My Best Pick 2016

Harendra Kumar

 Harendra Kumar of Elara Capital is bullish on Tata Communications thanks to falling debt and higher data growth

We all know about how the telecom space has been disrupted by aggressive competition and new technologies that effectively commoditised the voice business over the past decade or so. And just like all players have shifted from voice to data, so has Tata Communications. But unlike its peers, Tata is not a consumer telecom company but one that is focused on the business enterprise segment. Formerly known as VSNL, the Tata group entity continues to have the government as a stakeholder with a 26.12% stake. While most other players have hogged the limelight, Tata Communications has been the silent achiever. Though the group’s other listed entity Tata Teleservices hasn’t really made much headway, Tata Communications has reinvented itself from being just a state-run enterprise that was the sole provider of international wholesale voice services.

The company has transformed itself from a pure-play, long-distance voice company into an integrated communication provider with a larger focus on the high-growth data business. Led by a strong focus on network expansion and the ability to execute large network deals, the firm has been shifted from the Visionaries quadrant (lowest level) to the Leaders quadrant (highest level) since 2013, according to Gartner Magic Quadrant for Asia Pacific network service providers. This is an important milestone, as it allows the company to get higher request for proposal (RFPs) for large-scale network deals of global corporates.

 Big data

According to research firm IDC, global data generation is expected to grow tenfold by 2020, with emerging markets likely to surpass mature markets by 2017. Tata Comm is best placed to take advantage of this after completing its huge network investment — the world’s first wholly-owned cable network ring. To take advantage of the strong data consumption trend and sweating assets, Tata Comm is focused on offering customised data solutions to enterprises. The high-margin vertical is expected to improve revenue mix by 4% to 65% over FY15-18, driving data revenue CAGR 14% over the same period, with operating margin improvement (310 bps) rising to 23% by FY18. The voice business, which has already matured, should generate cumulative free cash flow of ₹1,350 crore (assuming 10% CAGR operating profit de-growth and capex of ₹130 crore). Thus, FY15-18 core top line and operating profit should grow at 7% and 15% to Rs.21,800 crore and ₹3,710 crore, respectively.

 Data margin triggers

Since the past two fiscals, as Tata Communications steadily moved up the Gartner leadership quadrant, our channel checks indicate that it has also started participating in many large RFPs for enterprise telecom connectivity. In the past few quarters, the company has won several complex deals, all of which come with global service contracts. Work on several of these deals is underway and will be recorded in the upcoming quarters. This will drive revenue growth and also provide sticky revenue, most of these deals are long-term in nature. Further, the company continues to see a steady flow of data growth from its enterprise business. 

Of course, most of this has been powered by a recent recovery in new services. Most importantly, the data margin has come off sharply by 190 bps in the past two quarters. There are two key reasons behind this trend. First, the company has been incurring heavy operational costs towards ramping new service segments, which will show results over the coming quarters. Secondly, the inherent nature of the business is lumpy thanks to large deals, and annual operating profit targets are broadly maintained. Therefore, there is little cause for concern over the structural data segment’s operating profit growth potential and the company is upbeat on the growth outlook. We have factored in a 310 bps data operating margin improvement over FY15-18 to 23%. The company’s management has charted data operating margin improvement potential to 30% over the next three to four years.

Focus on managed services with long-term contracts is also increasing the company’s share of the data portfolio. This would also allow Tata Communications to garner better margins. Within the traditional data connectivity business, the firm is slowly moving up the value chain, increasing its share of virtual private servers, a multi-protocol label-switching business that provides multiple geographic coverage and reduces competition. Segment-wise, cloud data centre services as well as transformation businesses (analytical services to BPO) are improving.

The management’s claim of 30% operating margin in three to four years compared with a 20% guidance in FY16 comes from the fact that, excluding new services, the data business is already clocking a 27% margin; this can grow by 50-100 bps annually. Apart from this, as new services reach ₹2,000 crore in three to four years with a more than 25% margin, the overall operating margin will see a very sharp improvement. The focus on data-specific enterprise customers has garnered healthy operating margin of nearly 28-30%. The continued focus towards value-added offerings to enterprise customers is expected to take data operating margins close to 25%. If the management’s data margin guidance of 30% holds true, then estimates for FY18, at 23%, have huge room for a re-rating.

No longer a drag

In 2008, Tata Comm ventured into the South African market by acquiring Neotel. The South African subsidiary is a loss-making venture and has remained a drag on overall profitability. In FY14, it turned profitable but continued to hold a high net debt-to-Ebitda ratio of 12.2x. The recent sale agreement of Neotel with Vodacom is, therefore, a big positive step to reduce leverage and further capex, leading to much better free cash flow.

After the prolonged regulatory approval process, The South African Competition Commission and Independent Communications Authority has given a positive recommendation to the Neotel acquisition deal subject to four conditions. The Vodacom management (Neotel’s buyer) has indicated that while it would have liked to close the deal without any preconditions, it would however go ahead with the deal even with the conditions in place, highlighting no risk to the sale. The next hearing date with the tribunal is largely a formality and the final approval should be in place by December-end. This implies that the transaction should be executed in the current fiscal.

Based on cash flow from operations and the Neotel sale (which is a given), we expect Tata Comm’s consolidated debt to reduce from FY15’s net debt of ₹10,600 crore to around ₹4,000 crore. Thus, out of a ₹6,600 crore reduction, ₹3,000 crore will be through the Neotel sale and the remaining will be through internal free cash flow.

 A better valuation

I believe that Tata Comm needs to get a better valuation compared with other consumer telecom providers for the following reasons, chief among them being regulatory risk. The consumer telecom business is perennially hampered by regulatory intervention, impacting profitability and cash flows. In the past, renewal auctions hampered cash flows. Now, call drops, 3G ICR issues, net neutrality and other factors hamper the consumer telecom business. On the contrary, the enterprise telecom business, where Tata Comm is entrenched, has little regulatory intervention. 

Then, there is the fact that Idea and Bharti’s leverage position continues to amplify owing to steady spectrum costs. Instead, Tata Comm’s debt is likely to reduce significantly. Plus, after factoring in the complete spectrum acquisition costs, return ratios for Idea and Bharti are sub-cost of capital at 12% even on a two-year forward basis. For Tata Comm, on the other hand, a steady data operating profit CAGR of 15% should lead to an overall operating margin improvement of 300 bps by FY18. Further, the capex-to-sales ratio might reduce from the peak of 16% to 8% in FY18, as the company has long since passed peak capex and looks to sweat assets. All these factors would improve core return on capital to 16% in FY18 from 4% in FY15.

The growing share of data in the overall business should also lead to a re-rating. The company’s lower growth in the past two quarters has resulted in a lower base. While the growth has been delayed by two quarters, our conviction on the growth trajectory remains intact. The higher multiple of data operating profit is driven by high growth expectation, better margin of 3.5x of the voice segment and superior return ratios. Assuming 7x EV/Ebitda to FY18 data Ebitda of ₹3,240 crore and 2.5x to FY18 voice Ebitda of ₹470 crore, we get 6.4x FY18 Ebitda of ₹3,710 crore. This will definitely have a ripple effect on debt reduction. If we take into account the multiple of 6.4x, the target price works out to ₹720, which is a 72% upside from the current price of ₹419.

The icing on the cake, however, comes from the huge tract of land that Tata Comm holds. In 2002, when the company acquired a 45% stake in VSNL, the deal excluded a 740-acre land bank held by the state-owned entity. As part of the transaction, the land was to be demerged into a separate entity. However, due to the indecision about who would be the capital gains tax payer for the land, the transfer is yet to be fructified. The government has formed an entity called Hemisphere Properties and acquired a 51% stake. The land identified for demerger carries a book value of ₹16.3 lakh. Considering the minimum government registration value, the land is currently valued at ₹7,570 crore. Even after factoring in a 20% capital gains tax rate and 20% dividend distribution tax, the land would still be valued at ₹170 a share. In short, the target price for the stock excludes the upside that the land value offers.

The writer has no position in the stock but Elara Capital has recommended the stock to its clients