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The New Telecom I: Is Telecom finished?

Monday 29th May 2000

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By Nick stride and Nikki Mandow

Theresa Gattung speaks, sitting upright, forearms resting on the table, minimal hand movements, in a torrent of words. If you have a one-hour interview, don't bank on getting in more than four questions.

With Telecom, of course, there's a lot to talk about. After 10 years of double-digit earnings growth, the behemoth of the share market seems to have run out of steam. Analysts think it will struggle to book a June-year profit over $800 million - that's down from $822 million in 1999 and $820 million the year before.

Yes, it's a watershed time, agrees the chief executive, who took over from Roderick Deane in October last year. The world is changing and Telecom's changing with it. Not least the style of the boss. Try to imagine Rod Deane talking like this: "I reckon there's a societal change going on which is about accessibility, life being a continual conversation, fluidity. Business' response to that, well, you will have heard about kairetsu, the whole Japanese notion of a loosely-linked web of companies and individuals who sort of form and reform.

"Could be alliances, could be equity, doesn't have to be, that sort of approach to life. Business is part of that. Telecom's part of that."

Welcome to the New Telecom.

Don't get us wrong. New Telecom isn't just about kairetsu and lots of women at the top, though there's a bit of that (see accompanying story). New Telecom is about being able to pull growth from a burgeoning market, rather than from mere cost-cutting. That means spending money, something rare in the Deane era. Telecom has spent $1 billion on the Southern Cross high-capacity cable to North America and $1.6 billion buying an 80% stake in Australia's AAPT. More recently it took a $94.6 million chunk of INL and launched the $150 million TNT Ventures fund - $40 million of which is Telecom's money - to fund crazy new ideas.

In the past few months, Telecom has also formed an alliance with Electronic Data Services (EDS) and Microsoft. As part of the three-way link-up, Telecom will pay $1.5 billion to outsource its information services business to EDS for a 10-year period. Telecom is also taking a 10% shareholding in EDS New Zealand, with an option to go to 49%.

The company has also flagged a possible spin-off of Internet-related businesses - always a good thing for the share price in the New Economy. And even the traditional big dividend cheques are under review. The current payout, says Gattung, "is not necessarily consistent with repositioning for growth".

Yes, folks, this is a new Telecom.

For investors accustomed to Old Telecom's blue-chip conservatism, it's all a bit unnerving. But Gattung is defiant: "There is no risk-free way for us to continue with our earnings growth in the foreseeable future."

Faltering but still fair

To be fair, it's not all Gattung's doing. The New Telecom actually started with Dr Death himself, reckons Paul Richardson, UBS Warburg's chief analyst and a long-time Telecom watcher. Thanks to Deane's cost-cutting efforts, the company is poised to storm into new technologies, and take a few risks. And let's face it, the business can afford a few dalliances. It's got loads of dosh, a big market share in most areas, and a commercial and financial foundation that's on a par with some of the best in the world. Its profit margin is huge. And it is more efficient than most. For example, between 1993 and 1997, Telecom increased its number of access lines per employee from 54 to 193, putting it on a par with the UK and the US, and well ahead of Telstra, Australia's incumbent telco, on 127 lines per employee.

Under Deane's tutelage, return on equity rose from 17.9% in 1993 to 77% in 1998 and 1999. The 1998 annual after tax profit of $820 million was the best ever and followed new record profits almost every year since Telecom emerged from the old Post Office in 1988. Analysts in 1998 were forecasting that in 2000 it would become the first New Zealand company to make $1 billion and the share price would breach $10.

Okay, so that hasn't happened but, still, financial analysts continue to love this stock. Just look at them line up to kiss the feet of the wealth-maker: UBS Warburg, Credit Suisse First Boston, Merrill Lynch, ABN Amro, Deutsche Securities and JB Were all rate the stock a long-term buy. Investment bank Goldman Sachs last month declared Telecom "one of our favourite companies in the Asian telecom universe" (let alone the New Zealand milky-way), and set a 12-month target of $10 for the share price. Goldman Sachs sees double-digit earnings per share growth reappearing from next year and thinks profit will top $1 billion in 2003.

Richardson is even more positive. He's reckoning on $11-a-share in 12 months - remember it got to $9.81 earlier this year before being clobbered along with other technology stocks.

Overseas investors are piling in too. San Diego-based Brandes Investment Partners disclosed a 5.2% stake in February and now owns 6.2%. Another US heavyweight, Franklin Resources declared a 5% holding in April.

Just why are these heavyweights so gung-ho on Gattung? Well, Telecom is big, in New Zealand terms at least. And it's rich enough to buy itself out of all sorts of trouble if necessary. Also, say the analysts, it seems to be getting the transition from Old Telecom to New Telecom just about right. Or as right as can be expected in such uncertain times. "I'm optimistic about Telecom," says Richardson, "because I believe whatever profit gets stripped, including from competition in the local loop - and there will be an inevitable loss of market share, and an inevitable decline in interconnect pricing - it will be offset by the size of the opportunities in new areas and in Australia."

Telecom's problems

The pros love it, no doubting that. So, explain this then: why has the share price been bouncing around like a spring lamb in a fry-pan? Well, there are plenty of reasons for shareholders to feel nervy about Telecom right now.

For one, profits (see graph) have tailed off and, for the first time in a decade, investors have had cause to wonder aloud if Telecom was faltering. It never reached the expected $1 billion or the $10 a share, and, if the Goldman Sachs' figures are to be believed, profits from the New Telecom won't arrive for a couple of years.

It's also carrying debt. The $1 billion investment in the Southern Cross cable and $1.6 billion purchase of the 80% AAPT stake is all debt-funded, meaning the annual interest bill has jumped by about $50 million. Goodwill amortisation on AAPT will take a further $60 million a year. As chairman Rod Deane commented at the last results briefing: "We're paying the price for investing in the future."

Combine this financial stress with the threats of regulation from the government, new competition on almost every front and disruptive new technologies like free Internet and, well, Telecom has lost its licence to print money.

"I believe it will continue to trade sideways for the next three months," says Ord Minnett's Telecom analyst David Wallace. "I can't see the catalyst to push it up."

Like the others, though, Wallace believes the long-term future for Telecom is rosy. Especially now that it's investing overseas. "The AAPT play is very good, as has been shown by the share price." The market re-rated Australia's number three telco to over $A10 a share, almost doubling Telecom's $A5.10 entry price, though it slipped back to $A7.18 as Unlimited went to press. AAPT already makes up 25% of Telecom's revenues, and is operating in a market seven times New Zealand's size.

Trouble is, argue the critics, it has all come a bit late. Martin Wylie, Telecom's company secretary for eight years until 1995 and now a telco consultant, says the company should have acted much sooner.

Until Gattung's appointment, the culture was one of cost reduction. The company the Baby Bells bought in 1990 had 23,900 staff. A fierce war on costs pruned those to just 6500 at last count. "The day came when you couldn't squeeze any more cost out of Telecom. That's the day the US shareholders left," says Wylie, referring to the exit of Ameritech in 1997.

"At the same time Telecom was beginning to surrender its monopoly to competitors," he continues. "For every dollar it loses it has to find another elsewhere. So it needs to reinvent itself as an Internet company and get into foreign markets. Unless a solution is found, the only way for profits to go is down."

Wylie concedes reinvention is what Telecom is doing now. But it should have started five years ago, he says, when competitors weren't nibbling away at margins, and technologies, like the Internet, didn't threaten its dominance.

Gattung bites back

Gattung doesn't buy Wylie's argument. She argues Telecom was early among telcos worldwide in setting up an ISP, and has beaten Telstra off the mark in rolling out ADSL technology.

And the Old Telecom/New Telecom hiatus hasn't been the only factor holding earnings down. For one thing, the economy hasn't been kind. Growth began to slow in 1997 and went negative in the March and June quarters of 1998. It picked up only in the second half of last year. True, the recession of 1990/1991 was longer and deeper and that didn't stop Telecom clocking up breakneck profit growth. But in those days, the low-hanging fruit of productivity growth hadn't yet been picked.

Moreover, says Gattung, revenue growth from the old voice business has, inevitably, been slowing. Toll prices have been falling for years, partly through competition but also because Telecom's costs have been shrinking.

With population growth at practically zero, there's a limit to the number of new access lines New Zealanders need. Thus, Telecom's revenue from national calls has been relatively static for the past two years. And voice traffic is, as economists say, "demand inelastic" beyond a certain point - no matter how cheap calls are, there's a limit to how much people will talk.

Telecom has deployed all sorts of widgets, such as Call Minder or Call Waiting, to lift call completion rates. But that sponge will eventually run dry and toll prices are expected to fall further.

Government on the case

Whether the New Telecom is five years too late is a moot point - which time will tell. Other threats loom larger right now. A Jim Anderton-Labour government attack on the beast could cost Telecom dearly. The government-appointed telecommunications inquiry, chaired by Hugh Fletcher, is due to report on September 29. Telecom's competitors are calling for the local loop - the near-100% monopoly "last mile" access network to homes and businesses - to be "unbundled", meaning they will be able to "rent" the network and install their own equipment at local exchanges.

The potential cost to Telecom is huge. A report commissioned by rival Clear from Jeff Todd's Todd Telecommunications Consortium in 1998, concluded that Telecom's monopoly over the local loop generated annual profits of $382 million (remember 1999 after-tax profits were $822 million). A later report, putting Ministry of Commerce-commissioned figures into the Todd model, upped the monopoly profit figure to $450 million. If either figure is correct (and Telecom disputes both), this is part of what's at stake for Telecom if the local loop is unbundled. Not all of it will disappear by any means - even Telecom's competitors accept they should pay an "economic rent" taking into account Telecom's actual costs plus some profit, though they haven't published a desired figure. But some profit is bound to go.

Will regulatory changes bring Telecom to its knees? Not likely, say the experts. "I've dealt with new entrants and incumbents in Hong Kong, Europe and Australia, and I don't know an incumbent anywhere in the world that's gone backwards as a result of a liberalisation of the rules," says an international telecommunications specialist with an interest in the New Zealand situation. "You can let an atomic bomb go off and you don't touch them. The engines of their market power are extraordinary. Even if they lose market share, they have all that free cash flow to spend themselves out of trouble."

Take UK incumbent British Telecom. Faced with a new regulatory regime, it was forced to halve its interconnection changes to new entrants between 1993 and 1997, and it saw competitors build a cable network that now passes 50% of British homes. Was BT crippled? Not on your life. During the same period, the company's turnover went from £3.2 billion to £15 billion. Earnings per share went from 19.8 pence to 32.8 pence.

In fact, says the expert, a change in regulatory regime might act as a spark to make Telecom more innovative and come up with more services. "It's like an elephant plodding along nicely. Then someone gives it a jolt with an electric cattle prod. It doesn't fall over, it just runs faster.

"In other countries, where regulation has been released earlier, the new entrants have had it easier because the incumbent is fat and lazy. Telecom has already made itself fitter, so it is in a good position to resist new forms of regulation."

Nasty pricks

Also attacking Telecom is a host of nasty competitors nibbling away at the last mile. Telstra Saturn, the joint venture between Telstra and the Wellington-based pay TV/telephony operator, Saturn, plans to spend $1.2 billion on a broadband hybrid fibre coaxial cable (HFC) network bypassing Telecom's last mile network, providing direct access to 65% of homes and 70% of businesses.

There is also Clear Communications, now fully owned by British Telecom. It is deploying a wireless LMDS (local multipoint distribution service) direct access network. Clear's first stage investment is costing $120 million. Smaller outfits, such as Walker Wireless, Radionet and S@fetynet, are all offering direct access, high-bandwidth wireless services (see "Where the wireless things are", Unlimited, May 2000).

Some accuse Telecom of under-investing in its network and short-changing customers on its high-speed data service. In doing so, critics say, it has left the back door open for competitors.

"As a user, I feel they're behind the curve," says Martin Wylie. When Telecom launched Xtra, Wylie says, it opted not to build a new network to carry Internet traffic. "But the existing network isn't equipped to cope with customers logged on for hours. I don't think they're exaggerating when they say the network can't handle it and they need 0867 to take the Internet traffic."

Gattung denies Telecom has skimped, pointing to annual capital expenditure of between $600 million and $700 million, mostly going into the existing network. Telecom is spreading its last mile broadband strategy between wireless CDMA (call division multiple access) and cellular technologies and ADSL (asymmetrical digital subscriber line), a mechanism for pumping fast data over the legacy copper network.

The battle is less about how money is spent and more about which technology will prevail, Gattung says. Telstra Saturn's move pits it on the other side of the raging debate over whether ADSL over copper or HFC and cable modems will prevail.

Spin-offs

Telecom has other problems, the sort you kind of envy. Like what to do with its most successful divisions: to float or not to float. Carve-ups, separate letter stocks and spin-offs are a trendy strategy worldwide at the moment, and one that investors encourage as being good for the share price. On the plus side, says Ord Minnett's David Wallace, you create a growth unit with a culture that should be able to move faster than the legacy business. On the other hand, the jury's still out on whether it's always good for the company. Take Fletcher Challenge. The reception was relatively euphoric when it launched its letter stock strategy. It's now bringing all the pieces back under the same roof. Overseas research indicates splitting off bits of a company isn't always in the best interests of the whole, some analysts say, and our companies should avoid trying to fix what ain't broke.

"It's possible that more transparency in terms of financial reporting on how well each business unit is doing would achieve the same result without pulling the company apart," Wallace muses. "The trouble is that international investors are saying 'when are you going to carve it up?'"

Then there's the problem of what to do with its biggest and brightest asset yet: AAPT. The foray into Australia came out of the blue and initially spooked the market. One Australian writer labelled the offer which netted 80% of AAPT "an abject success", arguing Telecom got far more than it needed for control but not enough - 100% - to access AAPT's cash flows. Gattung laughs. "No, it's a happy success," she insists. Staying listed puts a market value on Telecom's AAPT holding and allows share price-linked management incentives.

Although it will be a couple of years before AAPT contributes serious money to Telecom's bottom line, the subsidiary is growing at a breakneck pace. Analysts point out various ways the two can strengthen each others' businesses. Telecom, for instance, has put in a big team led by former chief strategist Karyn Devonshire, to chase business from major trans-Tasman and Australian corporates. AAPT's early adoption of CDMA technology will assist in Telecom's rollout.

Thanks to the market re-rating, Telecom had made a $A483 million paper profit on its AAPT stake by the time Unlimited went to press - not a bad start.

Now the number crunchers are hard at work on the potential for spin-offs to unlock the value of Telecom's new economy investments. Goldman Sachs estimates the non-legacy businesses are worth $12.7 billion. Adding $7.6 billion for the local loop/long distance business brings Goldman to $20.3 billion, or $11.63 a share.

But the really big gains will come from Australia, analysts say.

"Theresa Gattung's job is to defend and grow the home market and grab a reasonable amount of the value of the telco sector in Australia," says Patrick Russel, a Sydney-based analyst for Merrill Lynch.

"But the reality is, they're not going to triple their size in the home market. The Australian telecom market is capitalised at $A160 billion and AAPT has a market capitalisation of $A2 billion. If AAPT grows significantly and grabs 5% of the additional value created in Australia then there's potentially a $A6 billion ($7.2 billion) value increase to Telecom."

So ask yourself, has Telecom topped its growth, will profits remain static, and has the share price stalled? Is Telecom doomed by new technology, a government with regulation on its mind and competitors nipping at every turn?

We doubt it.

Nikki Mandow is Unlimited's business editor: nikki@unlimited.net.nz
Nick Stride is an NBR writer and regular contributor to Unlimited: nstride@nbr.co.nz

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