The market seems to be pleased with VSNL. Though it may still not be looked upon as one of the favourite telecom companies, investors are waking up to the fact that it has potential. According to analysts, bandwidth requirements in Asia-Pacific and India are expected to grow and this will augur well for VSNL, which announced a deal by Tyco, one of the three big global players in undersea cables, last month.

The VSNL stock has moved up around 38 per cent year-to-date to current levels of Rs 227. However, it does not look too cheap if one considers FY05 or FY06 earnings estimates. But investors who are ready to hold on for a longer timeframe - three-four years - may reap the benefits of the company's new strategic initiatives.

The right moves
Ever since VSNL's monopoly in international telephony ended a few years ago, it had to seek revenues from other businesses. Its recent entry into the data service business augurs well in this regard. "Data services is the big story in telecom worldwide and VSNL needs to join the big league," says an analyst. This is where the company's takeover of Tyco Global Network (TGN) for $130 million fits in.

The deal will make VSNL one of the top three undersea-capacity businesses globally along with Global Crossing and Reliance Infocomm (which bought Flag Telecom in January 2004). With the Tyco takeover, VSNL now owns a huge global network of undersea cables. Tyco's trans-Atlantic, trans-Pacific network spans 60,000 km and crosses Europe. It has one of the largest capacities globally which can transfer data at the rate of seven terabits per second (1,000 gigabits make a terabit).

Growth is expected to arise from the trans-Pacific network where TGN's strength lies - around 44 per cent of its capacity is situated in the Pacific route where there is less traffic currently. As for the trans-Atlantic section, where there is already a lot of traffic, it will be a source of steady revenues, feel analysts. Tyco's network happens to be fairly new (three years old) and one of most expensive ones.

According to estimates, Tyco would have spent around $3 billion in building its network, while the figures for the other leaders, Global Crossing and Flag Telecom, would have come to $750 million and $1.1 billion respectively. VSNL paid $130 million to acquire the Tyco network, which is lower than what Reliance Infocomm paid to acquire Flag Telecom ($210 million). But analysts estimate that VSNL will have to put in a considerable amount (at least as much as the cost of acquisition) to get the whole thing started, including lighting the unlit portion of Tyco's network that links Japan to Singapore.

VSNL's first self-owned undersea cable (spanning 3,175 km with 5.12 terabits of capacity), linking Chennai to Singapore, has been completed, adding to its bandwidth capacity. The Tyco deal complements this process by helping the company increase its presence in the region between Singapore and the US. The company has also signed a Rs 500-crore deal with Cisco Systems for broadband connectivity to provide data services in the domestic market. It intends to spend about Rs 1,000 crore in the next two years on broadband in the local market.

"We can expect the new deals to generate revenues after two-three years," says a telecom analyst from a leading domestic brokerage.

Demand on run
Such huge capacities will not be rendered useless if one looks at the demand for bandwidth in the years to come. According to Nasscom, bandwidth demand is expected grow over 50 per cent in FY05 to 15.42 gbps (gigabits per second) from 10.23 gbps currently. Demand is expected to double every year post-FY05. The highest demand for bandwidth comes from the Internet segment which is expected to grow over 100 per cent to 4.66 gbps in FY05. Such demand can catapult VSNL's position, especially with the kind of capacity it has acquired.

International bandwidth prices in the Asia-Pacific region are expected to fall by 20-25 per cent annually as there is already excess capacity and players compete for data-driven business, says a recent report by Gartner. With the SMW-4 cable - set up by a consortium of South-East Asian players to connect India to the western and eastern regions of the globe - there will be more capacity in the region, fuelling a further decline in prices.

The moot point is whether the fall in prices will be offset by growing volumes, considering the burgeoning demand. Currently, a one mbps (megabits per second) link from Mumbai to Singapore costs around $4,800 per month. VSNL stands to gain here once it starts its operations on a global scale though it is difficult to predict the kind of revenues this will generate.

Financials
VSNL's revenues have been slumping for the past few years due to pricing pressures arising out of competition in the international long-distance (ILD) telephony business. Net profit dipped 30.5 per cent to Rs 88.1 crore in the second quarter (Q2) of FY05 against the previous quarter. Operating margins declined 630 basis points to 22 per cent. For FY04, the company's profits declined 51.58 per cent to Rs 377.7 crore.

But VSNL has been diversifying its services, and segments other than ILD accounted for 25 per cent (Rs 193.9 crore) of revenues in Q2, compared to 23 per cent in Q1. It is heartening that these services accounted for 45 per cent of EBITDA (earnings before interest, tax and depreciation) in Q2, compared to 41 per cent in Q1, and are expected to grow on a linear scale going forward.

However, revenues from the ILD business have continued to fall in Q2 (down 4 per cent to Rs 584.6 crore). But higher revenues from other services have offset the decline in the ILD business to an extent. TGN's financials remain a concern for the company. A large portion of TGN's costs (about 80 per cent, amounting to $115 million in FY03) is fixed, which could nick VSNL's profits in the short-term.

"Though Tyco's operating losses could hit VSNL’s performance now, the business potential ahead will make up for it," says an analyst. Going forward, VSNL's marketing capabilities will be put to test to bring in volumes for revenues. For FY03, TGN's operating losses stood at $799.8 million.

Wait and watch
While it may too soon for analysts to give the green signal, VSNL seems to hold potential for investors who are generally willing to bet on the long-term potential of telecom data services. The company is doing the right things, albeit a tad late. It has the potential and qualifies as a long-term pick. Most analysts expect the fall in earnings to continue at least till FY05, with Tyco doing little for the bottomline.

"We expect an EPS of Rs 12.5 for FY05," says the head of research at a leading domestic broking house. This translates into a decline of 5.6 per cent against last year and a P/E of 15.6 times FY05 earnings (12-month trailing P/E stands at 14.8x).