Short-term margin overhang likely for Tata Communications stock

The management of Tata Communications presented its product-to-platform strategy and explained how it hopes to grow its new products and portfolios, and geographies. The management targets doubling of data revenue by FY27 to Rs 28,000 crore (implied 18 per cent annual revenue growth). The DPS (Digital Platform & Services) segment is likely to contribute over 60 per cent of data revenue.

Achieving this will require higher capex and opex, totalling $300 million in FY25, and is projected to be at a capex-to-sales range of 10-11 per cent. By FY27, Tata Communications hopes to hit an operating profit margin between 23-25 per cent but management accepts near-term margins may be hit. Other ratios such as return on capital employed (RoCE) of 25 per cent plus and net debt to operating profit should be lower than 2x by FY27. Again this implies revenue and operating profit annual growth of 14 per cent and 20 per cent over FY24-26.

Current data revenue growth is about 10 per cent, so this would have to almost double to hit a growth of 18 per cent. DPS currently accounts for 40 per cent of the data revenue and this would have to increase to 60 per cent (implying 34 per cent annual growth in this segment). The core services offering (commoditised connectivity solutions) are likely to post a 3 per cent growth. Growth could be driven by both organic and inorganic opportunities, and more million-dollar customers.

Cloud and security services may benefit from an increasing total addressable market (TAM), which is likely to post 16 per cent annual growth over FY25-28. The interactive and Internet of Things are expected to clock 14 per cent and 10 per cent annual growth, respectively over FY25-28. In the media segment, the capability of Switch (a new division of video production) will be monitorable.

Tata Communications has leadership in the Indian market, a trend of expansion in international markets, portfolio expansion (in media), and new product rollouts such as AI cloud, multi-cloud connectivity, and CloudLyte (platform). As a B2B service provider, it has a strong infrastructure network including owning the subsea cable network. The company provides connectivity in over 190 countries and directly connects to 35 per cent of the internet routes.

The capex guidance improved to $300 million in FY25 from $250 million in FY24 alongside higher opex. Operating profit margin may drag for a while due to acquisitions. However, the management expects the FY25 operating profit margin would be higher than FY24. RoCE may also experience dilution for the next two quarters before gradually improving.

The net debt jumped 60 per cent year-on-year (Y-o-Y) to Rs 9,000 crore due to inorganic acquisitions. However, given the free cash flow of Rs 2,000 crore, there isn't high pressure on the balance sheet since it can maintain a RoCE of 25 per cent for the long-term.

Valuations are elevated as with many other stocks. The targets may be achievable given the company’s strong capabilities and advantages and the growth prospects in its key markets. Investors should also be prepared for short-term margin pressures and execution of targets will be a key.