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GDS - cost saving and sustainable margin?

TCom’s GDS has seen 11.6pps expansion in EBITDA margin to 28.2% in FY21, which has helped it improve FCF and ROCE. We have deep dived to understand the costs, which have helped in margin expansion, and see if they are sustainable. 1) Network cost has added 340bps to margin and we expect an upside from operating leverage. 2) Employee cost added 175bps to margin, and considering it is 19.8% of revenue, we see more headroom for margin, and 3) other expenses added 600bps to margin of which R&M has been a drag.

We see flattish R&M cost in coming years. Margin of 100- 120bps within other expense was on account of covid-related savings, which will return on normalisation. Our analysis shows TCom’s GDS margins have headroom to grow from the existing levels, unlike investors’ fear of unsustainable margin expansion. We have updated the model for annual report and increased EPS by ~3% each for FY22E/FY23E. Our target price stands at Rs1,671 (from Rs1,461) as we increase P/E multiple (FY23) to 20x (from 18x). Maintain BUY.

* GDS EBITDA margin improved 11.6pps in past two years. TCom’s global data services (GDS) revenue grew at 6.6% to Rs141bn over FY19-21, but EBITDA grew at CAGR of 39% to Rs40bn during same period significantly boosting profitability, FCF and ROCE. GDS reported EBITDA margin improved to 28.2% in FY21 from 16.6% in FY19 (up 1160bps improvement). TCom GDS EBITDA benefited from the adoption of Ind-AS 116, which reclassified rent cost to depreciation and interest cost. If we believe the entire Ind-AS 116 accounting benefited only GDS and if we equate rent cost in FY19 to FY20 (conservative view), on comparable basis, GDS EBITDA margin rose to 28.2% in FY21 from 17.8% in FY19 (up 1040bps). This also means on comparable basis EBITDA grew at CAGR of 34% over FY19-21 which is impressive. The impact of Ind-AS 116 on EBITDA margin is 120bps.

* Network opex added 340bps to margin. Network opex has maximum operating leverage as these are fixed costs and expansion in revenue adds to margins. However, in case of TCom, network opex also houses direct cost which has been growing faster than revenue, thus, capping margin expansion. Nonetheless, network opex as % of GDS revenue has dipped to 26% from 28.9% in FY19, adding 340bps to EBITDA margin. Key assumption: We have deducted the direct cost of GVS from transmission cost to arrive at transmission cost for GDS. We believe inflation in network opex would be limited and therefore, on-net transmission cost will grow in low single digit.

* Employee cost has added 175bps to GDS margin. TCom GDS employee cost was 19.8% of revenue in FY21, unlike other telcos, it is significantly higher. The company has been shifting some of the work back to low cost regions of India, and some of it is due to legacy. It has been offering VRS to employees to streamline employee cost and reskilling others for new business. We believe the company has more scope for employee cost reduction as % of revenue. Key assumption – we have deducted the entire GVS operating expense from employee cost.

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