TATA COMMUNICATIONS: Focus on growth to dilute near-term earnings

(TCOM IN, Mkt Cap USD4.8b, CMP INR1324, TP INR1200, 9% Downside, Neutral)

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TCOM revenue grew 2% QoQ (in line), but EBITDA declined 5% QoQ (5% miss) due to weak data EBITDA margin. Management has reiterated its focus on growth. TCOM continued to garner a 7% FCF annualized yield and healthy ROCE of 28%.
We have reduced our consolidated EBITDA estimate and now expect a revenue/EBITDA CAGR of 12%/11% over FY23-25. While growth in data EBITDA has been soft, healthy FCF generation and continued deleveraging provide a silver lining, aiding valuations. We maintain our Neutral rating.

EBITDA declines 5% QoQ on weak data margin; FCF remains healthy

Consol. revenue grew 2.1% QoQ to INR45.3b (in line), led by 3% QoQ growth in the data segment. Voice segment revenue declined 4% QoQ, while other revenue grew 4% QoQ. The tailwind from INR depreciation of 3% QoQ supported revenue growth.
EBITDA declined 5% QoQ to INR10.8b (5% miss), affected by a 6% QoQ decline in data segment EBITDA. As a result, consol. EBITDA margin declined 170bp QoQ to 23.8% (100bp miss), in line with the management’s guidance of the 23-25% margin range.
Interest costs jumped 26% QoQ due to an increase in the borrowing cost amid rate hikes globally. Accordingly, adjusted PAT fell 14% QoQ to INR4b (in line).
Committed capex decreased 7% QoQ to INR3.9b in 3QFY23 from INR4.2b in 2QFY23. Net debt/gross debt declined marginally by INR1.3b/INR0.9b to INR63b/INR77b.
FCF declined by 45% QoQ to INR3.5b from INR 6.2b in 2QFY23, led by an 18% QoQ decline in CFO due to working capital changes. However, 9MFY23 FCF yields stood at 7% (annualized) v/s 6% in FY22.
The company posted RoCE of 28.4% v/s 28.1% in 2QFY23 (FY22 ROCE at 25.4%).

Key takeaways from the management interaction

The company maintains its double-digit growth ambition on the back of 23-25% EBITDA growth expectation in the DPS segment and 25-30% RoCE guidance.
Margins are affected by inflation in employee and energy costs, along with long-term contracts, which offer lower pricing power.
High FCF allows TCOM to explore organic and inorganic opportunities. It acquired the Switch business for USD58.8m.
The order book continues to grow every quarter and the sales funnel is improving, along with the win rate.

Valuation and view

We have reduced our consolidated EBITDA estimate and now expect a revenue/EBITDA CAGR of 12/11% over FY23-25.
The data segment reported double-digit YoY growth and management has reiterated improved funnel of new deal, but its translation into meaningful growth will be key for TCOM to achieve double-digit earnings growth.
The management’s guidance of a 20% increase in capex to USD300-325m can curb potential improvement in FCF going forward. Yet it could continue to garner healthy ROCE of over 20% and a high-single digit FCF yield. The decrease in leverage could be a silver lining, which could drive PAT growth.
We maintain our Neutral rating with a TP of INR1,200/share (assigned 9x/3x EBITDA to the Data/Voice business). Sustained improvement in earnings growth visibility will be vital for valuation rerating.

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