Telecom's lack of explanation fuels slump

By Neville Glaser

Friday 8th November 2002

By itself, Telecom's warning of a lower than expected first quarter profit was no big deal. But taken in context of poor results from Telstra earlier, it cast a shadow over the whole telco sector in New Zealand and Australia. It has put a question mark over a revival of the telco industry's growth prospects.

What made it worse is that Telecom came up with no real explanation and the market hates uncertainty more than it hates bad news.

Its shares fell 9% on Tuesday after the company indicated its profit for the three months to September 30 would be $145-150 million, below analysts' consensus forecasts of $160-175 million. The difference between the expectation and the reality equates to less than 1c per share in earnings but it does indicate its growth rate could be falling.

Despite the warning, Telecom said it was comfortable with market forecasts for its full-year profit result of $676 million to $760 million.

Investors were told that the shortfall was due to unexpected seasonality in the telecommunications industry the market already factors in July to September as the sector's weakest quarter.

Telecom management refused to explain why this additional seasonality has emerged. Full details are to be given with the quarterly result next Tuesday.

The news of lower profits coincides with the decision on interconnection pricing that went against Telecom this week. The competition regulator set the interconnection price between Telecom and TelstraClear at 1.13c a minute, half its negotiated agreement with TelstraClear of 2.6c a minute but in line with interconnection charges in Australia and the UK.

Many analysts believe this ruling while fairly serious in its implications had no great impact on the slide in Telecom shares this week. Most had built the lower interconnection fee into their forecast of future cash flows. Telecom says the negative impact of the ruling will equate to a revenue reduction of only $10-12 million a year, which will have negligible impact on its cashflow.

Moreover, Telecom has the potential to recoup some costs from its competitors should the regulator determine Telecom is not getting a fair return on meeting necessary service requirements in rural New Zealand.

The Commerce Commission is trying to determine the cost of Telecom providing services to loss making customers in mainly rural areas, and a decision is expected in March 2003.

If it finds it is not getting a fair return on its network, Telecom could get a cash fee from its competitors of up to $10 million, offsetting the revenue lost in the interconnection ruling.

Telecom shares rose sharply from $4.75 in mid-September to $5.22 at close on Monday, before the recent profit warning set them right back to $4.72 the next day.

The sale by US telco giant Verizon of its 20.9% stake in early October was seen as very positive for Telecom as the prospect of a major selldown had weighed on the share price for some time.

And with that out of the way, investors began loading more Telecom into their portfolios. The brokers too had become far more bullish on Telecom by October.

Of the 10 major brokers that analyse Telecom, two were sending out strong buy signals in October, five rated the company a moderate buy, four had the share on hold and only one signaled a sell.

Brokers believe Telecom continues to stack up well for long-term investors, because of its excellent free cashflow and duopoly market structure, dominating both fixed line and mobile markets.

While the regulatory environment is tightening around Telecom, it is still a lot more favourable than that found in many other developed markets.

Parts of Telecom's business are mature, with prospects for growth quite flat. But other sectors are only starting up.

It now has 46,000 Jetstream connections, 26,000 of which are in residential areas. It plans to deliver Jetstream to every corner of the country but the take-up of its broadband service is still very low compared to some other countries.

In New Zealand, Telecom dominates. But in Australia, it is a distant third operating through AAPT and that has proved to be a problem.

In a tough market, number one and two can flourish but smaller operators tend to suffer. Nevertheless, by slicing $850 million off the book value of AAPT, Telecom is thought to have already absorbed all the risks from this investment into its accounts and its share price.

It remains to be seen though whether the lower quarterly growth rate is due to one-off factors or something more permanent. Analysts on both sides of the Tasman are awaiting Telecom's explanation with some interest.

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