Marginal problems

IPO REVIEW

Despite robust prospects for revenues, Redington's thin margins are a dampener.

IT distribution and logistics company, Redington (India)'s public issue to garner Rs 125.7-149.5 crore for financing expansion is underlined by thin margins but prospects of robust top line growth.

The company is a distributor of IT products and a provider of logistics, supply chain management and support services in India, Middle East and Africa.

Given that world-over, the distribution segment is characterised by high volumes and low margins, the company's profitability crucially depends on its ability to move up the value chain further, both in terms of products as also in the logistics solutions and support service space.

The ever increasing demand environment for IT and ITES products provides a compelling reason for strong growth prospects. The domestic IT products market has grown at a CAGR of 25 per cent in the past two years.

And IDC (International Data Corporation) estimates put growth for the domestic market for IT products at a CAGR of 17.5 per cent between 2005 and 2010.

With a diversified presence across systems, peripherals, components, networking products and packaged software incorporating brands like Acer, IBM, Lenovo, HP etc, the continuing IT boom would reflect significantly on Redington's top line.

Moreover, an entrenched national presence with 10,474 channel partners and a well established relationship with vendors, some for over ten years make Redington well set to take full advantage of its large scale of operations.

A major portion of the issue proceeds are to be channelised in strengthening the domestic distribution segment. This entails chiefly the establishment of four automated distribution centres in each metro at an investment of Rs 52.12 crore to be phased out over the next three years.

As significant cost-reduction could result, this remains a sound investment. Moreover this should also cement Redington's position as one of the only two players with a national reach in the IT product distribution and logistics space. Threat from competition should also not worry the management much.

There are high sectoral entry barriers including enormous working capital requirements, logistical limitations due to geographical size, differential fiscal structures across the country and need for redoubtable vendor relationships.

The past financial performance also reflects the strong position of the company in the distribution and logistics space. The top line has expanded at a CAGR of nearly 85 per cent between FY04 and FY06. Margins have, however, been low. 
 

THE FINE PRINT
Rs crore	FY05	FY06	1HFY07	FY07E
Net Sales	4048.00	6790.00	4127.00	8148.00
EBIDTA	80.00	130.00	81.00	159.00
OPM (%)	1.98	1.91	1.96	1.96
Net Profit	43.00	72.00	39.00	76.00
NPM (%)	1.06	1.06	0.94	0.94
EPS	10.90	11.80	6.20	9.70
P/E @ 95				9.79
P/E @ 113				11.65
Source: Company, Analysts estimates

For the past two years, net profit margins have hovered around the 1 per cent mark while operating profits have barely crossed 2 per cent of sales. These margins look thin even considering the nature of the business. Globally, 5-7 per cent margins are not uncommon in similar lines of business.

Given that the service and repair segment entails greater profitability than the distribution space; Redington's investments in this space would be keenly watched.

The company plans to use a total of Rs 11.02 crore in expansion and upgradation of its service and repair centre (SRC) network by 2008. Though the company follows a variety of revenue models in this business, it is increasingly focusing on the annual maintenance contract model which applies when the product has exhausted the warranty period and entails an agreement with the customer.

This arrangement comprised 16.55 per cent of the service revenues of Redington in FY06.This includes establishment of 68 SRCs, establishment of dedicated SRCs for LCD repairs and networking products and upgradation of capacities of existing SRCs for processors and motherboards.

However, its share of support services for IT hardware and mobile handsets both in India and abroad as a proportion of consolidated revenues is a measly 1.33 per cent.

Moreover even considering the proposed investment, it doesn't appear that the contribution of the service support segment would be significant enough to reflect in a great upside in margins.

A key positive remains the company's strategy of foraying into new and higher margin verticals and business lines. The company has commenced business of digital presses, consumer durables and gaming consoles (like Microsoft Xbox).

The move up the value chain fits in with the company's objective of transforming itself from an IT product distributor to a supply chain solution provider. Given that the business is working capital intensive, this strategy would play out only backed by adequate resources at hand.

An important factor here is the management of credit cycles. The proportion of bad debts to sales at 0.09 per cent hence looks seemingly a positive.

A chief concern underlining the business is however the risk of inventory value decline and obsolence.

Given that most vendors offer limited protection for loss in inventory value, the decrease or elimenation of price protection could result in inventory write-downs which could affect the financial condition of the enterprise.

The international operations, which are mainly concentrated in the Middle East and Africa, contributed nearly 40 per cent of consolidated revenues in H1 FY07. The business in these key regions is conducted through its subsidiary Redington Gulf FZE headquartered at Jebel Ali Dubai.

The company plans to use nearly Rs 43 crore as investment in its subsidiary. This would mainly go towards establishing an automated distribution centre in Dubai and installing an ERP (enterprise resource planning) system in the subsidiary. The Middle East could remain a key overseas growth driver due to buoyant government and corporate investments channelised from the oil boom. IDC estimates suggest a 13.4 per cent CAGR growth between 2005 and 2010 in the Middle East IT products market.

The fragmented nature of the IT hardware support services market in the Middle East could also prove advantageous to the company's expansion plans in this segment.

Looking ahead, Redington also plans to foray into new geographical regions like CIS, Vietnam and Central Europe where IT penetration remains low.

Overall, international operations, which have higher profit margins as compared to domestic operations, and Redington's international plans should stand it in good stead.

Assuming a 25 per cent increase in earnings in FY08, the expected P/E would work out to 8.3 and 9.8 times estimated FY08 earnings, at the lower (Rs 95) and upper (Rs 113) end of the price band.

Given the low margin outlook, this looks a trifle overpriced at the higher end of the band. The business model is relatively unconventional, and offers investors the opportunity to buy a tier I player acting as an interface between vendors and resellers, dealers, retailers or assemblers.

But the business strategy does support a positive outlook on continued robust top line growth. Though margins have improved dramatically since 2002, they have remained stagnant for the past three years.

All in all, investors should weigh in the positives against thin margins before they loosen their purse strings.