Tulip Telecom Downgrade to UW: No respite  HSBC Research

Tulip Telecom
Downgrade to UW: No respite
 4Q results below estimates, margin decline by 300 bps
 Management suggests margins pressure, we build for c4%
yoy decline in FY13e revenues
 Downgrade to UW from Neutral and cut target to INR70 (from
INR125)

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4QFY12 results were below estimates with revenues c8% below our estimates and
sequential margin decline by 350bps (EBITDA 18% below our estimates). PAT declined c6%
and was 7% below our estimates. Management provided a capex guidance of INR6bn for next
four quarters. Separately management suggested extension in accounting year by another six
months to enable reporting in better alignment with the regulatory reporting requirements. We
note over the last two quarters revenue has declined by 6% and EBITDA margins by 330 bps.
Weak outlook. In addition to the poor 4Q numbers, management suggested that poor macro
environment continues to be a drag and that the company could be looking at a gradual
reduction in margins over the next few quarters. In our view margin decline suggestion from
the management is reflection of top-line pressures as well. We note the business model of the
company is based on operating leverage and a slowdown in order book prevents the ability of
the company to buy bandwidth in bulk and raises costs and results in margin decline. Despite
this management sticking with its capex guidance of INR6bn may not go well with investors
as it would only aggravate balance sheet concerns (we estimate 10% lower capex). While
management suggested no impact on operations because of change in reporting requirements,
this may raise investor concerns and possibility of one time adjustments cannot be ruled out.
FCCB redemption likely by debt. On the FCCB (Foreign Currency Convertible Bonds) issue
management didn’t provide any specific solutions, but maintained that it had several options at
its disposal. We believe that FCCB is likely to be redeemed by assuming debt and this would
adversely impact the profitability next fiscal because of increase in finance charges. We
estimate total FCCB liability at USD135m (assuming a redemption premium of USD35m).
Upside risk could stem from a possibility of unlocking value in Qualcomm venture and ability
to rope in a strategic partner at the data centre level.
Valuation and risks: We are downgrading to UW and cutting our target price to INR70
(INR125) as we estimate FY13e revenue growth of -4% and margin decline of 350bps. We cut
our FY13e revenues estimates by 18%, EBITDA estimates by 27% and PAT by 72%. We note
we were earlier expecting c14% revenue growth, 8% EBITDA growth and a 15% decline in
EPS. We continue to value Tulip on a mix of DCF and PE at 6x on FY13e earnings. Upside
risks include the ability to gain market share via bundling data centre and core offerings, stake
sale in the BWA venture and stake sale in the data centre business.


Valuation and risks
We value Tulip Telecom’s business using the average of PE and discounted cash flow methodologies at
INR70 (from INR125), attaching equal weightings to each. For our DCF analysis, we assume a cost of
equity of 15% and a cost of debt of c11%; we assume a target debt-to-total capital ratio of 30% and
Weighted average cost of capital (WACC) at 13% to arrive at a fair value of INR102 per share
(previously INR132).
Our DCF valuations have been cut as we cut our EBITDA by c30% for the next three years given our
assumptions that the DC business will take time to get scale and put pressure on consolidated margins and
suggestion by management for margin decline. EBITDA margins of c24% in FY13 are 170 bps lower
than Q4FY12 EBITDA margins. For our PE methodology, we use a PE multiple of 6x (using the 12-
month average of one-year forward PER) on FY13e earnings to arrive at a fair value of INR31 per share
(from INR 112, now lower as we have cut our FY2013e estimates by 72%). Separately, we value Tulip’s
investment in the Qualcomm venture at c50% discount to book value or at INR3 (no change) reflecting
the uncertainty over the ability to monetize investments in the Qualcomm BWA venture in the near to
medium term. Using our blended approach, we arrive at a 12-month target price of INR125.
Under our research model, for stocks without a volatility indicator, the Neutral band is 5ppts above and
below the hurdle rate for Indian stocks of 11%. Our target price implies a potential return of -18%, which
is below the Neutral band; therefore, we are downgrading the stock to Underweight. Potential return
equals the percentage difference between the current share price and the target price, including the
forecast dividend yield when indicated. Upside risks include the ability to gain market share via bundling
data centre and core offerings, stake sale in the BWA venture and stake sale in the data centre business.