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Winds of change

By Mark Revington

Friday 28th April 2006

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White caps on the harbour and the International Arts Festival in town - it must be a late-summer day in Wellington. High up in Telecom Tower in the capacious office of chief executive Theresa Gattung, you can see the waves yet not feel the wind's blast. It's tempting to view this as an analogy for Telecom, rocked by criticism over its broadband delivery, and the write down of its Australian subsidiary, yet insisting on business as usual.

The country's largest publicly listed company seems to have assumed the IRD's mantle of 'most hated organisation' lately, lambasted by critics from the prime minister down.

As Trevor Mallard joked when opening the Telecom Incubator Awards in mid-March, he was quite possibly the only government minister with anything good to say about Telecom. "I feel lonely," he quipped.

The flashpoint was Telecom's announcement that it had added 250,000 new residential broadband connections last year yet failed to meet a promise that one-third would be wholesale, a deal made to ensure competition in the wholesale broadband sector after local loop unbundling was rejected by the telecommunications commissioner.

Telecom fell short of the wholesale target by 20,000 but now Gattung disputes it ever made the promise. "We promised we would get 250,000 customers by the end of that year. We did. We believe we made a commit-ment to develop a wholesale market and we have honoured that and we have tried to figure out what comes next."

And that's the billion-dollar question - not just for broadband but for the whole future of the hugely complex business. Back when Rod Deane was running Telecom in the 90s, slashing costs and driving after-tax profit up from $402 million to $822 million in seven years, he told share-holders Telecom's future was not as a telco, but as an internet company with telephony.

By 1998, when net profit had reached $820 million, analysts were predicting Telecom's profit would reach $1 billion by 2000. That prediction is yet to be fulfilled. And Telecom's future, like large telcos all over the world, is tied to how fast it can transform from a telco to an internet company.

More than half its revenue now comes from data, internet, mobile and information technology services and Telecom has invested heavily in high-speed internet, mobile phone services and IT, to offset declining revenue from traditional sources like national and international calls.

Not only is it under siege from competitors and politicians moaning about its broadband services, its traditional calling revenue is also threatened by operators like Skype who offer free phone calls over the internet using what is sometimes called voice over internet protocol or VoIP. Ironically, faster broadband makes it easier for VoIP competitors like Skype to muscle in on Telecom's turf. Gattung notes Skype has added almost 100,000 New Zealand members with no marketing.

And don't forget while all this is going on there's been the Australian investment hanging over Telecom's head. Many blame the decision to invest in AAPT in Australia on former CEO and current board chairman Rod Deane. Telecom spent more than $2 billion acquiring AAPT to gain a foothold in Australia, completing the purchase in December 2000, but has struggled to make much headway against the incumbent, Telstra. This has forced Telecom to write down AAPT's value by $850 million in 2002 and again in December by $897 million, and leaves it searching for a partner or full buyout.
Add the uncertainty brought on by the government's apparent determination to revisit the local loop unbundling argument - an -argument Telecom thought it had settled in 2003 when it lobbied hard for a regulated wholesale market instead - and you might expect Gattung to feel under siege.

Not so, she insists.

"We're just going to get on with what we've been doing. We've announced fantastic new offers for customers. We're just going to promote them and accelerate people moving from dialup to broadband. We're actively working on the deployment of the next generation of services. But it's a bit hard to pull magic rabbits out of a hat here. The fact that we've rolled out a near-nationwide mobile network while all this has been going on appears to be irrelevant, yet that is what customers are jumping on."

Gattung's pretty good at staying on message but just for a moment the relentless optimism slips. "I'd say we're struggling to get our message out at the moment quite frankly. There's a lot of overt hostility in some quarters of the media and anyone who comes out and makes an argument that sounds like they're not hysterical or totally vitriolic gets jumped on from a great height."

Plenty of critics are unwilling to shut up. Put simply, Telecom is accused of being uncooperative and anticompetitive when it comes to broadband. Staunch critic Ernie Newman, chief executive of the Telecommunications Users Association (TUANZ), bluntly says that Telecom holds all the cards while it owns the lines. Newman, who is equally as passionate and persuasive as Gattung on the subject of broadband, argues that Telecom, in opposing local loop unbundling or some form of enforced competition allowing competitors access to Telecom's network, is simply protecting its patch the way any incumbent would.

"But they're going to have to succumb to an internationally normal regulatory environment at some stage. The longer it takes, the more painful it will be but the status quo is not an option."
Why is better broadband important, apart from allowing you to download the latest movies or hold real-time videoconferences with your business partner in St Petersburg?

A report by the Economist Intelligence Unit for the HiGrowth Project estimates that, given the current rate of broadband uptake, New Zealand is likely to have 50 broadband subscribers per 100 head of population within 16.8 years. Speed up the process so we get 50 broadband subscribers per 100 people within ten years and the report estimates that nominal GDP would increase by $314 million by 2010, $2,740 million by 2020, and $7,215 million by 2030.

Accelerate broadband uptake even more to 50 subscribers per 100 people within five years and the increase in GDP skyrockets accordingly.

It accords with Newman's argument that New Zealand should focus on faster broadband to increase productivity through better use of technology rather than the current business model, which he describes as "throwing more and more labour at business problems in an effort to solve them while other countries use technology".

Despite all the argy-bargy over broadband, and leaving AAPT aside, Telecom has done a pretty good job for its shareholders in paying dividends of up to 85% of net profit, something even Communications Minister David Cunliffe acknowledges. "They shouldn't be criticised at a moral level for being good businesspeople."

But is it a good long-term business strategy which provokes the prime minister to the extent that she uses her opening speech of the -parliamentary year to lambast the poor state of New Zealand's broadband and threaten more regulation in what is currently one of the world's lightest regulatory regimes?

Gattung guffaws. "You don't think we planned it?" she says of the government's outburst. For his part, Cunliffe won't specify exactly what the government wants from Telecom but says the benchmark is Clark's speech, which referred to low broadband uptake, high prices, low investment levels, low speeds and data caps.

"I've been very clear, and so has the public. No one in the government thinks the status quo is half good enough, nor is the speed of the game and we will be looking for substantial improvements by one means or another. The recent changes to broadband in the business area are a useful step forward but arguably not enough on their own."

The outlook
So what does the future hold? In June 2000, just after Gattung took over from Rod Deane at Telecom, Unlimited ran a story which said: "Telecom's profits have stalled, the government's on its case and, suddenly, every entrepreneur and his dog fancies a slice of Telecom's 'last mile'." The future then, according to Gattung, lay in spending money on new technology to develop new markets, rather than Deane's era of cost cutting.

Six years on, Telecom is once again under the gun with competitors queueing up to nip at its heels and the government baying for blood. So what's changed? The regulatory threat seems more serious now but also the internet is changing the telco paradigm. More often than not, those that have most keenly felt the loss of fixed-line revenue have been the incumbent telcos who dominated the markets in most Western countries as the telecommunications sector was privatised. But Gattung claims the technology challenges and business model shifts are the same around the globe for all telcos, no matter what the regulatory paradigm may be. "Everyone has to make this shift from a voice business to an internet protocol data business."

The company rejects government criticism of investment levels. Its capital expenditure is now 12.53% of revenue, behind the US and Canada but ahead of most European telcos, spending $585 million in the 04/05 financial year with expected investment in the 05/06 investment year of $610 million. Telecom's capital expenditure as a percentage of sales is 12.35%, slightly above the average in Asia and Europe and just behind the US.

In part, that rising tide of investment is to fund Telecom's $1.4 billion Next Generation Network which it intends to roll out later this year to deliver what some call the holy grail - the triple play of converged voice, video and data services through broadband or internet protocols.

The company recently completed the first step, a trial involving 120 residential and small-business customers using landline phones which work like cellphones, automatically switching between cellular and wireless networks. It plans a further trial using fibre connections to 430 homes in Manukau City's new planned development of Flatbush.

Everyone knows that the future lies in mobility and convergence between landlines and mobile phones, in a mobile phone that does pretty much everything from downloading television to turning the lights of your house on at night, and Telecom has joined the Fixed-Mobile Convergence Alliance, hosting a meeting of the group in Auckland in mid-March. But the rate of change has surprised Gattung. "We always thought increased mobility would be part of the future, but it's come on faster than we thought."

Telecom has become the market leader in the fast-growing information technology services sector after paying $88.3 million for Computerland and Gen-i in 2004 and merging them under the Gen-i banner. What Telecom calls its 'solutions' revenue, from information technology, grew from $54 million in 2004 to $321 million in 2005, a growth of $267 million. Of that, $240 million came as the result of acquiring Computerland and Gen-i.

"It's a fragmented market and we have less than 20% of it," says Gattung. "But it has been growing at double the market average for the past couple of years and has given some balance to our view that there is a future beyond voice telephony."

Ironically, Telecom seems to be winning of late in the mobile phone sector where it has faced real competition against Vodafone. The European giant came in and "kicked arse" initially, in the words of one analyst, but Telecom has been winning back market share at a rapid rate, unrolling its 3G network before Vodafone, and adding new customers at almost double Vodafone's rate in the December quarter. Telecom now has about 47% of the mobile phone market and mobile revenue as a proportion of Telecom's total revenue has slowly increased, from 16% in 2003 to 18% in the June 2005 financial year. Surely all this shows Telecom won't necessarily suffer horribly from more competition in broadband as well.

But Gattung sees the shift by telco users as another bullet in the argument against further regulation. The current debate is about fixed lines but Telecom's customers are moving to mobile.

"Vodafone and ourselves have quietly rolled out near-nationwide mobile broadband networks and 200,000 customers have joined up. They must see that as value for money. The rise of mobile hasn't been a factor in the conversation and I find that odd because it's what customers are doing."

You can't get either Gattung or board chairman Rod Deane to comment publicly on possible outcomes from the government's survey of the broadband sector due to be finished in July, but you can bet plenty is being said behind closed doors.

Gattung reckons Telecom is constantly threatened with further regulation and there's little point in sitting around trying to second guess what may happen. "There are so many possible options that it would be hard to have a contingency plan for everything. So you won't find a plan B sitting in someone's drawer that says if this happens, then this is what we will do."

What's the likelihood of Telecom avoiding more regulation by making another deal with government? The suggestion lingers that local loop unbundling was avoided in 2003 thanks to some astute last-minute lobby-ing from Telecom. But Cunliffe points out the telecommunications sector worldwide is famous for the lobbying that goes on. "We're clear that this is a serious look and we're not simply going to be lobbied out of doing what's in the country's best interests."

Share punters seem to agree as they have already factored the prospect of further regulation into Telecom's share price, which reached a two-year low recently. Long-time Telecom watcher Paul Richardson from BT Funds Management believes buyers got carried away believing Telecom was safe from regulatory threat and that the share price lately is a more accurate reflection of the company's position. "People have been wringing their hands about the share price. Well, other significant shares like Fletcher Building and Contact Energy go through significant price oscillations without anyone jumping up and down."

Analysts say Telecom has such a dominant market position that it's hard to see it seriously challenged by another telco even if the Government goes ahead with local loop unbundling or further regulation of some kind.

But you only have to look at Telecom's profits to gauge the impact of increased competition, Richardson says. Most forecasts were that Telecom would be earning more than $1 billion profit today. "It's earning around $800 million at the moment. Where's the other $200 million to $250 million gone?
It hasn't just gone on AAPT. There was a slow-ish period in the early 2000s but the economy has since been strong with strong consumer demand."

Telecom has gone through the money, according to Richardson, to meet Vodafone's competition in the mobile sector, on its Next Generation Network and adjusting prices and services to stave off regulation. "So maybe all Telecom is doing is peddling fast to keep on track. When people say to me there isn't much competition in New Zealand, I say well that's interesting. If that's the case, why isn't Telecom earning more money? And the answer is that those things are gradually impinging on it."

Gattung doesn't use the same words, but her message is similar. As customers become more mobile their relationship with telcos changes. Telecom used to have contracts with households, now it often has contracts with individuals, she says.

Back in 2000 the challenge facing Telecom was how to capture new reve-nue streams from new technology. Gattung reckons the jury is still out.

"Share prices in the telco market worldwide are still very low because investors are not convinced that we will all be able to make the shift. There is regulatory uncertainty in the market because everyone is saying unbundling wasn't the holy grail and that sits alongside the big issue of how the business model will shift, what customers will pay for, and what technology will prevail in the long term."

As Gattung acknowledged at the company's interim result presentation in Auckland in February, it's a tough world out there for telcos and Telecom has to run exceptionally fast just to stay still.

Don't hang up on Telecom too soon, however. You can point to market dominance, or Telecom's intransigence. Apart from its disastrous foray into Australia - and most telcos around the world have experienced something similar when attempting to expand into other countries - Telecom has proved to have exceptional staying power and that doesn't look like changing any time soon.


Culture shock
It isn't a startup as such - not when Telecom puts up $15 million. But Telecom's online retail shopping site Ferrit (www.ferrit.co.nz), is a window on startup culture for Telecom, according to the company's chief financial officer Marko Bogoievski.

The online retail site, launched in late November last year, carries no stock but links buyers to retailers and allows shoppers to make price comparisons online. In phase two, which Telecom plans to launch this year, shoppers will be able to buy direct from the site. Ferrit also encourages shoppers to log in so it can keep track of their likes and dislikes, and encourages feedback or reviews as a way of building an online community.

But it's as a window into startup culture, and the idea of launching a fast-moving, innovative business, that Ferrit is important to Telecom. "It does feel like a startup," says Bogoievski. "There are only a small number of people working all hours. But we're not kidding ourselves. There's not that same financial edge that a startup has when you're surviving on a credit card to fund your initiative. I don't know how we replicate that other than we've tried to create incentives that get close to equity-type participation."

Of course, Ferrit has to earn money. And it was never intended as Telecom's answer to Trade Me, which has such market mass it would be almost impossible to move - a little like Telecom in its natural telco environment. But the Ferrit site can build its own online community as Trade Me has done so successfully.

The site in some ways is a natural extension for Telecom, says Bogoievski. The retailers are all Telecom customers in traditional communications, data and managed services, and it was the retailers telling Telecom the time was right for another online shopping site.

The site was developed in four months. General manager Ralph Brayham, Telecom's former general manager of new media and business development, was given a free hand to create a semi-autonomous organisation within Telecom, says Bogoievski.

"I think he's done a bloody good job of launching it in a time frame that large organisations like Telecom typically can't get close to. And I think he's proved that, for some business ideas, there's a much better way to be more nimble and quicker to market."


Broadly speaking
First up, for anyone who hasn't been following the broadband debate - evidently there are one or two of you - unbundling the local loop means giving Telecom's competitors access to telephone exchanges so they can install their own equipment and have complete control of the services they offer over the fabled 'last mile' of copper wiring which links telephone exchanges to every home.

Essentially Telecom's critics say there will never be true competition until they have access to Telecom's line network, at a fair rental price plus profit, determined by an independent commissioner.

Sod off, says Telecom. That's our network and we paid millions of dollars to upgrade it. Go build your own physical network. And anyway, says chief executive Theresa Gattung, Telecom is about to start rolling out its Next Generation Network which uses fibre optic cable and roadside switching cabinets, which will make exchanges obsolete.

If that's the case, say Ernie Newman of TUANZ and Colin Jackson of InternetNZ, why doesn't Telecom open up the 'last mile' now? Unless there is independent regulation, whoever controls the local loop controls the broadband market and it will remain a cornerstone of New Zealand's broadband service for a few years yet.

She's a hard road finding the perfect broadband solution. It doesn't matter how fast data comes down the line, it's the clarity that's important. And it's easy to get swamped by data in the tit-for-tat debate over New Zealand's broadband.

Telecom says its new broadband offerings, which start in early April, are world class. They will include download speeds of up to 3.5Mbit/s and three new services that offer upload speeds of up to 512kbit/s. All existing residential customers will be upgraded automatically.

Rubbish, say critics. They are faster but not world class - not while they're still governed by data caps. Business New Zealand released a study that said the new prices are among the best in the world. Computerworld picked holes in the study and concluded that it used outdated information from 21 of the 30 countries evaluated.

Business Roundtable chairman and Telecom director Rob McLeod put his name to a newspaper column that argued New Zealand needs to lift its productivity so more people can afford decent broadband services, using some dubious data from Britain to make his point.

And on it goes. Communications Minister David Cunliffe says he doesn't accept that it's too late to unbundle the local loop. "I haven't made a decision that we should but it's getting less and less important if the new generation network, for example, is running fibre past the exchange to a roadside cabinet. One could argue that unbundling would create an incentive for next-generation network roll-out to occur a lot more quickly as a defense by the incumbent."

What the government wants, says Cunliffe, is investment in a variety of ways to deliver broadband and more competition around the basic loop, which suggests Cunliffe and his colleagues will press on with unbundling this time.

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