Telebomb

Monday 1st October 2001

Telecom's two-year decline must end soon, surely? Nope, reckons Roger Armstrong

We said it two years ago. Let's say it again: Who'd want to be Telecom chief executive Theresa Gattung? Filling the enormous shoes of Roderick Deane, Gattung inherited a company wrung of every dime, sitting on dud investments, facing new competition and riding the cusp of a global telco divebomb. Looking back you really wonder why she couldn't smell the poison kilometres from the chalice.

Certainly the numbers are telling a horrible story. The last two years have been nasty ones for shareholders: a 35% drop in Telecom's share price, a 55% decrease in dividends and underlying profits down about 24%. With just about all local investing institutions "underweight" in the stock prior to the recent "gimme" placement (in English: they hated it), Telecom's transformation from market darling to near pariah has been about as slow as a ferret up a trouser leg.

It's by no means all Gattung's fault. Telco share prices have been smacked all over the world. Telecom's price decline since Gattung took over is just a point or two under Telstra's fall over the same period. Moreover, while Deane was worshipped by the share market in his day, history shows he probably extracted too much cash from the business, which left it under-invested and gave competitors an opening to exploit, especially in the area of business customers.

And hasn't the competition been tough! The ownership changes of BellSouth to Vodafone and Clear to British Telecom has reinvigorated the market. In the past two years Vodafone has taken its mobile phone share from 16% to 45%, mostly as a result of its superior technology (text messaging and global roaming) and smart marketing. Clear has gone from being an inept competitor to (with the aid of BT's financial backing) a large nuisance to Telecom, especially in the business market. In the past 12 months alone it has grown its number of business access lines from 10,000 to 41,000.

And still it comes. TelstraSaturn has committed to spending $1 billion, which (if it does) will give it, arguably, a superior network to Telecom in the four major cities. At the same time, prices in some areas of telecommunications have plummeted. International call rates are down a remarkable 75% in two years. That's great for customers, but a right nose bleed for Telecom shareholders.

No matter what Gattung had done, Telecom was always likely to flounder in recent conditions. These are all beyond her control.

Aussie schmozzie

So is Gattung simply a victim of history? Well, if that was the whole story then probably yes. But it's how she has responded to the decline that stamps her mark on Telecom.

It is hard for a managing director to accept that his or her business is going to shrink - it is always much more glamorous and enjoyable to grow. Thus, Gattung's decision to push for growth in Australia. Telecom spent $2.4 billion buying third-placed telco AAPT and will have over $3 billion invested in Australia by 2005. At 30% of market cap, that's a significant amount for Telecom, but it remains a bit player against the might of Telstra.

Pushing overseas because your domestic market looks poorly - rather than because you have a fantastic product or business model - is, in my opinion, a recipe for disaster. At the very least, expanding from a position of weakness cranks up the risk several-fold. (For more about this, see "Aussie Buggers".)

Telecom argues AAPT is a "beachhead" from which valuable growth opportunities will come. Right now it is so far away from earning its keep you wondering whether all the growth opportunities in the world will make the investment stack up. Try these numbers. With about $2.7 billion invested in Australia and analysts forecasting earnings (before interest and tax) of roughly break-even in the coming year, Telecom is about $400 million (pre-tax) short of earning its required rate of return on this investment. Since Telecom has bought AAPT, falling returns on investment in the telecommunications industry have become a global trend, making it hard for the company to ever make up this deficit.

The other part of the Australian strategy announced to date is the purchase of a 20% stake in Hutchison Australia's 3G mobile rollout. Telecom will put in $A400 million for the slice while Hutchison will put in $A800 million in cash and licences for its 80%. Telecom is paying double the price of Hutchison per percentage point, in recognition of the global 3G expertise that Hutchison brings to the deal.

Given that penetration of mobile use in Australia will be very high by the time the Hutchison 3G network is running, the business will need to entice people to switch networks rather than rely on market growth to succeed. It will also need to sell people "added value" 3G services, many of which have not been developed yet.

How Telecom did the investment analysis on this proposition is beyond me. The uncertainty of the income streams makes this a very risky investment. Since Telecom is paying 40% goodwill for its stake, the venture as a whole has to earn 1.7 times its cost of capital before Telecom is in the money.

Telecom argues that the driving force behind the investment was the access it will get (through Hutchison) to cheaper handsets for all its mobile needs. I remain sceptical about this claim. Could such advantages not be gained through arrangements with other telcos (forming a buying group, say)? Or maybe the answer was for Telecom to sell its New Zealand mobile network, since it doesn't appear to have the scale to compete against global players without paying an "entry fee", in the form of this sweetheart deal with Hutchison.

Contrast the high-risk push into Australia with Telecom's once-mooted disposal of its rural customer base in New Zealand because of supposed "unsatisfactory" returns. This area would be the lowest risk part of Telecom's business, with competitors sensibly concentrating on the cities. I wonder whether Telecom is analysing risk properly if it keeps on going for the roughies in Australia and simultaneously tries to ditch its safest New Zealand business.

Southern Cross saviour

If Telecom has lost large chunks of value in Australia, as I believe it has, why hasn't its share price under-performed Telstra's? The main reason is that Telecom has made about $1.1 billion (about 60 cents a share) on its 50% ownership of the Southern Cross Cable. This is a positive legacy Deane left for Gattung (along with a culture of strict financial discipline). Telecom is now both a domestic business that needs cash to modernise, and an overseas businesses that needs cash to grow - which leaves it with limited financial flexibility. It is facing stiffer competition in its local market every day, and at this stage the prospect of pay dirt seems far off in Australia (especially to cynics like me). Apparently, Gattung is a very positive and uplifting leader. And the editor tells me she does one very good lunch. My thinking is that she'll need to cook up something pretty damn tasty before shareholders will be delivered anything but bitter pills.

Roger Armstrong is a former professional analyst, and is now an independent financial advisor. He has no shares in Telecom

Roger Armstrong
finn.ltd@ihug.net.nz

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