The 5G Revolution and Sterlite Tech

Imagine a world where machines can talk. Not just talk but negotiate with each other as we do on a daily basis. Your smartwatch keeps track of your blood pressure and heart rate to then inform your personal doctor in the off chance there are anomalies. You enter the kitchen to make yourself breakfast and find out that you’ve used up all the milk. But don’t worry, your refrigerator has got you covered. It has already made a purchase order based on your eating habits and your driverless car is just about to pick up the produce from your grocer.

While all of this may sound futuristic to you, some of the smartest minds in the world are already working their socks off to realise this futuristic dream and they are making commendable progress on what they call Machine to Machine(M2M) communication. As of now, a Samsung washing machine can place an order for detergent on its own and even conduct self-diagnostic tests to identify defects and request a service centre to fix it. However, there is one tiny problem. All of this mammoth processing and data transfer seemingly happens on what is today considered an outdated solution — 4G. While 4G can easily cater to the needs of “human communication”, it falls short when millions of machines start to talk. So how do you get them all working at the same time?

Well, you switch from 4G to 5G or in other words, you simply provide more bandwidth i.e. increase the capacity to transmit the maximum amount of data between two points in a given time period. With billions of connected devices, we will need a lot more bandwidth than we currently possess and 5G is specifically designed to address these needs. And for 5G to deliver its intended peak data rates, an interesting piece of technology, optical fibre cables (OFCs) have emerged as an industry favourite and the whole world is gearing towards a new era in network communication.

And at this point, its probably obvious that companies that produce these wonderful cables are in line to see major paydays and there is one company that has emerged from the annals of obscurity to mark its authority as a prime contender for being the top OFC supplier in the world — Sterlite Technologies. After splitting away from the power business in 2016, Sterlite tech was spun off as an independent entity with interests in network solutions and fiber tech and has since grown considerably to emerge as one of the darlings of the investor community. Today’s story is about Sterlite where we attempt to find out if all this optimism is premised on irrational exuberance or sound fundamentals.

But before we get into Sterlite we must address another basic question. How does a manufacturer of optical fibre cable differentiate his product offering when they look, feel and operate the same way. How do you sell these products and emerge as a top dog when the product is highly commoditized.

Integration is the secret

Well, for starters it’s an extremely challenging endeavour that often compels manufacturers to fight the tide in an attempt to drown competition. Yet, Sterlite seems to operate under little to no pressure. Because unlike its competitors, the company has a very unique advantage — It has a fully integrated supply chain.

Over the years, Sterlite has transformed itself from a manufacturing-focused company to an end-to-end service provider. It began operations selling optical fibre cables and stuck to it for some time. The company would import its raw material (glass preforms mostly), from external suppliers and then manufacture optical fibres and cables and sell them onwards. Sterlite quickly found out that it could gain more control over its chain of operating activities, increase efficiency and reduce costs if it manufactured ‘glass preforms’ internally. In management schools, professors call this backward integration, a process in which a company produces parts of its raw material internally, in an attempt to optimise operations and control costs.

Today, Sterlite fulfils all of its “glass preform” needs internally. Now at this point, you are probably thinking if you can go backwards what stops you from going ahead. Well, nothing, if you have enough initiative that is. Along with selling OFCs to telecom infra development companies, Sterlite started taking control of steps in its supply chain that included network integration, sales and after-sale services, a practice that’s called forward integration.

And although these integration jargons might seem funny and rather obvious developments over the course of a company’s business lifetime, investors must bear in mind that Sterlite happens to be the only Indian company that has a fully integrated product offering in the optical fibre business. It also happens to be the largest player in India and the most profitable entity simply because it can better control costs and post better profit margins.

However, all this talk is of the present. What does the future hold for Sterlite?

Keep the Orders coming

Stock Markets are driven by future prospects. When investors see companies that harbour significant money-making potential their eyes light up. But more often than not, people rely on their subjective feelings to determine this underlying potential instead of more consistent quantitative metrics. However, if you took some time to snoop around you are likely to stumble upon solid lead indicators of future revenue potential. One metric that captures this idea succinctly is the order book.

Manufacturing companies like Sterlite are largely driven by contracts. They don’t often sell products to a large set of customers, instead, they have a limited list of clients who buy in large volumes. All of this is captured in the order book which represents customer orders that will be filled in the future. Sterlite has an order book that is likely to keep its manufacturing facilities occupied till 2020 and this gives us a reasonable idea about the company’s business potential. A more refined version of this idea is captured in another metric called the book to bill ratio.

The ratio measures the value of orders coming in compared to the orders completed. It is pretty simple math; take the bookings (orders) / billings (revenue) and voila you have a number that accurately measures how quickly a business fulfils the demand for its products. As long as the company isn’t delaying projects or running into roadblocks a ratio greater than 1 indicates considerable business potential and Sterlite has been pretty consistent in drawing in those large orders.

Point of Interest: Sterlite’s stock surged 10% after it was awarded an advance purchase order to design, build and manage the Indian Navy’s communications network. The deal was worth a whopping 3500 Crores.

However, despite the incredible numbers, there seems to be a problem. Almost 50% of all outstanding shares of the company is pledged as collateral with banks, a practice that is extremely uncommon in large enterprises and the management seems to think that this is a non-issue. So is it?

Pledging Shares — A Death Trap

Typically whenever you try and raise money by pledging shares, the amount that is lent by banks is less than the market value of the shares. Imagine you fancy a new mobile phone and you need some urgent cash to make the purchase happen. So you go to a bank to borrow some money in the hope that they will accept some of your ‘Sterlite’ shares as collateral. You pledge Rs. 10,000 worth of shares in the hope that the loan will be sanctioned. The bank accepts and lends you Rs. 9,000 and treats the difference, Rs. 1000 as a buffer in the event the stock price falls slightly. All of this works extremely well until the share price remains relatively stable.

In case the stock price begins to fall precipitously, the bank will ask you to provide more cash or shares to shore up the collateral. If you refuse, the bank can then sell these shares to maintain its margin. Now, this is a rather benign reaction because the total worth of all shares pledged amounts to a meagre Rs. 10,000. Although you do lose your shares, the repercussions are rather limited. But imagine this amount is much higher i.e. 7000 Crores. If this were to happen on a large enough scale, banks selling large volumes of shares in the market could create an oversupply which could then lead to further fall in prices creating a vicious cycle that might be detrimental to the stock.

As of today, the promoters at Sterlite Tech have pledged nearly 97% of their shares i.e. close to almost 50% of all available shares. Back in 2013, RBI, in its financial stability report noted that a company with 50% of its shares pledged as collateral fell under the high-risk category. Unfortunately, out of the 217 publicly listed companies that are worth over 10,000 Cr, Sterlite is the only one that finds itself in this rather ignominious list.

Point of Interest: The promoters state that they raised money from banks for alternative investment opportunities outside Sterlite Technologies

Outside of this, the management has also been embroiled in controversy for making decisions that are not necessarily considered investor/people friendly. Albeit none of this can be attributed to Sterlite Tech, it’s still the same bunch that control Vedanta Limited, Sterlite Power, Sterlite Industries etc. ( all different entities doing very different things) and the fallout of bad management decisions elsewhere has in the past affected Sterlite Tech as well.

Pro tip: Any corporate governance issues involving unscrupulous, bad man/money managers, can often have devastating consequences on the stock and the company

Demand Supply Mismatch

Outside of the problems related to management, there are larger issues at play. A major concern for the majority of the OFC players has been the Chinese market. Chinese telecommunication service providers China Mobile, China Unicom and China Telecom alone consume more than 50% of the world’s total optical fiber production, which makes this market a rather important one. At a time when companies across the borders are on a capacity expansion spree with excessive exuberance, we could reach a point where cumulative production capacity exceeds demand considerably and this won’t bode well for the likes of Sterlite. About a quarter of the company’s exports go to China and a significant glut in their economy could affect the entire fibre industry. So it pays to keep an eye on how the Chinese market is looking after itself.

Pro Tip: Investors must bear in mind that as of today demand far outsrips supply and according to Sterlite this scenario is unlikely to change until 2020

Satellite — The new Optical Fibre?

Then there is the threat of satellites — disruptive technology that could render optical fibres obsolete. While mere mortals conceive of incremental change, the likes of Elon Musk have already sought to revolutionise the way people connect to the interweb. SpaceX has plans to launch over 7000 satellites over the next 9 years to provide a satellite-based broadband network to the entire world. To put this development in perspective, there are only 1,886 active satellites presently in orbit. So sceptics continue to believe that this radical increase in capacity is bound to play spoilsport and affect the optical fibre business.

However, the current incumbents do not seem too troubled by these developments. Tejas networks, a fellow player in the optical fibre business had this to say about the matter and we paraphrase —  “Satellites can offer speed but not necessarily capacity. They can provide coverage, but not bandwidth. Satellites are economical solutions that enable internet access in remote areas where fibres can’t reach. So they will complement each other in solving connectivity problems.”

Pro Tip: Investors must bear in mind that any disruption of a sufficient size can and will affect the business. Fibres dethroned copper cables as the go-to-solutions for network communication and it is quite possible that optical fibre could meet the same fate some day. So while there is reason to be optimistic there is also good reason to exercise caution

Guide us to the Straight path

And that leaves us with a lot of hope but moments of doubt as well. Sterlite Tech is an amazing stock by all accounts. It has generated significant returns for people who bet on the company early and it’s got the financials to back it up. But it’s also a company that brings with itself significant risks because of the business it operates in. We hope investors understand the implication of their actions and we hope that Sterlite continues its upward journey.

Fellow reader, I ask you, Where is your bet?

. . .

Disclaimer: No content on this website should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. The author accepts no liability for any actual investments based on this article.

Enjoyed reading? Show us your love by sharing...

Review & Analysis by Pawan, IIM Ahmedabad

Liked what you just read? Get all our articles delivered straight to you.

Subscribe to our alerts


Stay updated

Get our latest content delivered straight to your inbox or WhatsApp or Telegram!

Subscribe to our alerts