Telecom NZ on the ropes

Telecom New Zealand’s 2005 annual report makes an interesting read. The board asked its 8,560 staff members what they thought the business would be like in the future. The responses received were ‘inspiring, incredibly exciting and perhaps a little scary’. It’s that last adjective that worries us.

Telecom NZ has many of the same problems as Telstra. With Telstra, however, we feel we have a clear understanding of the direction it is heading, how it will deal with its problems and how far down that track it has progressed already. Telecom NZ, however, is being dragged kicking and screaming into the 21st century by the New Zealand government. For the time being at least, we have no such clarity.

Telecom NZ was spun off from the New Zealand Post Office in 1987, fully privatised in 1990, and listed on the New Zealand, Australian and New York stock exchanges in 1991. The ‘90s telco boom dragged Telecom NZ along with it. From a $2.00 listing price (all figures are NZ dollars unless otherwise stated), the shares were changing hands for more than $9.00 in 1999 (although shareholders only owned four shares for every five they originally held due to a 1994 consolidation). Investors thought the company could do no wrong and so, it seems, did management.

Management blindsided

In comparison with the regular spring cleaning at Australia’s own former telecoms monopoly, the board and senior management at Telecom NZ has been remarkably stable—at least until now. Dr Roderick Deane has recently announced his retirement, but was chief executive until 1999 and has been chairman since. He is also chairman of Fletcher Building and sits on the boards of ANZ Bank and Woolworths —a hefty workload for the chairman of a company undergoing radical change.

When Dr Deane made the move from CEO to chairman, he handed the reigns to then 37-year-old Theresa Gattung. Gattung was an internal appointment—often a sign of depth in a company’s senior management—and was seen as the person to lead the company into the ‘information age’. Things haven’t worked out as planned though.

An expensive acquisition turned out to be a lemon and recent unfavourable regulatory decisions seem to have completely blindsided management, not to mention the share price. As Deane handed the baton to Gattung in October 1999, investors’ love affair with the telecommunications sector was about to come to an end—but not before Telecom NZ could participate in the folly.

In September 1999, Telecom NZ launched a takeover bid for Australian telecommunications company AAPT, valuing the company at A$1.5bn, and it ended up with 80% of the shares. When Telecom NZ bought the final 20% for A$444m in August 2000, AAPT wasn’t making any money but was expected to ‘make a positive contribution to the group’s earnings in two or three years.’ Unfortunately, its loss-making status hasn’t been called into question in the six years since—and that’s before the interest costs related to the purchase are taken into account.

Management finally took its medicine this financial year and wrote down the value of AAPT by $A836m. With Telstra turning the screws on resellers, we doubt it is worth the lower amount, but time will tell. Dr Deane’s retirement apparently had nothing to do with this disastrous investment, but it should have had.

Regulatory right hook

Like Telstra in Australia, Telecom NZ owns the vast majority of telecommunications infrastructure in New Zealand. If anyone else wants to provide services, they have to pay Telecom NZ to use its equipment. The regulatory environment, though, has been perceived as more benign and clearer than Australia’s and, accordingly, Telecom NZ has been preferred to Telstra by many investors. That has all changed in the past month.

The New Zealand government is concerned that its lax regulatory environment is impeding competition and holding back the take-up of broadband and other new technologies: ‘The Government has become increasingly concerned about the significant gap in broadband internet performance between New Zealand and leading OECD countries. Today’s pre-Budget announcements on telecommunications are designed to overcome the problem.’ Overcoming the problem will cost Telecom NZ.

The government’s main proposal is to decouple the local loop from the rest of the telecommunications infrastructure. ‘Unbundled local loop’ is something we hear a lot about in Australia: it means that the copper wire linking customers to the local exchange is separated, from a regulatory perspective, from the rest of the network. Competitors will be able to place their own equipment in the exchanges and offer broadband connection services to customers, just as they can in Australia. The change will spark more direct broadband competition, but it will also accelerate a reduction in fixed-line revenues. And, as you can see from the attached table, fixed-line revenue is even more important to Telecom NZ than it is to Telstra. And we’ve seen the effect a reduction in this revenue can have on overall profitability.

It is difficult to see how Telecom NZ could have avoided this regulatory blow, but management’s preparation for a more competitive environment could certainly have been more advanced. That, however, would have involved rolling out new broadband networks and attacking its own existing highly profitable business. Even some of our favourite management teams, such as Graham Turner and his Flight Centre crew, find that extremely difficult.

Taking it on the chin

That all sounds like pretty bad news and you might be wondering why we’re writing this review. The answer is simple: the stock has been smashed from A$5.56 in January to A$3.76 today. Combine a smashed share price with a business that is almost certain to be making reasonable profits in 10 years’ time, and our adrenalin starts to rush. So how does the current price stack up against the business value?

The current price is 11 times last year’s earnings and less than 9 times free cash flow. Return on equity is exceptional. The current dividend yield is 10.1%—although Australian investors can’t claim imputation credits—and included in the profit is a loss-making business (AAPT) that is at least worth something. This last factor has been a good indicator of opportunities for us in the past. If Telecom NZ can sell AAPT (which it has indicated it is trying to do) it will get some cash and its earnings will increase.

Looking in the rear-view mirror, the price to value equation looks pretty good. But analysing the past is only useful in as much as it helps point to the future and, even armed with all this history, our vision out the front window is, well, a little scary.

How will management react to the new regulatory environment? How severely will it affect profits one, two and five years into the future? What sort of capital expenditure will be required to achieve the Government’s aims? We just don’t know the answer to these questions, and, for the time being at least, the share price isn’t low enough for us to take on the unknown.

It’s definitely one to keep on your radar screen, though, and we’ll be doing the same. For now, though, we suggest you AVOID.

Steve Johnson