Jenny Ruth: There's life after Telecom for GDC

COMMENT

The future is no longer looking quite so grim for GDC Communications, but it still faces an uphill struggle.

The last time I looked at the company, in April, it could only talk about the possibilities of replacing at least some of the almost $40 million in revenue it is losing as its Telecom network maintenance contracts expire.

Last December, Telecom said it was cutting its maintenance contractors from four to two. For GDC, losing the contracts meant losing its mainstay and only profitable part of its business. Its total revenue last year was $56.8 million.

It has since regained a quarter - $10 million - of what it lost in revenue from subcontracting to the two companies now providing Telecom's maintenance, Downer and Areva (formerly Alstom).

As the initial shock of losing the main contracts wore off, GDC had pinned its hopes on its claim to be the most efficient service provider.

Given that it has acknowledged it wasn't one of the two lowest-priced tenderers to become one of the main contractors, you'd have to think the subcontracting work the company has picked up, which runs through to 2008, will be at particularly sharp profit margins.

Nevertheless, managing director Geoff Lawrie says the contracts will still be profitable. And he still hopes to pick up more work, estimating that ongoing contract revenue should be between $12 million and $15 million by the end of the year.

He says that after losing the Telecom contracts, the company decided it needed a minimum of $10 million in revenue to allow it to retain critical mass. But it has had to dramatically cut costs to make that amount of business viable.

Staff in the contracting division have fallen from 350 to about 160.

Not all of GDC's new business will come from Telecom, but most will. Lawrie estimates Telecom accounts for about 80 per cent of the available work.

Still, "there are other companies doing some interesting things that we're working with. They're nowhere on the scale of Telecom. This has enabled us to operate with a degree of independence that we didn't have before."

The full impact of losing the Telecom contracts won't show up in GDC's results until after the first half of next year. It lost the first contracts last month and the others expire in April.

GDC claims gains in its other two divisions, voice solutions - which sells PABX and other telephone systems and services to businesses - and the technology division, which sells services such as leasing software, server hosting and network infrastructure on a subscription basis (known as an applications service provider or ASP).

But that wasn't readily apparent in this year's first-half results.

Revenue in the six months to June fell 5.7 per cent to $25.7 million, earnings before interest, tax, depreciation and amortisation dropped 40 per cent to $1.34 million and the bottom-line loss doubled from $344,000 loss in the same period a year earlier to $686,000.

Lawrie says the loss of revenue reflects a number of factors including that the Telecom contracts contained "sinking lid" clauses on the basic contracted work. But there was also discretionary network building work, such as connecting up new subdivisions, associated with the contracts which GDC used to get in the geographic areas its maintenance contracts covered but which is now going to the other two main contractors.

The sinking lid clauses also meant a natural squeeze on margins as the company did the same amount of work for less revenue.

And GDC also introduced a staff retention scheme to ensure it could keep enough workers to complete its existing contracts and make it possible for it to remain viable.

"If we hadn't done that, we would've been out of this business."

Lawrie talks about the need to put aside any animosity the company might harbour towards Telecom. Animosity would be understandable, particularly since Telecom had named GDC its service company of the year in 2002.

GDC's relationship with Telecom is "multi-dimensional and quite complex", given that it still sells Telecom services through its voice solutions division and that, in other areas, it competes against Telecom.

But Lawrie says he doesn't think the contracting industry is sustainable in its present shape.

"Price, demand and quality are not in equilibrium," he told the annual shareholders' meeting in May.

"Under the rates prevailing at the moment, I find it impossible to understand how the business can sustain quality and service levels."

In particular, skilled technicians are leaving the industry. "You can make more money driving a truck than being a skilled telecommunications contractor these days."

So something has to give? Lawrie doesn't answer the question directly but does say: "The expectation that there are going to be ongoing changes in this industry is one of the reasons why we've decided to stay in it. If you're a very efficient, low-cost provider, there are always opportunities in a competitive market."

Lawrie also says Telecom has "never been able to grasp the notion of partnership". That's unlike even IT giants such as Microsoft. He makes this claim despite Microsoft's well-publicised antitrust problems in the US and Europe. (Lawrie was Microsoft's New Zealand managing director before joining GDC in 2002.)

"There are literally tens of thousands of companies that make their money around Microsoft," he says.

GDC expresses the hope that Telecom will "act like a mature industry participant" in the ASP market. Lawrie agrees to the suggestion that Telecom could use its clout to start a price war.

"We've always got to be conscious of their ability to do things at a price and bundling level that we simply can't match." Telecom had previously been a reseller of GDC's ASP service.

The first-half results do show GDC's ASP division isn't growing quite as fast as it would like. Its revenue rose 45 per cent over the previous first-half. But the annual report talked about the ASP division matching last year's 70 per cent growth in revenue.

If that could be achieved, the division would be making a positive ebitda contribution and be close to break-even on a monthly basis at the bottom line by year's end.

"We haven't grown that business as strongly as we wanted to in the first half," Lawrie admits, but says the company has a strong focus on growth and customer acquisition.

GDC is aiming to raise a little over $3 million in fresh capital through its four-for-five rights issue.

Its balance sheet at June 30 shows total liabilities of just under $12 million against $21.9 million in total assets, which doesn't look that stretched.

However, all of its borrowings, $4.2 million including its overdraft, fall due within a year and the rights issue prospectus points out that the company "was in breach of one of its covenants applying to its bank facility" at December 31 last year.

That suggests its banker, Westpac, is anxious to get its money back and may not believe in the company's future.

Lawrie says although Westpac "had a particular interest" in seeing how GDC copes with the loss of the Telecom contracts, all the company's forecasts show it will be consistently cashflow-positive. Net cashflow from operations in the latest six months was $943,000, and $1.1 million for 2003, despite the bottom-line losses reported.

Lawrie says the company will also continue to produce positive ebitda results.

Although the rights issue proceeds will be used to repay bank debt, the company is also talking about acquisitions of related businesses in the medium term.