12/4/2019 Why I sold Sterlite Technolgies at a loss – Candor Investing

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AUGUST 22, 2019 BY AMEY KULKARNI

Why I sold Sterlite Technolgies at a loss 

Selling your stock at a loss is always painful.

Taking such a decision decision takes a lot of courage.
However, difficult things have to be done if one wants to make real money in equity
markets – get rid of your weak positions before they pull you down with themselves.

Today, I want to write about one such stock which I have sold at a loss – Sterlite
Technologies.

Let us first look at what is good about the company

Sterlite Tech is one of the largest manufacturers of optical fiber preform in the world.
There are only about 10 manufacturers of the preform core.
The company is growing phenomenally fast and expanding both – markets served and
its product basket.
Sales Growth (3 yr) = 34%
Profit Growth (3 yr) = 54%

Autonomous vehicles, large-scale data centres, HD video streaming, Internet of Things

(IOT) and other technologies are possible only with higher speeds and lower latency
(lag) ie increased penetration of fiber optic. High data speeds with low latency are
today a basic expectation of the consumer.
Thus, fiber optic demand is a secular growth story.

Sterlite Tech has increased optical fiber capacity from 10 Mn fkm in 2010 to 50 Mn fkm
in 2019.
The company has also entered network integration services and is executing massive-
scale projects for the Indian Navy, Bharatnet etc.
Sterlite Tech also acquired Elitecore in 2016 so as to get the capability to service
telecom carriers with OSS/BSS (Operating Support Systems/ Business Support
Services) software services.
Read more about this capability in this Gartner’s Magic Quadrant report for OSS/BSS
service providers.
https://www.gartner.com/doc/reprints?id=1-6808JHC&ct=190212&st=sb

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In 2018, Sterlite Tech also acquired a fiber optic cabling company based out of Italy to
be able to gain better market access in Europe.
Sterlite Tech in the last few years has been able to attract global talent eg Anshoo Garg,
ex-head of AMDOCS is now head of Network Software at Sterlite, Ayush Sharma the
founding member of the open SDN (software defined networks) is now spearheading
Programmable Networking & Intelligence at Sterlite Tech.

A good balanced analysis of Sterlite Tech may be found here

https://finception.in/stocks/sterlite-technologies-ltd/

However, the backbone of the company still remains optical fiber manufacturing and
most of the revenue and profits still come from this segment – especially more so with the
recent capacity expansion from 30 Mn fkm to 50 Mn fkm.

Now, let us look at what the company mentions in its 2017 annual report about Market and
Competition risks

By the company’s
own admission, the
market for optical fiber is extremely competitive with very low barriers for capacity
expansion by existing players. This means, though it is very difficult for new players to
gain access to the technology of producing optical fiber preform, it is quite simple for the
existing players to expand capacity.

Sterlite Tech is a price taker and the way it is trying to overcome this risk is by expanding
capacity and gaining economies of scale. We can easily extrapolate the strategy of other big
players in such a competitive market – with increasing demand, the other players are also
aggressively expanding capacity.

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The market for optical fiber preform (the core) is dominated by approximately 10 players
globally including China. Almost all players had announced aggressive capacity expansion
projects in 2017 and 2018.

“In a commodity business, demand increase happens gradually, supply increase

happens in jumps (steps).”

1. What this means is that when demand outstrips supply making the business very
profitable for the existing players, they start by expanding capacities.
This is what happened in 2017 and 2018.

2. All players make healthy profits and typically phase is characterized by faster increase
in profits than revenues. (as seen in the financials of Sterlite Tech from 2016).
3. New capacity comes online in large chunks and a day comes when supply again
becomes larger than demand.
4. Prices collapse and many of the weak players start losing money and the leveraged
ones start going bankrupt.
5. It takes years for the demand to again outstrip the supply and for the prices to rise and
become profitable for most/all players in the industry.

We see that step 1 & 2 were playing out in calendar years 2017 and 2018.
Come 2019 and one of the large tenders for procuring optical fiber cable by China mobile
saw a significant reduction in discovered prices.

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The Sterlite management immediately came out to emphasize that this was a temporary
issue and gave elaborate reasons as to how and why it will not affect the performance of
Sterlite Technologies. You may read one of the interviews by the CFO of Sterlite
Technologies here.
https://economictimes.indiatimes.com/markets/expert-view/china-issue-temporary-
wont-hit-sterlite-big-anupam-jindal/articleshow/67687245.cms?from=mdr

Let us look at the numbers being reported by Chinese optical fiber producers.
YOFC which is one of the largest producers in China reported a 35% reduction in revenue
in the Mar 2019 quarter.

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Well, the optical fiber demand in China is 1.5 times the global demand ex-China. The
management of Sterlite Technologies repeatedly opined that a “temporary demand
slowdown” in China would not impact business outside China.

Now, let us look at what Corning, the company that invented the optical fiber had to say in
its Conference call in Aug-19.

This is dramatic – instead of growth which was predicted at the start of 2019,
Corning now sees the market for optical fiber to show contraction.

The weakness that started in China has now spread to India and South East Asia.
What was the impact on Indian optical fiber producers?

Aksh Optifiber, one of the players producing optical fiber based out of India defaulted on
loans in May 2019. CARE ratings downgraded the company debt to D for non-servicing of
debt on 27.05.2019
http://www.careratings.com/upload/CompanyFiles/PR/Aksh%20Optifibre%20Limited-
05-27-2019.pdf

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Step 4 is complete.
And there is a lot of data as seen above to suggest that step 5 will play out in the market.

Does the current valuation price-in all the negatives about the business, company,
industry and its future?

As on 20.08.2019
Market Cap = Rs 5,410 Crs
Total Debt = Rs 2,067 Crs
Enterprise Value (EV) = Rs 7,477 Crs
Sales (12M trailing) = Rs 5,642 Crs
Operating Margins (12M trailing) = 21%

In my opinion, the operating margins could reduce to anywhere between 12% to 15%
Assuming 15% operating margins,
Operating Profits (Est) = Rs 846 Crs
EBIT (Est) = Rs 627 Crs
Thus, Sterlite Tech is trading at a valuation of
EV/EBIT (Est) = 7477/627 = 12

If the operating margins reduce to 12%,

Operating Profits (Est) = Rs 677 Crs
EBIT (Est) = Rs 458 Crs
EV/EBIT (Est) = 7477/458 = 16

In a commodity industry, with supply outstripping demand, expectation of demand de-

growth and falling prices a valuation of EV/EBIT of 12 seems expensive.

The fall in profit after tax (PAT) will be even more dramatic.
The stock price chart of Sterlite Technologies suggests that the market is expecting some
such thing to play out since Jan-19.

The stock price has come down by 60% just in the last 8 months.
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12/4/2019 Why I sold Sterlite Technolgies at a loss – Candor Investing

Note:
I purposefully not written about the issue of pledging of promoter shares and the shares
being unencumbered later as this factor did not play a part in my decision.

Disclaimer:
This article is not a stock recommendation but an illustration of the kind of analysis that goes
into fundamental research and equity investing.
I (@amey153) am a SEBI registered Investment Advisor.

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4 thoughts on “Why I sold Sterlite Technolgies at a loss”

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Shiva / August 23, 2019 at 06:16 Reply

Good input

 Liked by 1 person

Gunasekhar / September 7, 2019 at 08:38 Reply

Very good analysis

 Like

ORCHID TOWER / August 23, 2019 at 17:38 Reply

I got the very good inside. Thanks.

 Liked by 1 person

sridhar / October 13, 2019 at 16:42 Reply

Good analysis

 Like

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