How Zen Technologies is building an IP-driven defence business

It was hard to change the long-held perception that a homebred company wouldn’t have the capability to develop cutting-edge technologies on its own. The team got its first breakthrough when it successfully managed to sell the first simulator to the state police forces of Delhi and West Bengal.

The success of Pokhran-II (nuclear tests) in 1998 was a game changer. It reset the market dynamics in response to the sanctions imposed by the US. “There was a complete shutdown on any kind of technology, including simulators.” Seizing the opportunity, the Hyderabad-based company invested and built its first advanced warfare weapons simulator and earned recognition for its focus on research and development from the government.

About 11 years after it was established, Zen Technologies listed on the Bombay Stock Exchange (BSE) in 2004. In the coming years, it made a mark for itself as a “proven leader in building training systems for developing and measuring combat readiness”. Currently, the defence company claims to have a portfolio of over 40 products and 1,000 simulators and training systems that have been designed and developed in-house, and are shipped across the world.

Armed with a knack for picking opportune market trends, Atluri confides he knew the going would get tough in 2010: “I don’t know why but I knew that we can’t expect any business for next one-and-a-half to two years.” Similarly, he had predicted in 2022, “We have reached a point of inflection and we are going to do very well now onwards,” he recalls. Both the predictions came true in a way, he adds.

How much is Foxconn paid for manufacturing a $1,000 Apple iPhone?”

This is the second question Atluri puts forth for me to ponder.

“It earns $5 for assembling and manufacturing the phone,” he explains. He is alluding to the fact that there is higher value creation in developing intellectual property (IP) over manufacturing. “Let them Make in China,” he exhorts. “But let us focus on developing the IP. That’s where there is money to be made.”

Also read: India's defence companies have been on a roll. Will it change under Modi 3.0?

In essence, this is the crux of Zen Technologies’ business model. Its main strength lies in its ability to create a strong IP barrier to fend off competition. Currently, it holds 75 global patents out of the 155 it has filed so far. In the last five years, the company has deployed close to 10 percent of cumulative sales, or over ₹85 crore, into R&D projects. This has created high-entry barriers for new entrants.

“Our products are characterised by a bill of materials that contribute around 25 to 40 percent of the final product cost… highlighting the intrinsic value of our IP,” the chairman notes. This also provides a cushion for profit margins if the cost of components rises.

Unlike its peers, the pure-play IP defence company does not depend on the government to finance its R&D. “My biggest problem with government funding is that there is so much monitoring, paperwork, submission of reports that product innovation goes for a toss,” Atluri rues. “Besides when promoters have their skin in the game, they push extra hard to successfully develop the product because the downside can be so horrible for our stakeholders and family.”

Instead of taking assistance from the government to bankroll its R&D, Atluri negotiates with the government to guarantee some orders if the products satisfactorily meet their requirements. “Otherwise, they don’t have to pay me anything,” he adds.

The company’s financial metrics have improved over the years. The profit after tax margin soared from 4 percent in FY22 to 30 percent in FY24, while its return on capital employed increased from 1 percent to 41 percent during the same period. It posted its highest ever turnover and profitability of ₹430 crore and ₹129 crore respectively in the previous fiscal.    

Vikas Gupta, smallcase manager and CEO, OmniScience Capital, says, “As we have seen around the world, drone swarms can be used to attack. Defending against these using conventional systems can prove difficult and expensive. Trained manpower is a strong component of defence and Zen’s combat training systems and anti-drone systems make it quite unique.”

Prahasta, an automated quadruped that can be used as the first line of defence

In fact, the share price rocketed from ~₹12 per share in August 2014 to ~₹80 in August 2021, to ~₹840 last August, and it closed the trading session at over ₹1,800 apiece on August 28. The stock currently trades at a P/E of 105.5 and its market peers are less expensive.

Many market experts also highlight that most defence companies are overvalued at current levels. Consider this: Hindustan Aeronautics, Cochin Shipyard and Mazagon Dock Shipbuilders trade at a P/E ratio of 38.1, 59.8 and 39 each. “The reward for investors entering the sector today doesn’t seem as promising as, say, three to five years back,” Gupta cautions.  

Kotak Institutional Equities points out that the current profitability of most defence companies seems to be on the higher side, and they expect the competitive intensity to rise with the entry of private sector players. “We would note that lower profitability assumptions will imply much higher implied revenues, which may not be feasible in the context of the market opportunity,” its analysts say in a report.

However, the underlying factors remain strong for the defence sector in the long run. One, the geopolitical situation is volatile, and countries are looking to arm their forces with hi-tech defence equipment. Two, the government’s thrust on ‘Make in India’ and other policy initiatives are nudging companies to focus on domestic production and exports.

“The opportunities for the Indian defence sector remain large and sustainable for decades. The existing order book of companies is for five to 10 years. Then there is also a larger latent order book,” Gupta reasons.  

Zen Technologies’ FY24 order book of ₹1,402 crore includes exports to the tune of ₹437 crore. “As we go ahead, our challenge will be how to scale-up operationally to execute the orders,” Atluri explains. “We outsource our manufacturing, so our capex has been minimal.”      

The final integration and software handling is done at the company’s Hyderabad facility and the management plans to expand its facility but doesn’t require any additional investments in plant and machinery. “The market experts who believe that there is no steam left for defence stocks to deliver aren’t able to see what’s actually happening on-the-ground,” Atluri argues.

The leadership team has given a growth guidance of 50 percent CAGR for the next three years. Atluri says the long-term revenue mix between anti-drones and simulators will be marginally tilted in favour of simulators but is likely to be evenly balanced in the next two to three years. In FY24, the order book for anti-drones and simulators was ₹600 crore and ₹800 crore respectively.

“Our IP is our sustained competitive advantage, which gives the company the ability to earn forever,” Atluri says.  

The global defence market was pegged at $2.1 trillion in FY24 with a year-over-year growth rate of 3.8 percent. Mixed reality training, real-time monitoring, AI and analytics are some big trends shaping the future of military simulation worldwide. But key risks include aggressive bids or pricing strategies by international competitors, high concentration of orders from a single client or country, and supply chain disruptions.