Primary Offer. Tejas Networks: Connecting to growth

The Indian listed space has many software service providers, but the global slowdown in technology spends has made the sector unexciting. Investors still keen on technology stocks can consider the upcoming initial public offer (IPO) of Tejas Networks, a products company.

Tejas’ products are used to build high-speed communication networks that carry voice, data and video traffic from fixed line, mobile and broadband networks over optical fibre. Its customers include telecom and internet service providers, utility companies and government entities.

With the rapid growth in data traffic, thanks to the increasing penetration of smart phones, opportunities are plenty for players in the network equipment space. Further, the Centre’s Digital India initiative and Smart cities push are opening up new prospects.

The company’s offer document highlights that it holds a 15 per cent share of the domestic optical networking market, and that it is the second largest player (next to Huawei with 36 per cent market share).

Tejas is making a fresh offer of shares to raise ₹450 crore. Some existing shareholders of the company are also selling their stock worth ₹326 crore in the offer. At the upper end of the price band of ₹250-257, the company is asking for a valuation of 25 times its estimated earnings for 2017-18. This looks a little expensive. In FY17, revenue growth was 40 per cent (against annual average of 25 per cent in the last four years) and profit growth was 122 per cent.

If there is a slowdown in capex of telecom players or if the pace of rollout of BharatNet or other government projects falters, revenue growth may moderate. Also, since Tejas is a product company, the R&D and manpower costs are large. The net profit margin is about 8 per cent. Profit may be hit sharply if revenue does not grow fast enough to cover fixed costs as was the case in the past — in two out of the past four years, it posted a loss.

Tejas doesn’t have any strict comparables in the listed space. However, D-link, a networking equipment manufacturer for the home and enterprises segment, and Sterlite Technologies, an optical fibre cable firm, have the same growth drivers and opportunities.

Sterlite, whose revenue is thrice that of Tejas, trades at 23 times its expected earnings of FY18.

With rapidly rising data traffic, the future looks promising for players in the networking equipment space. The Digital India and Smart cities programmes translate into increased spend on optical fibre networks. While the target is to reach 2,50,000 gram panchayats through BharatNet (optical fibre network), only 19,785 have been connected till now.

As the government goes ahead with its digital initiatives, the demand for data, and thus for networking equipment, seems set to grow. Further, since all telecom service providers are increasingly looking at 3G and 4G services to grow market share, it is becoming essential to invest in optical fibre transmission to improve user experience. India has just 15-20 per cent of its cell towers connected on fibre compared to 70-80 per cent in developed countries.

India is Tejas’ principal market, contributing 60-70 per cent of its annual revenue. The rest comes from Central America, Africa and South-East Asia. Its top customers are Bharti Airtel, Tata Communications, Aircel, BSNL, Power Grid Corporation of India and RailTel Corporation of India. Most of Tejas Networks’ competitors are global companies such as Huawei, Nokia, ECI Telecom, Ciena, ZTE and Fibrehome.

Tejas provides an end-to-end portfolio of optical and data networking products across all three types of networks — access, metro and long haul. Simply put, the company makes equipment that connect communication devices such as computers, phones and audio/video conferencing systems, to the internet.

Like most other hardware players, Tejas too outsources its manufacturing. This helps it grow revenue without the capex burden. Two vendors — Sanmina Corporation and Rangsons Electronics (a Cyient company) — handle end-to-end contract manufacturing for the company. They procure the components, manufacture the printed circuit boards (PCBs), test and assemble them and then ship the PCB cards to the company. Tejas handles the product assembly, integration of software and hardware and the final product testing in-house.

Known for its innovation in networking equipment and the ability to adapt, Tejas has successfully crossed the technology shifts from 2G to 3G and later to 4G. The company invests a significant amount in R&D — 8-12 per cent of its revenue annually over the past four years. In FY17, when the revenue was ₹878 crore, the company spent about ₹70 crore on R&D. The cost of materials consumed works out to about 60 per cent of sales. So, with input costs, R&D related manpower expenses and other miscellaneous outlay, the operating margin comes to 19-20 per cent. However, while this operating margin looks healthy, at the net level, depreciation and interest costs pull down the margin to 8-9 per cent.

The company has shown good improvement in managing its working capital cycle in recent years. Its receivable days have improved from 265 in FY15 to 160 in FY17. However, since it has to pay its creditors in 93 days (trade payable days), its working capital requirements are high. Most of the borrowings are short-term in nature and used for working capital requirement. Tejas had debt of ₹225.9 crore in FY17 and interest costs were ₹31.5 crore.

While future is promising for the networking equipment business, there are some risks to investing in Tejas. First, given the company’s notable fixed costs and the increasing R&D expense every year, there is the risk that the profit may slip to the red in the years when sales is lacklustre.

Two, since technology is changing rapidly, it may render some of the company’s products obsolete. This could materially impact profitability. In FY13, for instance, the company had to write off assets worth ₹38.6 crore due to change in technology.

However, given that the company has a large product portfolio, it is largely hedged from a one-off exceptional event.

COMMENT NOW