Is NBCC a company with a sustainable moat?

Is NBCC a company with a sustainable moat?

I was asked this question recently and I used it as an opportunity to get back to my blog, something I had quite forgotten!

Before we dive into the answer, a short word on: 1) what is a moat and 2) what is NBCC all about.

Moat

It was Buffett who, in saying the following, introduced the investing world to the term ‘economic moat’:

" In business, I look for economic castles protected by
unbreachable ‘moats' "

 An economic moat then, is a type of sustainable competitive advantage (due to entry barriers, low costs, high switching costs etc.) that a business possesses that makes it difficult for rivals to attack its market share and profit. The term is derived from the water filled moats that surrounded medieval castles. The wider the moat, the more difficult it would be for an invader to reach the castle.

National Buildings Construction Corporation (NBCC)

The company:

1. Is a Government entity – a Mini-Ratna (implying more leverage in decision making by the Government), which came out with an IPO in early 2012 in the price band of 90-106/- (current price hovering around 100/-).
2. Has a current market cap is 1200 cr., no debt and ~ 1500 cr. in cash (of which one could assume ~ 600 cr. as excess cash since rest of it are against payables/ advances); this implies an EV of 600 cr.
3. Has ROE of > 20% for the last 6 years and a negative working capital (company takes advance from its customers) 
4. Has an average 6 year Free cash flow of 200 cr. Additionally has interest income (which should be considered as operating income assuming the current financials and business model continues) of 70-100 cr.; EV/ FCF of ~ 2x.
5. Is in the following businesses:

• Main business comprises of project management and consultancy for civil construction for Government (Ministries/ Police/ Army etc.) as well as for PSUs (including public sector banks etc.) 
• Other business consists of Real Estate development for both Residential and Commercial properties

Does the company have a moat??

The company’s Project Management Consultancy division's model is rather simple. It:

- gets orders from Government/ Government undertakings
- takes advance from the customer
- gives the contract to a sub contractor
- provides any advance to the contractor if required (but backed by bank guarantee)
- supervises the work and
- earns anywhere from 6-10% on such contracts

Reading the above, one view could be that the company is surviving due to the preferred treatment given to it by the Government. And we don’t know whether this is sustainable.

And as per me, that’s a correct view. The fact is that the company’s business model is entirely dependent on the preferred treatment from the Government.

But it is also true that doing Governmental construction is their Raison d'être – that’s why the company was created. For the company, this creates a large, virtually recession free market. And as an investment opportunity, I have no problem with that – none, zilch, zip.

Now coming to the question on whether this is a sustainable moat (I would say that this is a moat). If the quality of the construction was outstanding or there was some great value addition in what they were doing, then I'd say yes.

But if one were to see any of their constructions, one would realize that it’s nothing to write home about (though you may ask legitimately – how many Government buildings does one know for which one could write home about??). Hence, I would conclude that this is not a moat that cannot be breached tomorrow (in the sense that there is nothing to stop the Government from allowing others to do all these jobs).

Then why do I still like it?? 

Because while it is not an unbreachable moat, I am not certain why the Government would want it to be breached!

To understand my logic, lets reverse the argument – why would the Government want to change the arrangement? The margins that NBCC charges are small - so I don’t see an incentive there. Additionally, in the current environment where bureaucrats want to save their backsides from any decisions that can be questioned later, there may be an inertia towards asking someone other than a 'Government' company (read NBCC) to do work for them, even if the quality is not so great.

So while I'd say that the moat is not the strongest, I think the unique arrangement due to which NBCC gets its business may be around for enough time for us to take advantage of the situation.

The Real Estate (RE) division, on the other hand, is different than the PMC in that it gets good margins - 40% and more - because it buys land, builds on it and then sells it. But the profitability depends on whether there are any projects that they are working on. As of now, they have a couple on hand: the Okhla commercial complex that is close to completion and a couple of sectors in Gurgaon. They still haven't opened the booking on these, but when they do, that will drive their profits over the next few quarters. There are other projects that will also be worked upon, so while the inflows will be bulky, we should expect a decent inflow in the immediate couple of years.

The potential crocs in the moat

Another couple of aspects of the company that we need to be aware of before we think everything is nice and dandy about the company:

• The nature of company's business is such that it is susceptible to allegations of corruption. When a Govt. company works with multiple contractors, corruption is forever a lurking possibility – though as per the company, they have recently taken certain precautions like moving to e-bidding above a certain contract size. They are also working on a whistle blower policy. 

• Contingent liabilities as at March ’12 were in excess of 1000 cr. on account of ‘claims against the corporation not acknowledged as debts’ (the amount is 1/3 of their Annual revenues and ~5x their PAT). However on more thorough investigation, it became clearer that these are more in the nature of posturing by some of their customers (of the total amount shown as contingent liability, Rs 570 cr. is on account of a single account – Canara Bank – for which NBCC did some work at Mumbai. NBCC made a claim of Rs 356 cr. and Canara Bank put a counter claim of Rs 570 cr.). In other words, these are the result of some disputes that ran into arbitration. Some of these came to light at the time of the IPO’s due diligence. For one, the management is working to bring these amounts down by settling the disputes. Secondly, their agreements with the sub-contractors are commercially quite strong and protect NBCC from risks arising out of claims of non-performance. And lastly, as per the management, most such arbitration cases in the past have resulted in a net recovery in favor of NBCC, rather than a payment. Ergo, I’d say that these are part and parcel of the nature of their business and something that can be managed with some more focus and attention. Net-net, I am not losing my sleep over the contingents. 

• Management’s notes to accounts included the following comment: ‘Balances of Trade Receivables/ Trade Payables and Loans and Advances are subject to reconciliation and confirmation’. (For information as at March ‘12, the Trade Receivables and Payables are to the tune of ~ 850 cr. and ~ 1170 cr. and ~ 550 cr. respectively – each one being a scary number by itself). Regarding this, my view is that the company’s management has been rather lackadaisical about it. This is a comment that has apparently been carried on for years (and has more to do with reconfirmations rather than reconciliations) and one that the management did not realize the import of, until the analysts questioned it. Again, there is every hope that they will work on getting the reconfirmations so that this doesn’t have to resemble a time bomb on every Annual Report. I am not completely comfortable about this but am willing to give the company some time to clear the cobwebs. At the same time, I don’t think the company is following some banana accounting policies with no controls whatsoever. 

In summary, I'd say that the company doesn’t exactly have the moat of the quality of a Colgate or an HUL. But it looks cheap, quite cheap. And recession free to a large extent. And in light of the RE income that is likely to come soon, it could show bulky profits as well. So there is opportunity to make money though it may not be a multi-bagger and I wouldn't hold it for a very long period.

Hope that makes sense.