The incredible shrinking Telstra

For most of the past decade the challenge for Telstra's management has been to slow the inexorable decline in its traditional fixed line revenues while offsetting them with growth in its broadband and wireless offerings. In the December half the accelerating structural changes in telecommunications overwhelmed it.

A 6.9 per cent fall in revenue from the public switched telephone network (PSTN) – Telstra's legacy copper network – led to a 2.5 per cent fall in the group's overall revenues. Revenue gains in fixed line broadband and its mobile business weren't sufficient to offset the $222 million decline in PSTN revenues (Interview: Telstra skips a beat, February 11).

The rate of decline in the PSTN has steepened – in the preceding six months PSTN revenue was down 4.8 per cent – and that acceleration appears to have taken Telstra management by surprise.

There was a note of resignation in David Thodey's voice when he discussed the PSTN, which now accounts for only 24 per cent of Telstra's revenues versus 30 per cent only three years ago.

With consumers increasingly using wireless – about 10 per cent of Australian homes no longer have a fixed line – fixed line broadband growth flattening and voice volumes being displaced by lower-margin SMS and email communication, there is a sense of inevitability in the continuing implosion in the PSTN.

The impact of the decline is being exacerbated by fierce price-led competition as its rivals seek to grow their customer bases in anticipation of the roll-out of the national broadband network.

Disconcertingly for Telstra, while its mobile business grew revenue by 4.7 per cent Thodey conceded that, as in fixed-line retail broadband, it had lost market share. That's partly because Optus made an insightful call on the impact that smart phones, particularly the iPhone, would have on the market and backed its judgment with very aggressive pricing (Winning the iPhone war, November 11, 2009).

Telstra, trying to balance volume, share and profitability – and hampered by its inability to re-price its offerings quickly because of the well-chronicled problems with its new IT platforms – was slow to respond, although more recently it has been fighting back.

Thodey is clearly concerned about the erosion of Telstra's retail dominance, restructuring the management of the group's consumer-facing businesses late last year and rolling out new and more competitive products and offers.

The December half performance does, however, raise a legitimate question of whether Telstra's management has been distracted and destabilised by the abrupt and brutal regime change that occurred last year in the wake of the federal government's declaration of war on the group and the ensuing difficult and threatening negotiations over the NBN (The NBN terms of engagement, December 18, 2009; A coalition of Telstra's willing, December 18, 2009; and A huge rethink for Telstra, Decmber 11, 2009).

While the weak top line performance – sales declined right across the group's businesses – appeared to shock analysts, there were some significant positives in the result.

Very good cost control and the continuing tapering off of capital spending – now that Telstra is nearing the end of former chief executive Sol Trujillo's massive transformation program – meant that the bottom line performance, but more particularly the group's cash flow generation, was very respectable in the circumstances.

Telstra did still invest $1.6 billion in its businesses in the first half but a 37 per cent increase in free cash flow, to $2.6 billion, enabled Thodey to reaffirm his target of $6 billion of free cash flow for the full year.

The other elements of his guidance – continuing declines in sales revenues, low single digit growth in earnings and stable margins – underscore the difficulty of trying to manage against the erosion of the PSTN and of juggling the relationship between sales growth and margins.

Thodey's task is further complicated by the continuing uncertainty about the impact of the NBN – Telstra is still in discussion/negotiations with NBNCo and the federal government but had nothing material to report today – which means he has to position the group so that it can either cooperate with the NBN or compete with it.

That may help explain why, to the displeasure of at least one analyst, Telstra only maintained dividend despite the surge in free cash flows. For Thodey and Telstra, financial firepower and flexibility equates to options.

If Thodey wants to prevent the shrinkage of the PSTN from shrinking Telstra itself, he may soon have to exercise some to regain some real momentum and win back share in the markets where there is growth.