TATA COMMUNICATIONS: A mixed bag; Digital recovers, core connectivity weak

(TCOM IN, Mkt Cap USD5.5b, CMP INR1678, TP INR1850, 10% Upside, Neutral)

• Tata Communications (TCOM)’s 3Q results were a mixed bag as ~10% YoY revenue growth in the Digital portfolio was offset by continued weakness in core connectivity (-1% QoQ).
• TCOM’s adjusted EBITDA margin improved ~150bp QoQ to 20% on account of the deconsolidation of lower-margin TCPSL and NetFoundry business and slightly lower losses in the Digital portfolio.
• TCOM’s revenue and EBITDA were boosted by INR285m prior period revenue recognition. Adjusted revenue/EBITDA missed our estimates by ~3-4%, due to weaker growth in core connectivity.
• Management indicated that funnel additions remain robust, especially in the international business. However, order booking was relatively slower in 3Q (vs. 1HFY25) on account of elongated deal conversion cycle. Management maintained its ambition of doubling data revenue and improving EBITDA margins to 23-25% by FY27.
• We currently build in ~11% CAGR in TCOM’s data revenue over FY24-27 and expect digital to account for ~51% of TCOM’s data revenue (vs. ~47% in 3Q). An acceleration in digital revenue along with margin improvement remains the key for re-rating.
• We roll forward our estimates to Mar’27 and raise our SoTP-based TP to INR1,850. After the recent correction, the stock trades at ~10% premium to its LT average EV/EBITDA. We reiterate our Neutral rating and await consistency in growth before turning more constructive on the stock.

Data revenue up ~6% YoY (~2% miss); adj. EBITDA flat YoY (4% miss)

• Adj. consolidated revenue inched up modest ~2% QoQ (+3% YoY) to INR57.7b (~3% miss). TCOM recognized INR285m in other operating income pertaining to reversals from the prior period (vs. INR865m in 2Q).

·   Data revenue at INR49b (2% miss) grew by 1% QoQ (+6% YoY), with core connectivity declining ~1% QoQ (+3% YoY), while the Digital portfolio grew ~4% QoQ (+10% YoY).

·   Adjusted for FX benefits, the reported revenue growth would have been lower at ~2% YoY (flat QoQ).

• Adj. consol EBITDA rose ~11% QoQ (but flat YoY) to INR 11.5b (~4% miss), likely on account of weaker growth in the loss-making incubation business and deconsolidation of the lower-margin subsidiaries.

·   Consolidated adjusted EBITDA margin improved 150bp QoQ (-65bp YoY) to 20% (15bp miss). Deconsolidation of TCPSL and NetFoundry boosted margin by ~40bp.

• Reported Consol PAT at INR2.4b inched up ~4% QoQ (19% miss).
• Adjusted PAT (including losses from assets held for sale) declined ~4% YoY to INR2.2b (24% miss) due to lower EBITDA and a higher tax rate.
• Net debt was stable QoQ at INR105b despite adverse FX and TCPSL’s deconsolidation impact.
• Committed capex further inched up to INR7.5b in 3Q (vs. INR10.2b in 1H), while cash capex was up ~9% QoQ at INR4.9b.
• Reported FCF improved sharply to INR8.4b (vs. outflows of INR5.8b in 1H).
• Reported RoCE (annualized) declined further to 16.0% from 16.4% in 2QFY25.

Key takeaways from the management interaction

• Demand outlook: Management indicated that funnel additions remained robust, especially in the international markets, with the large deals funnel growing 50% YoY. However, the pace of order-booking was slower in 3Q (as compared to 1HFY25) as the large deal conversion cycle remains elongated.
• Benefits of improvement in discretionary spending: Management noted that improvement in discretionary (IT) spending does not necessarily correlate to the demand drivers for network investments, which account for ~60% of TCOM’s portfolio. However, it expects an improvement in discretionary spending to benefit TCOM’s interaction and IoT businesses.
• Doubling of data revenue: Management indicated that FY27 revenue ambition was predicated on the Enterprise’s rising needs for network fabric. However, adverse macroeconomic factors were not considered in its guidance of doubling data revenue to INR280b by FY27. TCOM continues to invest in people and capabilities to meet the ambition of doubling data revenue by FY27.
• Margin improvement: TCOM continues to aim for improving margins to the 23-25% range by FY27. Management noted that growth acceleration in digital portfolios remains the key lever for margin improvement.
• FX and one-off impacts: Adjusted for the boost from rupee depreciation, TCOM’s revenue growth would have been even lower at 1.8% YoY (+0.2% QoQ). Further, the deconsolidation of TCPSL and Net Foundry adversely impacted the topline by INR360m but boosted the EBITDA margin by ~40bp.

Valuation and view

• We currently model ~18% CAGR in digital revenue over FY24-27 and expect digital to account for ~51% of TCOM’s data revenue (vs. ~47% in 3Q). An acceleration in digital revenue remains key for re-rating.
• We cut our FY25-27E revenue by ~1% and build in ~11% data revenue CAGR over FY24-27, with data revenue reaching INR236b by FY27 (vs. TCOM’s ambition of INR280b). We believe TCOM’s ambition of doubling data revenue by FY27 remains a tall ask without further acquisitions.
• We lower our FY25-26E EBITDA by ~1% each as the cut in revenue is offset by a slight improvement in margin. We now assume the FY27 EBITDA margin at ~22.6%. However, with a rising share of inherently lower-margin businesses in TCOM’s mix, we believe that margin expansion to 23-25% by FY27 could be difficult.
• We ascribe 10X EV/EBITDA to TCOM’s data business and 5X EV/EBITDA to voice and other businesses. We ascribe an INR27b (or INR95/share) valuation to TCOM’s 26% stake in STT data centers. We roll forward our estimates to Mar’27 and raise our SoTP-based TP to INR1,850. After the recent correction, the stock now trades at ~10% premium to its LT average EV/EBITDA. Reiterate Neutral.