Telstra versus Telecom NZ

Well, the comparative chart below shows the ugly story of the last three years. As you can see, both stocks have lost significant percentages of their value, although Telecom has fared marginally better than its Australian counterpart.

Given that we have an outright Buy recommendation on Telstra and a negative view of Telecom, an explanation is in order. On the surface, the similarities between these companies are many. But there are differences, one of which is extremely important in our view. And that is financing.

In the table on the facing page we've picked out some key ratios to illustrate this point. The most common ratio measuring debt levels is net debt-to-equity. This shows how much debt a company owes to borrowers (after subtracting cash on hand) compared to the equity owned by shareholders.

The appropriate ratio really depends on the business and industry. In general, strong companies with plenty of cash flow like these two can safely manage a higher debt level than a cyclical company like Abigroup (see page 15). But you can see that Telstra's ratio of 90%, while not low, is much more conservative than Telecom's at 416%.

Interest cover is another measure of financial strength we like to use. This ratio is all about measuring how many times the company is able to pay, or 'cover', its interest bill.

Two kinds of interest cover are shown in the table. The first is 'cash interest cover', which takes the amount of actual cash generated from operations before interest is paid and divides it by the amount of cash paid in interest over the year.

The second is accounting interest cover, usually just referred to as 'interest cover'. This ratio divides earnings before interest and tax (EBIT) by the amount of interest the company racked up throughout the year.

You can see that on both measures Telstra scores far better than its cousin across the Tasman. And that's a key reason why, despite a lacklustre management team, we're happy to recommend Telstra – it's difficult to imagine the company getting into serious financial strife any time soon.

Having said that, the stock has fallen 10% since issue 112/Sep 02 (Buy - $4.87). In that review we mentioned that Foxtel (50%-owned by Telstra) had a proposal before the Australian Competition and Consumer Commission to 'restructure' the pay TV industry.

The cheer from Telstra and its Foxtel partners News Corp and Publishing & Broadcasting was almost audible on 13 November when the deal received a tick from the regulator. The decision has cleared the way for a content sharing arrangement with competitor Optus and a 'bundling' of telephone, internet, broadband and Foxtel services.

In theory, an amalgamated bill will make customers more loyal. It will also enable higher prices to be charged as most consumers will struggle to unscramble their monthly accounts.

Telstra's CEO Dr Ziggy Switkowski, being a bona fide rocket scientist, is likely to be one of the few people in the country who will actually be able to calculate how much he is being slugged. Not that his monthly bill is likely to put much of a dent in the $2.69m he took home in 2002.

Meanwhile, the corporate news over in New Zealand hasn't been as good. While the stock price has moved up since our last full review in issue 92/Nov 01  (Sell/Switch to Telstra - $3.93) we did get something right in that review.

And that was our prediction about the pile of goodwill on Telecom's balance sheet relating to its purchase of Aussie phone company AAPT.

In the year ended 30 June 2002, $862m of write-downs forced Telecom into the red with an accounting loss of $188m being recorded.

In the annual report, chairman Roderick Deane made some soothing comments about the write-down having 'no impact on our cash position'.

Technically, that's true. But had that ill-fated acquisition not taken place, that capital – about 50 cents per share - could have been in shareholders' pockets, in the form of a special dividend for example.

Instead, by the board's own admission, it overpaid for AAPT by that much. Needless to say AAPT shareholders must be laughing themselves silly. That being the case, we'd like to see a little more contrition from Telecom's board and management.

At the end of the day there are many similarities between these stocks. But two important differences have led us to make opposing recommendations. The first is financing, which we've already discussed. The second is price.

Not expensive

At these levels Telecom isn't expensive but Telstra looks downright cheap, as we've been saying for sometime.

It offers a fully-franked dividend yield of 5% and a PER of 15.4, which is modest for such a dominant company (note Telecom doesn't have a PER this year because it made a loss).

That's why we continue to rate Telstra a good BUY , despite the 'stock overhang' as a result of the possible, but apparently delayed, sale of some of the Government's remaining stake.

That doesn't worry us nor other long-term investors. Telecom shares are down a little since last issue (Sell/Switch to Telstra - $4.26) after going ex-dividend on 25 November. SELL and SWITCH to Telstra.