Telstra feels its way

Even with all the competition and lower prices, the company turned in high underlying earnings growth of 9% to give an after-tax profit figure of $2.1bn.

The two main drivers of this were continued strong growth in demand for telecom services and the 'new' economy divisions of mobile, internet and data lines.

Cost cutting

Apart from that, it was cost cutting which kept the company on track – important enough but lacking a bit in the vision thing. CEO Ziggy Switkowski says cost cuts of $193m fed into the December half profit and the target is $550m in savings for the full year and even greater cuts next year. This will mean job cuts – which won't make him very popular in an election year – and more contracting out of non-core services.

As good as the result looks on the surface, we would like to note two things. Growth in demand for telecom services while still growing, has slowed considerably. We're betting that with a slowing economy growth will be even lower in the next six to 12 months.

In addition to this, Telstra's revenues from traditional services - local calls, long distance and international fell by nearly 3% - higher than the average annual fall any year since the company lost its monopoly position.

Our fear is that, while the company is more than making up for those falls with new sector growth (where sales rose 33%), it faces enormous competition. Income from these high tech sectors may be less reliable and stable than the old Telstra cash cows.

Much depends on Telstra's ability to leverage growth in Asia. On paper the opportunities look good. The markets there are opening up and the lower prices of telco assets worldwide mean cheaper access for the Australian company.

Our concerns, however, are the same as we have always had – Ziggy's choice of Asian partner, Richard Li Tzar-kai and his Pacific Century CyberWorks (PCCW). Li's company is less than two years old and Li has got as far as he has on two things: the huge start he had by being Li Ka-shing's son and by riding the internet bubble.

PCCW's stock code in Hong Kong is 008. To the Chinese, eight is a very lucky number, but last year it failed the younger Li. Rising debt levels and a crashing internet sector combined to punish his stock, a position that won't be easy to reverse.

Since the technology stock crash of last year, the company increasingly looks like it lacks a clear strategy. It has faced setback after setback including being forced to reduce by a quarter the size of a US$2bn loan it was seeking for its internet venture with Telstra after the banks baulked. It has lost several joint venture partners and has seen its ailing broadband TV subsidiary Network of the World (NOW) fail.

But most painful for the young Li, was his father having to ride to his rescue late February when Hutchison Whampoa- headed by Li Ka-shing- signed an $803.4m asset swap with PCCW. The deal left Hutchison with 0.8% of PCCW.

The boy has been giving Li Ka-shing headaches for a while. He failed to tell his father ahead of PCCW's US$38bn takeover of Hong Kong Telecom and the old man was so furious he didn't talk to Richard for days. The feud was so serious it had to be settled by a close family friend.

Telstra will welcome the arrival of Li Ka-shing who will, hopefully, become a buyer of the 15% of PCCW which former owner Cable & Wireless wants to dump. But after that, Ziggy may find the going a bit tougher. They are, after all, in competition with Li Ka-shing in the mobile business in Hong Kong and, while the wily old man may have sentimental reasons for helping his son, that won't hold true for uppity gweilos- as the Chinese call foreigners- trying to get a slice of his hometown action.

The wrong horse

Ziggy, it has always seemed to us, backed the wrong horse.The problem is it was a big bet and curtails the company's ability to manoeuvre into new- and inevitably costly- deals with other partners.

Telstra's main project on the drawing board with Li is to build a fibre-optic Internet backphone to be called Reach. This idea encapsulates many of the problems of the telecom industry in general, in particular falling prices and sky-high expenditure.

Gerry Moriarty, Telstra's group managing director for infrastructure services and wholesale and chairman of Reach, says the company could spend 10% to 15% of sales on capital investment as prices charged by Reach would fall as competition remained strong.

Telstra has forecast sales of US$165m- we shall see. Meanwhile Ziggy may be reflecting that he should have gone with age and experience rather than youth, hope and hype for his Asian adventure.

In issue 74 (Hold- $6.45), as part of the discussion of our new defensive portfolio, we recommended you hold Telstra while directionless. Little has happened to change our mind. Telstra, of course, will continue to provide good dividend streams, the sad thing is it could be doing so much more. HOLD WHILE DIRECTIONLESS.