

The major segments of the business of Nesco Ltd i.e. exhibition center and the IT Park are doing very good. As a result, the company has been able to accumulate a lot of cash and investments. However, another business division of the company, Indabrator, which manufactures capital goods, is not adding great value to the shareholders. Indabrator has a history of reporting losses and it faces challenging business environment most of the times. However, still, Nesco Ltd has been putting additional money in Indabrator, which provides a very low return on the employed capital. An investor may believe that the capital allocation decisions of the management to put additional money in Indabrator leaves scope for improvement. This is because an investment in bank fixed deposit, mutual funds, govt. securities etc. provides a higher return than an investment in Indabrator.

Investors notice that Nesco Ltd has a history of weak audit controls, delayed payments of statutory dues, poor records maintenance of fixed assets and inventory. Such kind of operating environment is the potential ground for frauds where the financial numbers reported on the books may not match with the actual material present on the company plants and warehouses. As per the audit report in the FY2018 annual report, Nesco Ltd seems to have resolved these issues in present times. This is because the auditor has not highlighted these issues in the recent annual report. However, an investor should pray that there should not be any old fraud buried deep in the books, which may come across in future due to the lax audit and compliance culture prevalent in the company in previous years.

Going ahead, we suggest that investors should monitor the timeliness of completion and leasing of IT building 4, which is currently under construction. Investors should monitor the development of the proposed plans of the company where it plans to restructure almost the entire existing layout of the exhibition center and existing IT buildings. Investors should monitor the amount of additional investments and business performance of Indabrator.

Investors should keep a close watch on the developments related to the completion and commencement of operations of the convention center by Reliance group and plans of any other upcoming convention center in Mumbai. This is because new convention centers have the potential of affecting the business of Nesco Ltd significantly.

Further advised reading: How to Monitor Stocks in your Portfolio

These are our views on Nesco Ltd. However, investors should do their own analysis before taking any investment related decision about the company.

You may use the following steps to analyse the company: “Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks

Hope it helps!

Regards,

Dr Vijay Malik

P.S:

 

DISCLAIMER

Registration Status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:

Currently, I do not own stocks of the companies mentioned above in my portfolio.

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