Sterlite – a complicated story

Introduction

Sterlite is a vertically integrated manufacturer of fiber optic cables. The manufacturing of fiber optic cable starts from silicon chemicals which is converted into preform which is used to draw fiber which are combined to make the end product – fiber optic cable. Preform is a glass rod with extremely high purity and forms the core of the fiber. It is the most important component of the fiber optic cable and the quality of the cable derives to a large extent from the quality of the preform. The manufacturing of preform requires highly specialized manufacturing process. Preform is to optical fiber cable what software was to the computer industry. Just as majority of the profits of the computer industry was captured by software manufacturers, preform captures 70% profitability of the optical fiber cable supply chain. In fact, there are only seven companies across the globe with the technology to manufacture the preform and Sterlite is one of them. These are – Corning, Prysmian, Shin-Etsu, Sterlite, Fujikura, Furukawa Electric, and Sumitomo Electric. Additionally, there are two Chinese companies which license the technology to manufacture the preform – YOFC and Hengtong Optic.

Demand Supply

Today fiber optic cables are the most preferred medium for data transmission and carry over 99% of internets total mileage. This is because they suffer from less interference from weather and other disturbances and hence offer better signal quality. As a result, they need less amplification to boost signals and can travel over larger distances. Additionally, they are more cost effective as well.[1]

There is expected to be an ever increasing demand for data driven by multiple factors. These include cloud computing, IoT, upcoming 5G rollout, business data and so on. Data consumption has increased at a truly exponential rate during the past. At the same time, it is not expected to slow down any time soon. Data grew at a CAGR of more than 100% before 2013, dropped to 70% in 2015 and 2016 and further to 60% in 2017 and 50% in 2018. It is expected to continue to grow at 50% CAGR over the next 5 years till 2023.[2]

This will in turn lead to increasing demand for fiber optic cable. Fiber demand increased at an explosive rate of 50% per annum during the dot com boom from 45 million km in 1998 to 91 million km in 2000. During the ensuing slowdown, the demand came down to 54 million km in 2003. From 2003, the demand has grown at a CAGR of 17% to finish at 493 million km in 2017 as shown in the figure below.

Figure 1: Demand of fiber optic cable (1998-2018)[3]

The global preform capacity had been growing at a slower pace than the demand of fiber optic cables up till 2017, as seen in the figure below.

Due to preform shortage and the robust demand for fiber optic cables in 2017, consumers of fiber optic cable were unsure if they will be able to get their required quantity at reasonable prices. During this time, Verizon announced two mega deals to procure fiber from Corning and Prysmian over the next three years. In April 2017, Verizon signed a $1.1 billion, three-year fiber and hardware purchase agreement with Corning. Verizon will purchase up to 20 million km (12.4 million miles) of optical fiber each year from 2018 through 2020. In May 2017, Verizon signed a $300 million 3-year deal with Prysmian.[4]

During this time period, Sterlite’s performance has been quite impressive. Revenue growth has accelerated during the last 3 years at a rate of 14%, 24% and 40% in FY17, FY18 and 9 months of FY19 respectively. At the same time, the net profit margin has increased from 7% in FY16 to 12% in 9 months of FY19.

  FY16 FY17 FY18 9mFY19
Revenue 2275 2594 3205 3296
Revenue Growth 14% 24% 40%
PAT 159 217 334 398
NPM 7% 8% 10% 12%

The order book has also seen impressive growth as can be seen from the figure below:

*Revenue representative of last 4 financial quarters

At the same time, the shortage of preforms also lead to announcement of additional supply from major manufacturers.[5]

  • During 2017, Corning announced capex of $250m to increase manufacturing capacity for optical fiber and plans to have the facility fully operational by the end of 2018
  • Prysmian announced a 3-year expansion plan of EUR 250m
  • Furukawa Electric announced plan for $150m capex
  • Shin-Etsu announced capex of $160m[6]

The additions in supply are coming on stream now. At the same time, the narrative of the accelerating demand seems to have taken a hit. After growing at CAGR of 17% from 2003-17, the demand growth has slowed down to 4% in 2018.[7] There is a lot of uncertainty going into 2019 as the biggest consumer China seems to have slowed down. While still unclear, it does not look like there is going to be much improvement in 2019 as well. From all accounts, it looks like we may be in a period of a slowdown which may last a while. [8]

The other piece of the puzzle is the pricing of the fiber optic cable. Data on this is difficult to get but I’m presenting what I have been able to get. The price of fiber optic cable has gone down from $330 per km in 1983 to $60-70 per km in 1994[9] to $100 per km in 1998 to $15 per km in 2003[10] to $9 per km in 2011[11] to ~$8 per km currently in 2018. Sterlite has admitted in their Q3 FY19 earning call that this has come down to $7.5 with the slowdown in China. As is apparent, the long term trend of the fiber prices has been downward although there are fluctuations in the short term in response to supply and demand situation.

Conclusion

Currently the situation for the fiber optic cable industry is not looking good, neither from a supply demand or from a pricing perspective. It remains to be seen how long the slowdown will last. However, the demand for fiber optic cable will pick up speed again as 5G rollout picks up. 5G will require a much higher density of radio stations compared to 4G. As per Fiber Broadband Association, to go from 3G to 4G requires 25X more fiber and from 4G to 5G requires 16X more fiber. As the major rollout of 5G is expected to take place from 2020 onwards, the demand for fiber should increase again during 2020 and beyond. From a long term perspective, it does look like the demand will continue to be robust and provide a long runway for manufacturers of fiber optic cable.

Vertically integrated manufacturers are in a much better position to weather the current slowdown in the industry. Although Sterlite is vertically integrated, but the other point to note about them is their treatment of minority shareholders. While there are groups, which have a reputation of treating minority shareholders fairly, Sterlite does not fall in this category. Quite the opposite, in fact. While you may read about their record elsewhere, suffice is to say that they do not have a good track record in this regard. Hence, I would be very careful when investing with this promoter group.

Another good write-up on Sterlite to get a more complete picture is given here.

Sources:

[1] Explain that stuff – Fiber Optics – September 2018

[2] Fierce Wireless – Deeper Dive—Will growth in data traffic ever slow down? – September 2018

[3] Prysmian Group – Company Presentation, May 2013 (Slide 73), Communications Today – OFC, the stage is set for the next 10 years – December 2018

[4] Fierce Telecom – Verizon signs $300m optical cable purchase with Prysmian

[5] Fibre Systems – Furukawa plans to double fibre production capacity at OFS – September 2017

[6] FOMSN – Shin-Etsu announces expansion of preform production – October 2017

[7] CRU – Optical fibre and cable industry review – January 2019

[8] Bloomberg Quint – Lower fiber cable prices in China to hurt Sterlite Technologies – March 2019

[9] NY Times – Fiber optic cable demand outstrips supply – November 1996

[10] Lightwave – More consolidation is required to balance supply and demand in optical fibre market – March 2004

[11] Photonics Media – The coming market for optical fibre and cable – February 2012

Value investor

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