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VSNL: Inflection point? - Views on News from Equitymaster
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VSNL: Inflection point?
Oct 26, 2005

Performance Summary
International long-distance telephony and bandwidth major, VSNL, has announced mixed results for the second quarter and first half of FY06. While the topline has grown at a decent pace for both the periods, bottomline has languished on account of depressed operating margins due to higher network costs.

Financial performance: A snapshot…
(Rs m) 2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Sales 7,785 9,295 19.4% 15,737 18,292 16.2%
Expenditure 6,072 7,385 21.6% 11,763 14,061 19.5%
Operating profit (EBDITA) 1,713 1,910 11.5% 3,974 4,231 6.5%
Operating profit margin (%) 22.0% 20.5%   25.3% 23.1%  
Other income 294 317 7.8% 534 608 13.9%
Depreciation 568 893 57.2% 1,115 1,689 51.5%
Profit before tax 1,439 1,334 -7.3% 3,393 3,150 -7.2%
Extraordinary items 2 35   - 187  
Tax 560 459 -18.0% 1,244 1,157 -7.0%
Profit after tax/(loss) 881 910 3.3% 2,149 2,180 1.4%
Net profit margin (%) 11.3% 9.8%   13.7% 11.9%  
No. of shares 285.0 285.0   285.0 285.0  
Diluted earnings per share* (Rs) 12.4 12.8   15.1 15.3  
P/E ratio (x)         20.9  
(* annualised)            

What is the company’s business?
VSNL is India’s largest international long-distance (ILD) services provider and was incorporated in 1986 under the Indian Companies Act, 1956 to take over the activities of the erstwhile Overseas Communication Services (OCS). In February 2002, the Government of India divested 26% of VSNL's equity to the Tata Group that now has the management control. Being the pioneer of Internet services in the country, VSNL provides international telecommunication services, directly and indirectly, linking the domestic telecommunications network to approximately 237 territories worldwide. The company operates a network of earth stations, switches, submarine cable systems and value added service nodes to provide international telephony, telex and telegraph and Internet services. The company has also started its DLD (domestic long distance) and broadband services in the country.

What has driven performance in 2QFY06?
Strong growth in the telephony segment: VSNL’s telephony and related services segment (99% of revenues) has grown its revenues by 20% YoY during the quarter. This segment includes international long distance, domestic long-distance, Internet, broadband and other integrated telecom services for corporates. Within the segment, while ILD revenues (50% of segment revenues) have grown at 7% YoY during 1HFY06, NLD revenues (9% of segment revenues) have clocked a revenue growth of 130% YoY. This has mainly been on account of strong growth in volumes for both the businesses as tariffs have declined over a period of time. While volumes for the former (ILD) have grown by 41% YoY during the first half, the same for the latter has recorded a robust 168% YoY growth. VSNL is gradually reducing its dependence on the ILD segment where the company had a monopoly till the government opened the segment to private competition in the year 2002, and this is a positive sign.

Higher network costs dent margins: Substantially higher network costs have dented margins for VSNL for both the periods. As a percentage of sales, these costs have increased from 53% of sales in 2QFY05 to 69% of sales in the latest quarter. Even other operating expenses have risen strongly, thus adding to the pressure on profitability.

Cost details
(Rs m) 2QFY05 % of sales 2QFY06 % of sales
Network Cost 5,340 68.6% 4,906 52.8%
Operating and other expenses 1,518 19.5% 810 8.7%
Staff costs 527 6.8% 354 3.8%

But for lower taxes: Contraction in operating margins has led to VSNL reporting a YoY decline at the PBT level. However, an 18% YoY decline in tax expenses (on account of lower effective tax rate) has helped the company in recording a marginal 3% YoY increase in bottomline during 2QFY06.

Integration of Tyco and Teleglobe:VSNL had recently acquired Tyco Global Network, an undersea cable network that spans a length of 60,000 kms and connects the North American, European and Asian continents and Teleglobe, which is a leading provider of voice data, IP and mobile signaling services. While Tyco came in for a consideration of US$ 130 m, Teleglobe had cost the company a sum of US$ 239 m. The management has indicated that the integration of these acquisitions is in progress and the company expects to consolidate these by March 2006. The management has also estimated both these entities to achieve cash break-even by the end of FY07.

What to expect?
At the current price of Rs 320, the stock is trading at a price to earnings multiple of 20.9 times its annualised 2QFY06 earnings. Despite the lacklustre performance on the bottomline front, we believe that VSNL has shown a marked improvement in its financial performance over the past few quarters. As far as the company’s ILD business is concerned, we would reiterate that the worst regarding tariffs may be over and that that volumes are likely to drive the company’s topline in the future, as tariffs remain stable.

After the government opened up the ILD segment for private sector participation in 2002 and prematurely terminated the monopoly stand of the company, VSNL has faced immense competitive pressure. The acquisition of Tyco and Teleglobe will, thus, bring some respite to the company. The respite, in our view, is from higher contribution from non-ILD services, which have been predominantly voice-based till now. With global bandwidth prices under tremendous pressure on account of increased competition and supply, combined with the recent TRAI order of a 70% reduction in bandwidth prices, the strategy of VSNL to play the volume game might stand it in good stead in the future. In our view, the trick lies in increasing the share of value-add segment contribution to revenues in an otherwise commoditised sector. VSNL seems to be taking steps in this direction. However, benefits of such efforts are unlikely to make a meaningful contribution in the next two years.

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