Telecom shift a dilemma for Gattung

By BRIAN GAYNOR

Theresa Gattung is in the hot seat. Faced with increasing domestic competition, she has to transform Telecom from a predominantly New Zealand organisation into a growth-oriented international group.

The initial response to this change in direction, which was announced on Tuesday, was negative, with the stock closing down 40c for the week at 705c.

Growth-oriented investors are not convinced that the new blueprint will be successful and income-bias shareholders are unhappy with the dividend cut.

There is a strong argument that the new strategy should have been adopted years ago. The American/New Zealand consortium that controlled the company until 1998 placed too much emphasis on a high dividend payment and too little on the long-term growth of the group.

When the Ameritech/Bell Atlantic/Fay, Richwhite, Gibbs, Farmer syndicate bought Telecom for $4.25 billion in July 1990, it was a relatively bloated organisation with historical net earnings of just $257 million.

Their main objective was to raise earnings by consolidating its dominant position in the domestic market and slashing costs. This was a low-risk defensive policy that facilitated a high dividend payout.

The strategy was successful, particularly as far as its share price performance was concerned. In the first five years of privatisation, staff numbers were cut from 16,260 to 8570 and other costs reduced.

Telecom also capitalised on its semi-monopolistic position in the traditional telephone business and took early advantage of the growth in mobile phones.

In the five years ended March 1995, net profit grew to $620 million and the dividend payout from 77 to 91 per cent.

But there were a number of negative signals. The group's Pacific Star Australian investments recorded huge losses and had to be shut, and its dominant domestic position was being eroded by increased competition. Telecom became a price-taker rather than a price-maker in many of its core activities, particularly international calls.

Earnings growth slowed in 1997 and at the end of the year the two main United States shareholders, Ameritech and Bell Atlantic, announced they were quitting.

Their timing was superb. Ameritech bailed out at $8.85 a share and Bell Atlantic at a similar price through a complicated exchangeable bond offering. The American/New Zealand consortium realised a total profit of $7.2 billion, excluding dividends, on its Telecom investment.

Their legacy was a company in a relatively weak position to achieve long-term sustainable growth. It had completed its cost-cutting programme, was facing more competition in its domestic economy and had very limited offshore growth plans.

Its sharemarket rating was high because of the huge dividend payout and capital repayment and share buy-back schemes.

The low level of capital expenditure has had a serious impact on the company's network. Many of its switches and cables are old and unable to handle internet traffic. Much greater internet speed is achieved in the United States and Europe because of superior transmission network quality.

The company recently admitted that it would have to spend plenty to upgrade its network - or lose internet customers to wireless operators once wireless becomes cheaper and has a wider coverage.

Telecom has been slow to recognise that the high dividend/low investment policies of the American/New Zealand consortium would have a negative long-term impact on its share price performance.

Last year, the company took its first step in a new direction with the $1.57 billion acquisition of 80 per cent of AAPT, the fast-growing Australian telecommunications company.

This purchase, which was debt-funded, had a negative impact on the group's balance sheet and Standard & Poors downgraded its credit rating.

The results for the June 2000 year showed the impact of the partial shift from low to high-growth strategy. Net profit declined from $834 million to $783 million, the lowest level since 1996/97.

Analysts were quick to claim that the result was in line with forecasts, but 12 months ago their consensus forecast for the June 2000 year was $881 million, and many were expecting a profit in excess of $900 million.

This is the second year running that Telecom has substantially under-achieved on early profit forecasts.

The AAPT investment had a net negative impact of $63 million, with Telecom's share of AAPT earnings more than offset by amortisation of goodwill and funding costs.

Telecom maintained its dividend at 46c a share, even though AAPT does not pay any dividend.

In the domestic market, registered users of the Xtra internet service grew 39 per cent to 287,000 and cellphone connections by 45 per cent to 980,600. But Xtra is under pressure from free internet providers and Telecom's cellphone operation is facing intense competition from Vodafone.

In recent months Vodafone has added more new customers and its total market share has risen to one-third.

On Tuesday, Telecom said it was switching from an income to a growth stock. Consistent with this policy change, an offer will be made for the remaining 20 per cent of AAPT, capital expenditure will be substantially increased and the dividend payout cut from 100 to 50 per cent.

The dividend reduction was inevitable because Telecom is faced with huge expenditure in the current year. The remaining 20 per cent of AAPT will cost $A444 million ($581 million) and $1 billion will be spent on capital expenditure in New Zealand and $A500 million by AAPT in Australia.

Tuesday's announcement concluded Telecom's compliance with the questionable policies of the American/New Zealand consortium. It now has an aggressive Australasian growth strategy, a realistic dividend policy and a catch-up capital expenditure programme.

But a simple analysis of the AAPT acquisition shows that the new policies are high-risk and there is no guarantee that they will be successful.

The annual interest cost associated with the AAPT acquisition is $140 million, assuming a rate of 7 per cent. As AAPT is expected to achieve little better than break-even in the 2000/01 year - because of additional interest costs, depreciation and amortisation associated with its aggressive expansion plans - the investment will continue to be a drag on Telecom's earnings.

Herein lies the dilemma for Theresa Gattung and her relatively inexperienced management team. The expansion into Australia is unavoidable but it comes at a time when the group has been weakened by the high-dividend/low-investment policies of the 1990s.

In the short term, Telecom's earnings will fall, because profit growth in New Zealand will not be sufficient to compensate for the negative impact of the AAPT acquisition.

In the medium to longer term, the group's share price performance will be heavily dependent on the success of its Australian growth strategy.

Analysts remain confident that Telecom will succeed even though the group is expected to report lower earnings for the June 2001 year and cut its dividend from 46c a share to the 20c to 24c range.

Most broking houses have maintained a hold or a buy recommendation on the stock.

One thing is certain: Telecom's share price will remain highly volatile until its long-term outlook becomes clearer. In the meantime, the stock will offer excellent short-term trading opportunities as opinions on its long-term prospects swing between positive and negative.

Disclosure of interest: Brian Gaynor is a Telecom shareholder.