The Hindu Business Line : Tulip IT Services: Invest at cut-off

INVESTORS with a high-risk appetite can consider subscribing to the book-built initial public offering by Tulip IT Services (Tulip) at the cut-off price. Risk-averse investors can stay away from this offer. The price band fixed for the offer is Rs 100-120. In this range, the price-earnings multiple works out to 20-24 times its 2004-05 earnings per share, if fully diluted. However, based on the first half performance for FY 2005-06, on an annualised basis, the PEM will drop sharply to under 10 times. Since Tulip is on an investment mode, we have downplayed the sharp improvement in financial performance.

Though the pricing (on a full-year basis) is quite stiff, the company's foray into the burgeoning Internet Protocol/Virtual Private Network (IP VPN) market holds good potential for growth. Since Tulip is already an entrenched player in the network integration business, its ability to use the references to build a customer base in the IP VPN market appears promising. From a risk-reward perspective, however, we will be comfortable if the stock is priced at the lower end of the price band in the book-building process.

This IPO is being made by Tulip to expand its presence in the IP-VPN market using a wireless base for last mile access. A Virtual Private Network allows users at remote locations to access a secured private network virtually from any location without installing expensive leased or private lines. The project cost is estimated at Rs 134 crore. The buoyancy in the economy is likely to stimulate the growth of IP VPN market, especially on the banking and corporate front. Research studies by IDC and Frost & Sullivan, the IP VPN market is projected to grow at an annual rate of 30 per cent till 2008.

Since the operating margins are likely to be much higher, at least above 15 per cent in the IP VPN space, Tulip's overall margins are expected to improve. Tulip clocked an operating margin of 5.8 per cent on a revenue base of Rs 343.22 crore in FY 2005. Though the operating margins have improved to 12.4 per cent in the first six months of FY 2006 on revenues of Rs 195.60 crore, the sustainability of margins is yet to be established. Besides, the revenue growth in its core network integration business is slowing down and this segment is getting intensely competitive.

At the same time, there are substantial challenges and risks associated with this public offer. One, the regulatory risks are quite high. The regulations governing the IP VPN licence have undergone considerable changes in the past year. This business that enjoyed zero-entry fees, till recently saw the Department of Telecommunications levying an entry fee of Rs 10 crore.

In early November, the government came up with another significant policy change. It has decided to do away with IP-VPN licences altogether, with all the players being allowed to migrate to long distance (national and international) service licence at an entry fee of Rs 2.5 crore for each licence. Though this policy change brings some certainty to the regulatory structure, the grey area relating to spectrum availability and allocation for wireless users is yet to be settled. The policy on spectrum is likely to be decided only in the first quarter of 2006.

Two, for providing inter-city connectivity, Tulip proposes to take leased lines or optical fibre from multiple infrastructure service providers such as GAIL, Railtel or Power Grid Corporation. Since the latest policy provides for these infrastructure players to directly enter into the long distance arena or lease it out to other non-integrated mobile operators, the pricing will get competitive.

Three, the technology risks are also likely to be higher, with WiMAX, a standards-based wireless technology to be launched in India by the end of 2006. Though the offer document claims that Tulip's existing network can easily adopt to the new WiMAX standard at an incremental cost, it will result in an increase in operating costs for this venture.

Finally, the competition that Tulip is likely to face in the IP VPN segment is expected to be intense. Since the opportunities in this are growing, it is likely to attract several private sector players, in addition to Sify, a long time player in this space, a couple of existing private sector players and the PSU major, Bharat Sanchar Nigam. The success of Tulip will hinge on its ability to stick to the network rollout plans and cross-sell to its existing customer base. The lead managers are Karvy Investor Services and Yes Bank. The offer closes on December 15.

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