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Tata Communications' Q3FY18 results (Upgrade to Neutral) - Data margin recovery drives EBITDA beat

Q3FY18 result highlights

• Much improved operating performance: Revenue was down 2.4% qoq to Rs41bn (voice -14.2%; data +1.6% qoq in INR terms; IDFCe Rs42.5bn); EBITDA at Rs6.12bn beat estimates (IDFCe. Rs5.6bn).Margins at 14.9% improved 150bps qoq (GDS +210bps to 18.7%; GVS at 6%). Net profit of Rs100m missed estimates on higher tax rates which included impact of Rs160mn on account of change in US tax.
• Data margin reversal key highlight: Data revenue growth was just 6.8% yoy in USD terms (+4.4% in INR terms) as ~38.5% growth in growth services was offset by weakness in ATM business. Traditional services revenues grew+5.7% yoy. Data margins recovered sharply to 18.7% (+210bps qoq) led by sharp margin rebound in traditional services of 400bps qoq to 31.6%. Growth services remain in investment model with EBITDA loss of US$18.7m. Management’s focus on cost optimisation in legacy services seems to have delivered results.
• No respite in growth services EBITDA bleed despite scale: Growth services of TCOM continues to scale with revenues now run-rating at US$89.6m/qtr. Most businesses begin to deliver sizeable EBITDA at this revenue scale; however TCOM continues to bleed US$9.6m/qtr. We were expecting moderation in EBITDA losses with revenue growth but EBITDA losses have remained at same level. Additionally TCOM incurred US$9mn EBITDA loss in the innovation portfolio. While capex has come down, it seems to have been replaced by opex loss as cumulative EBITDA bleed stands at US$75m (Q3 annualised).

Key positives: Traction in Growth services and margins in traditional data

Key negatives: Continued softness in voice and traditional data growth

Impact on financials: FY18E/FY19E/FY20 EBITDA up by 4.9%/0.2%/0.0%.

Valuations & view

TCOM has corrected 7% over the past 3 months and has underperformed. We like the service portfolio that TCOM is building, and improved margin execution this quarter is encouraging. That said, we have limited clarity as to at what scale does the growth services start to turn the EBITDA and valuations for purchase of TTSL enterprise business isn’t known. However we would like to see more stable margin delivery and growth to get more constructive on the name. Given that stock is now trading below our target price of Rs655, and improved margin execution, we upgrade TCOM to Neutral. Despite the beat there is little upgrade to our EBITDA estimates and target price (unchanged at Rs655).