Brian Gaynor: Telco investing? Get the right number

Australian and New Zealand investors must decide in the next few weeks whether to participate in the latest Telstra share offer.

The decision is complex for New Zealand investors because they have to consider several issues, including whether Telstra is a better proposition than investment in Telecom at current market levels.

The outcome of the Telstra versus Telecom debate will depend on several issues, including the earnings outlook for each company, the regulatory environment and the dividend yields adjusted for franking credits and imputation credits.

Telstra's privatisation started in November 1997 when the Australian Government sold 4.29 billion shares (33.3 per cent of the company) to 1.8 million investors at A$3.30 a share.

The issue was in the form of instalment receipts with A$1.95 (A$2 for institutional investors) paid in November 1997 and the remaining A$1.35 (A$1.40 for institutions) in November 1998.

Investors in this sale did particularly well, as the company's share price peaked at A$9.20 in February 1999.

In October 1999, the Government sold another 16.6 per cent at A$7.40 a share to reduce its holding to 50.1 per cent.

This was also in the form of instalment receipts, with A$4.50 (A$4.75 for institutional investors) payable immediately and A$2.90 (A$3.05 for institutions) payable in November 2000.

It is important to note that New Zealand retail investors paid the same amount as institutional investors in both sales.

One of the selling points of the second was that the full dividend was payable on the instalment receipts. Unfortunately this did not compensate for the decline in Telstra's share price, which closed at A$6.35 - compared with the issue price of A$7.40 - on the final payment date.

The Government's third offer, which closes on Thursday November 9, will dispose of 2.15 billion shares or 17.3 per cent of the company.

The remaining 4.3 billion shares or 32.8 per cent will be placed in the Future Fund, the Australian equivalent of the New Zealand Superannuation Fund.

The sale has several features, including:

* The issue is in the form of instalment receipts with the first payment of A$2 (A$2.10 for institutions) due on November 9. As with the previous sales, New Zealand retail investors will pay the same amount as institutional investors.

* The final instalment is due on May 29, 2008. The amount payable, estimated to be about A$1.50, will be determined by the institutional offer next month and will be announced on November 20.

* Holders of the instalment receipts will get the full dividend of A28c a year. At the purchase price of A$2.10 this is a yield of 13.3 per cent to New Zealand investors before tax (NZ residents will not get imputation credits).

* Australian retail investors will receive a loyalty bonus of one new share for every 25 instalment receipts held and paid in full. The bonus will not be issued to New Zealand investors.

The first point to note about the latest sale is that it is strongly oriented towards Australian retail investors.

No other group receives the A10c discount or the 1 for 25 bonus issue.

Telstra's pitch to Australian retail investors has been successful, as it has 1,515,000 domestic shareholders - 7.3 per cent of the country's population.

Telecom has 50,500 shareholders - 1.2 per cent of New Zealand's population.

The second issue to note about Telstra is its business mix and ebitda (earnings before interest, tax depreciation and amortisation) margins.

Telstra makes only 33 per cent of its revenue from its "public switched telephone network" - the traditional monopoly fixed-line rental and local and long-distance calling operations - compared with 48 per cent by Telecom in New Zealand.

Telcos tend to protect their telephone network operations for as long as possible because they produce higher margins and usually require less capital expenditure than other parts of their business.

Telecom is a classic example of this, as it generates an ebitda margin of nearly 60 per cent from its fixed-line business - one of the highest margins in the world - but a much slimmer 35 per cent margin from its mobile operations.

Telecom's overall ebitda margin (excluding its AAPT operations in Australia) was 49.3 per cent in the year to June, compared with 42.1 per cent for Telstra and a mean of 40 per cent for 45 of the world's largest telcos.

Telecom was too protective of its public switched telephone network business and too slow to invest in broadband.

As a result it has been hit with draconian regulations that are forcing it to make substantial investments in broadband.

The company will also face greater competition in this area and in mobile phone operations.

These regulatory measures are broadly consistent with worldwide trends, including in Australia. These have implications for Telecom and Telstra including:

* Their traditional high margin fixed-line business is in decline

* There is a big switch to mobile and internet/broadband where telcos face much stronger competition, falling prices and lower margins

* Most companies faces declining revenue and static margins or static revenue and declining margins.

The end result is that telcos have an uncertain earnings outlook and trade on relatively low price/earnings multiples and high dividend yields throughout the world.

So there is little reason to invest in these companies unless they are particularly undervalued or have an innovative and entrepreneurial management team.

Telecom's net earnings are expected to fall from $820 million before unusual items for the year to June, to $800 million for the current year and $780 million for 2007/08.

This gives it a prospective 2007 price/earnings multiple of 10.8 and 11.5 for the following year.

The earnings outlook for Telstra is slightly more encouraging as it is less reliant on traditional fixed-line operations and its ebitda margin has already fallen to the low 40 per cent range.

Telstra's earnings are expected to rise from just under A$3.2 billion for the year to June year to just over $3.2 billion in the current year to $3.3 billion in 2007/08.

In dividends, Telecom is expected to pay 31c for the June 2007 year and Telstra A28c.

For New Zealand investors on a 33 per cent marginal tax rate, Telecom has a gross dividend yield of 10.3 per cent. Telstra's ordinary shares yield 7.3 per cent and its instalment receipts 13.3 per cent.

There is no compelling reason for New Zealand individuals to invest in the latest Telstra offering, particularly as they won't receive the A10c discount, the 1 for 25 bonus issue, or New Zealand imputation credits.

Telecom has struggled in recent years because of its inflexible approach towards deregulation and competition and the disastrous purchase of AAPT in Australia.

Sentiment towards the company has been more positive since Wayne Boyd became chairman in mid-year.

Boyd has started on strong note but he need to make many more changes before Telecom becomes an attractive investment for New Zealanders.

* Disclosure of interest: Brian Gaynor is an investment strategist and analyst at Milford Asset Management and a Telecom shareholder.