KGB Interview: Telstra's Andy Penn

Telstra’s chief financial officer tells Alan Kohler, Robert Gottliebsen and Stephen Bartholomeusz:

– Increasing the dividend is a vote of confidence from the board in Telstra’s long-term growth.

– Significant investment in mobile technology and infrastructure will continue in the second half.

– Telstra will aim to meet the government’s needs on the NBN but keep shareholders at the centre.

– E-health, global applications and digital music are seen to be Telstra’s three largest growth areas.

– How offshoring processes has temporarily fixed costs.

– Where Telstra will be in five years.

Stephen Bartholomeusz: Andy, today you announced the first dividend increase for eight years – half a cent. One assumes, given the small size of it, that you’re trying to send a message to the market and the shareholders. What sort of message are you trying to send?

Andy Penn: Yeah look, I think over the longer term what the board has said is that clearly our shareholders value the dividend, and they value a fully-franked dividend, and therefore we’ve committed to seek to increase that over time. We had 8.7 per cent earnings per share growth today and that’s basically put us in a position to be able to make good on that aspiration. So it was, as you say, an indication that we see growth and that we’re confident about how the business is going.

SB: Presuming what you see is sustainable growth, not just growth in a half year.

AP: I think that’s right, Stephen, and I think the board wouldn’t think about increasing the dividend if it also had to think about reducing it again in the future, so it’s obviously a very considered decision.

SB: For most – if not all – of that eight-year period that you’ve maintained that dividend, you’ve had to borrow to pay for it. Have you had to do that this time?

AP: Well, no. We’re very strong in terms of our free cash flow generation. As you would have seen today, we announced that we had cumulative excess re cash flow of $1.8 billion, so the dividend payout ratio when adjusted for the Sensis impairment is less than 100 per cent, as indeed it was last year as well. Earnings per share last year were 30.7 cents and we paid out a dividend of 28 cents. So we’re in a good position.

Robert Gottliebsen: However, just on simple sums – and I know each half year is different, but this year your earnings per share in this half year didn’t cover your dividend and when you look at the cash flow in sums in a different way, just as you state them, again in the half year there’s a deficit if you include the interest. Is this a good model? I know it’s a good model for shareholders because they get the dividend, but shouldn’t you be funding a greater level of capital expenditure? This is not a good model longer term for most companies.

AP: Well sorry, I don’t agree, Robert. I think we clearly generated strong free cash flow from the business in excess of our interest costs and our dividend and that enabled us to increase the dividend.

RG: After capital expenditure though. You spent a lot of money on capital.

AP: We spent $1.8 billion on capital but we generated enough free cash flow to cover that as well. We increased our excess free cash flow. You might recall at the full-year, last year in June, it was $1.6 billion. We increased it to $1.8 billion, notwithstanding the fact that we actually announced acquisitions of $226 million in the first half as well.

So we’re in a strong cash position. We’re generating excess free cash flow slightly ahead of our earnings. Our earnings per share were 13.7 cents per share and that included the $100 million impairment for Sensis. So when you adjust for that we clearly have the dividend covered. And I think more importantly we are in a position where both last year and this year we’ve got a sustainable position of our earnings per share being ahead of our dividend.

RG: In a company that is going to have to stay right ahead of the game, it’s a high technology business and it requires a lot of capital. Shouldn’t you be spending a lot more capital? Or are you really sort of spending, if you like, the mobile dividend because you spent all that money on a mobile network and now you’re getting a dividend from that? Shouldn’t you be doing something else rather than spending so much on shareholders’ dividends? It’s great for shareholders at the moment.

AP: Well, we’re making really material investments in all of our networks including the mobiles network. As you know, we just completed the accelerated rollout of the LTE network. We’ve now got an LTE (long-term evolution) network four times the scale of any other competitor in Australia. Our geographic coverage across all of our network is more than twice the scale of any other operator in Australia. We’re going to continue to invest in the second half of the year. We’re going to deepen our LTE penetration. We’ve got a number of quite innovative developments ahead of the 700 spectrum, which will become available in 2015. We’ve got a big investment in the second half of the year, $1.3 billion in that spectrum.

So we’re making some very, very sizeable investments, exactly to your point, because technology is changing rapidly and more importantly how our customers are using mobile devices is changing very significantly as well and so we need to adapt to that. And you may have seen the LTE broadcast trial that we did at the MCG the other day which is actually to how do we get more effective broadcasting of media over mobile phones and that’s going to be made a lot easier under the 700 spectrum, so…

Alan Kohler: Do you know the extent to which you were outspending your competitors in mobile?

AP: In terms of capex?

AK: Yeah.

AP: Well our capex-to-sales ratio is 15 per cent at an overall organisational level. That is probably lower than a couple of our competitors but in terms of absolute spend we would be outspending, yes.

AK: And how much of your cash that you talked about came from the national broadband network this year? Or how much is coming from the NBN now?

AP: The income from the NBN that we reported in the half year was about $300 million. About half of that, however, was cash that was previously received and was just at amortisation. So about $150 million.

AK: And what does it rise to, sustainably, the cash from the NBN?

AP: It depends in terms of the rollout of the NBN. I think when I spoke to the market a couple of years ago, we were saying that at its peak it’s about $1 billion per annum but that’s when the NBN rollout gets to its peak level of rollout and that’s obviously not the situation.

AK: And how long does that go for?

AP: Well, the overall rollout you’d need to sort of refer to what NBN Co is currently saying but I think in the initial explanatory memorandum that we provided to the market that was estimated to be a 10-year period.

AK: Because what I’m trying to get to is that the number that’s always used in terms of what the NBN means in terms of money to Telstra is $11 billion, but that’s net present value of future cash flows, right? So what is the total dollar number that Telstra gets from the NBN in present-day dollar terms?

AP: You’re right, Alan, it’s a net present value calculation. But you’ve also got to remember the $11 billion is basically also compensatory because effectively what’s happening with Telstra is the government is seeking to renationalise the network and, as a consequence of that, we effectively will exit the wholesale part of our business and in recompense for that, and recompense for our assets, we receive some cash flows from the government. Now, what they turn out to be in terms of the physical numbers will depend on the timing of the rollout basically from a net present value point of view, and I couldn’t predict what the rollout is going to be.

AK: And anyway it’s changing now because you’re in a new set of negotiations.

AP: Yeah, so the timing will be, but from our point of view we’re happy to work very cooperatively with the government to meet whatever they need to meet their policy obligations, provided effectively the agreements that are in place – the economic value of those – don’t change for our shareholders.

AK: Have they agreed to that? You’ve started negotiations; have they said upfront ‘We agree, the number’s the number, $11 billion is your starting point’?

AP: Well, they said at the time of the policy announcement – both in the policy and also in the prime minister’s comments at the time – that they recognise that a very important principle is to keep our shareholders happy.

AK: I’m asking if they reaffirmed that when they started the negotiations.

AP: Well, I’m not sure that they needed to reaffirm it. I think it’s out there on the record that our shareholders are to be kept up and that’s absolutely the principle we’re working towards.

SB: In relation to the NBN, you always get asked about capital management and acquisitions and the like. You’ve got a free cash flow budget of $5 billion, all your debt covenants and interest cover and so on at or below your target ranges – so there’s balance sheet capacity there. Is it fair to say that you won’t be able to do anything fundamental in terms of balance sheet management, whether it’s acquisitions or capital management, until you’ve got that new NBN deal in place and you know what your future cash flows will look like?

AP: I think the framework allows us to basically manage regardless of whenever those contracts or those deals are renegotiated because we have strong free cash flow from the business and that’s enabled us to reinvest in the business. To Robert’s question earlier, we put an extra $500 million in the LTE network. We announced acquisitions with total investment $226 million in the first half of 2013 and we’re going to continue to invest. We recently announced the joint venture with Telecom Indonesia. We’re going to invest capital there. We’ve increased the dividend, so we’re pulling all of those levers.

SB: But with $2.5 billion worth of asset sales proceeds coming towards you, plus the free cash flows, plus the balance sheet capacity, you’re normally in a position to think about very large amounts of capital, you know, whether it be $5 billion or whatever. But presumably you can’t do that kind of magnitude of transaction, whether it’s capital management or whether it’s an acquisition, until you actually do know when you’re going to get cash from the NBN Co.

AP: Yeah. I’m not sure I agree, Stephen. I mean we’re managing the business around the things that we can control and the investments that we need to make. I mean we want to work cooperatively and quickly with the government to rework the agreements in a way in which it actually provides them the ability to implement the policy they want to implement and protect our shareholders, but we… you know, we have to manage within that and I think we can and we’re making those investment decisions, we’re making those acquisitions regardless.

RG: Andy, you’ve mentioned three industries that you wanted to expand into; one was e-health, one was global applications and platforms and the third was digital music. Could you tell me what your plan is for each of those? What’s the plan, for example, in e-health?

AP: Yeah, sure. Well look, the really interesting thing is that networks today are playing a really important role in increasing productivity across a range of dimensions, whether it be in business or whether it be with consumers. How we use networks today, how we use mobility today has changed dramatically and so there are a few areas that we see, as you mentioned, that are really important.

So, in e-health I think we all appreciate the health system, the infrastructure in the health system is not very efficient in terms of how it communicates with each other and within itself and then how it passes important medical records across… securely from practitioners to practitioners and so that’s the area that we’re investing in is how do we improve the effectiveness and the productivity of the health system by trying to help streamline some of that technology and enable that messaging to happen more freely. I couldn’t give you a prediction on the size of that and the scale of that market growing, but it’s… I think the scale of the market at the moment is about $4-6 billion per annum, so it’s a substantial market. In global applications – global applications is really about recognising that software is playing an increasingly important role in how networks operate. I’ll just give you one example. So, we’ve got an investment in a company called Kony. So, in any enterprise today, most enterprises today have apps that basically their customers can download. Banks would be a good example. So, a bank has got an app, so that customers can transact through the app. They have to develop those apps, but they have to develop them for different operating systems and those different operating systems include Microsoft’s Windows 8, iOS for Apple, Samsung and many of those operating systems actually have differences depending on the device, so if it’s a Samsung 3 or it’s an iPhone 5 or an iPhone 4. It is actually a quite complex exercise to basically be able to do all of that development. So, what Kony does, it has a single platform. You write the software once and then we distribute it across all mobile devices. So, that’s another really interesting area where software is playing a really crucial role in mobility. And then of course finally in digital media, media is clearly the one data or the one area that is actually driving a lot of the demand over the networks. So, again an important investment we’ve made in digital media is in Ooyala and Ooyala’s business is basically distributing media across an IP network, so its customers are people like ESPN or Fox or Disney and it’s how to do you distribute media effectively over multiple devices, and then, more importantly, how do you then communicate back to the customer, who’s watching what on what device at what time of day, so you can operate that much more efficiently.

RG: But in the music industry the rewards tended to go to the appliance makers or the telcos. Do you think that down the track in the media business, rewards will not go to the media companies as much as they’ll go to the telcos and appliance makers?

AP: No, not necessarily, Robert. I mean I think, you know, there is value in content and there is value in local content, so content continues to remain really, really important. What’s changing is how you distribute that content, so previously you may have just have had a linear broadcast of content over a satellite network or through a cable network. Increasingly, the Internet is playing a role in the distribution of content and not just for traditional content providers either, but even for businesses, for enterprises today, they’re using media and digital right the way across their enterprises, so there is definitely value to be accreted for people like telcos and people like us who are providing those services.

AK: Well, in digital media you could have bought Business Spectator, but you missed out.

(Laughter)

AK: Seriously, though, Telstra’s been talking about content for fifteen years. They’ve never gone anywhere with it, tried to get anywhere, never made any money out of it. I mean why is it going to be any different this time?

AP: Well, I’m not sure that we haven’t got anywhere with it. I mean in fact if you look at our most recent results, we sold 124,000 T boxes in the six months, pay TV. Paylite TV revenues are up 65 per cent. We’re seeing increasing movie downloads. BigPond Movies, we’ve now got 100,000 active users downloading three movies a month. So, we’re getting a lot of traction there and, of course, we also enjoy the investment with Foxtel, Foxtel’s launch, Foxtel Go, Foxtel Play. They’ve got the S-Blog platform coming up very soon and other plans to launch a triple play offering in the foreseeable future as well. So look, we’re doing a lot in the digital media space, but it’s not just actually us as a content owner. What is clear is that distributing media across IP networks is crucially important for all media providers, so today it’s not good enough just to provide even free-to-air just through a linear network, you need to be able to provide it via an app on an iPhone or an iPad, etc. And how you do that is a telecommunications challenge and problem, not a media challenge, so we’re investing in both parts.

AK: So, on that subject, do you think there will ever be a time, given the importance of IP networks for media, when the NBN will make money?

AP: Well, I think that’s a question you probably need to pose to the government or even the NBN Co.

AK: No, no, no. But you guys must have looked at… No, you look at this.

AP: Well, as I say, I think it’s a question for NBN Co and the government. But I mean I think the point is that media is one of the things that’s driving most of the volume of the traffic on the network, which is why it’s important for us to invest in technologies such as LTE broadcast, because they transmit data across the network far more efficiently than old technologies and we have to do that literally just to keep up with the growing demand.

AK: So, I suppose I’m wondering… You mightn’t be able to answer this either. But you’ve got the HFC network which according to policy the government is going to let you keep and operate as a wholesale network. So, given the importance of media now and distributing it, do you think that there’d be a cause for you to invest in it?

AP: Well, we have invested in it.

AK: And to grow it. I mean and to roll it out even further than you have.

AP: Well, what we have invested in the HFC network… Literally within the last two years we upgraded to DOCSIS 3.0. That was a significant investment. I use the cable network at home. I get great speeds off the network. I use it for Foxtel. I use it for broadband at home. So, it is just another asset that we have at Telstra which is actually about providing a great fixed broadband service for customers, so we definitely will continue to invest in it.

SB: You can get 100 megs on the cable downloads, but there are limited upload speeds. Is there a technology or is there an investment you could make to improve that because that’s the obvious criticism?

AP: Yeah. No, you can. I mean the physical infrastructure is there and certainly you can make investments to improve the upload speeds as well as the download speeds, like copper in the same way.

RG: You’ve been increasing your productivity. To what extent have those productivity improvements come about by outsourcing overseas call centres and other activities – IT activities. In other words, to what extent have you achieved productivity by taking the activity out of Australia and putting it offshore?

AP: Well, productivity is really first and foremost about actually improving your processes or changing your processes, but whether you do them in Australia or elsewhere in the end is just a temporary solution.

RG: It would fix the cost though of what you do?

AP: Well, it does, but only on a temporary basis. Really, fundamentally, what it is about is actually improving process at the grassroots level, at the core level, and so that’s what we’ve really been trying to do is actually improve the way in which we execute some of our processes. So whether it be a customer’s activation, whether it be dealing with an assurance problem or fault – eliminating the faults in the first place, whether it be basically enabling our customers to do more and more work online and more and more servicing online, which many do. There are multiple ways in which we can do it, so that is first and foremost what sits at the heart of our productivity efforts rather than location.

RG: But location is also part of it as well.

AP: Well, we operate right the way across the Asia Pacific. We make no apologies about that. And we provide service out of Australia. We provide service out of Asia as well.

SB: And you’ve identified network application services as one of the growth areas for Telstra and there’s significant growth occurring, nearly 30 per cent growth in revenue, but huge growth in head count, 700 more people, and costs. Is the long-term profile of that business as attractive as the other things in the portfolio?

AP: Well look, it’s… I think… So, you’re right, Stephen. We’ve invested heavily in that business. We’ve brought over about 350 people from Defence with Defence contracts, so that added head count. We’ve also invested in other head count. We’ve also taken on other large contracts. And it’s predominantly a services business, so it is a people in heavy business who are in fact are in terms of our overall productivity we’ve increased FTEs in the first half of this year and we’ve increased those in very skilled jobs in the NAS area, so but it is a different model. But importantly it’s a model that actually adds value to our core business as well because network application services is all about actually – how do we use our networks in a way that actually helps our customers improve their productivity? So, for example, it may be by helping our customers take some of their operations to the cloud, so we offer cloud solutions as well. Cloud was up nearly 30 per cent for managed data networks, so that’s actually rather than just providing customers with physical infrastructure to run privately owned enterprise networks to actually do the management and the servicing of those. That was up 65 per cent. So, it’s a different economic model. It’s a lower EBITDA margin, but with a lower capital intensity, but importantly it actually supports the rest of our business as well.

RG: What will the Telstra business look like in five years? Would it be fundamentally different? With all these things taking place, are we going to be looking at a totally different sort of business? It’ll be a telecom, of course, but how’s it going to change?

AP: I think the rate of pace of innovation in technology and in telecommunications as well is increasing; it’s not slowing down and I think you see that every new generation of iPhone that comes out or tablet that comes out. And the role that it plays both in our private lives, but also the opportunity for productivity improvement… In fact, we were just talking about cloud. The rate and pace of the growth of cloud or the opportunity in cloud is just phenomenal for businesses to improve productivity. So, I think what you’ll see Telstra become is increasingly, you know, a technology led… a great Australian technology led organisation and I think the opportunity for it to continue to be at the forefront of innovation in that space is tremendous. It makes it a great place to work.

AK: We’ll leave it there. Thanks very much, Andy.

AP: Thanks very much, Alan.

SB: Thanks, Andy.

AP: Thanks, guys.