Download Telstra Financial and Economic Profit Analysis

Telstra Financial and Economic
Profit Analysis
A Report to the ACCC
Imy Rahaman
Jim Holmes
Version 3.3
31 October 2001
CYHO4
2
Contents
Contents ........................................................................................................................2
Introduction....................................................................................................................3
Executive Summary.......................................................................................................4
1. Financial Review .......................................................................................................5
1.1 Telstra ..................................................................................................................5
1.2 Benchmarking....................................................................................................10
2. Economic Profit .......................................................................................................19
2.1 Basis of Preparation ..........................................................................................19
2.2 Interpretation of Results.....................................................................................20
3. Limitations and Suggestions for Further Work ........................................................22
Appendix – Information Sources .................................................................................23
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Introduction
We are pleased to present our report to the ACCC, which has asked Ovum to prepare
an analysis on the financial performance of Telstra using financial benchmarks and a
high level economic profit analysis.
The report provides a base of factual quantitative information sourced from a
combination of published financial accounts and other public domain information, e.g.
investment bank research and website information.
We have then provided our interpretation of the figures, providing a quantitative
assessment supplemented by brief interviews with our telecom analysts in Australia
and Europe.
The financial analysis consists of a review of the Telstra Group and benchmarking
against SingTel and Telecom New Zealand (NZT) as proposed by the ACCC.
The economic profit analysis consists of a high level deconstruction of the 2001
accounts. A broad range of WACC rates has been agreed between the ACCC and
Ovum for the purposes of this report. We provide commentary on the WACC rate in
this report.
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4
Executive Summary
Telstra maintains a dominant position in many Australian telecommunications
markets. Its AUS20bn in revenues still dwarf its competitors’ revenues - for instance
Optus at about one quarter. Performance has remained robust despite the market
downturn and a softening in performance from the fixed and mobile business lines.
This has been compensated for by increased wholesale profits in 2001.
Telstra’s overseas performance has been poor. With access to capital limited by the
telecoms downturn, Telstra and its investment partners may see an increasingly
tough outlook for their joint ventures and other overseas interests given their negative
performance in the last financial year. Pricing pressure is likely to increase not just
because Telstra’s subscribers are the main targets of competitive operators, but also
as price is increasingly used as a defence against a worsening business environment.
The flip side of this is that Telstra will see its competitors suffering and possibly
imploding (e.g. OneTel) and larger business consumers may look to the stable
incumbent as a relatively safe haven.
We have concluded that Telstra’s financial performance compares favourably with the
comparison carriers, SingTel and NZT. We also conclude that Telstra’s economic
profitability does not appear, prima facie, excessive when compared to returns
achieved by other incumbents. However when returns are benchmarked against our
initial estimates for Telstra’s WACC, returns greater than the WACC appear to be
achieved. In our view, incumbents can and do achieve returns in excess of their
WACC; an on-going legacy of their former monopoly status. Telstra is no better or
worse in this regard than its peers. This merely underlines the case that there are
structural factors that continue to allow such operators to extract such "economic
rents”.
Telstra has financed its acquisitions – particularly recent overseas acquisitions –
1
through increasing its debt exposure, resulting in its gearing increasing 12
percentage points to 40% in 2001. Even at this level, Telstra’s gearing is within the
limits suggested by industry comparisons.
Although the limits of our study do suggest further areas of fruitful enquiry, we can
conclude that we have been able to find no support for the proposition that Telstra is
receiving a poor return on investment on-shore and is therefore being driven to invest
off-shore as a result.
Finally, from our discussions with industry analysts we conclude that Telstra is in a
strong position compared with many of its European and US counterparts. We are
unable to rule in or out, from the available evidence within the scope of this project,
that this strong position results from monopoly or anti-competitive behaviour.
1
Debt/(Debt+Equity)
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1. Financial Review
1.1 Telstra
Over the three year period of review, Telstra has shown flat EBITDA margins of
approximately 48% on a rising revenue base, although the revenue growth rate has
2
been falling. This can clearly be seen in Figures 1.1A-B . The falling revenue growth
(average 3.5%, 3 year compound average growth rate (CAGR)) may be partly
attributable to increased price pressure and subscriber base erosion. However, it is
interesting to note that this levelling off in growth has occurred within a highly
acquisitive period in which Telstra has increased its debt burden from 30% of its total
capital base in 1999 to 40% in 2001.
Telstra’s liquidity position (i.e. its ability to meet short term debt obligations) has
improved somewhat over the last year with the liquidity ratio dipping from 0.7 (1999)
to 0.6 (2000) and now up to 0.8. Given that receivables quality is likely to be high
(consistent, low default risk, low concentration) a below unity ratio is not a concern in
itself. Indeed, current borrowings have dropped to 28% of current liabilities from 35%
in the prior year promoting the view that debt levels are still at comfortable levels
unlike some of Telstra’s global counterparts. The low 3G debt burden has helped
reduce pressure on gearing and this is corroborated by the cashflow analysis (interest
payments are well covered by new financing and operating inflows). Although still
high, interest cover fell from 12.4 in 1999 to 9.4 in 2001 reflecting the gradual shift in
the balance sheet towards more debt.
As expected for an incumbent carrier, operating cashflows have been stable and
strong at AUD6.6bn/USD3.3bn for the previous three years. This inflow is being
eaten by significant dividend outflows (peaking in 2000 at AUD 4.4bn, roughly double
the previous and following year’s payments) and the stable capex spend of over
AUD4bn. The most striking outflow over the three year review has been the
investment spend. In 1999 Telstra’s cash outflows for investments were AUD112m.
2000 investment outflows were five times this. 2001 was five times again at
AUD3.2bn/USD1.6bn. Total capital expenditure outflows have risen from AUD4.4bn
in 1999 to AUD7.6bn in 2001 on a stable operating cashflow base of AUD6.6bn. As
with its peers, Telstra is investing heavily in building future income growth.
The wisdom of its choice of spending priorities remains to be seen however, and one
must note the present context in which the incumbents AT&T and BT are reversing
their acquisition strategies. Telstra has taken AUD1.3bn in losses in 2000-01 on
disposal and write downs of its investment portfolio. This amount is comparable to
the total book value of investments on the 2001 balance sheet with only a minority of
the losses and write-downs relating to prior year acquisitions. The exit of other
incumbents from the Asia Pacific Region together with the recent writedowns provide
some level of credence to the view that Telstra may have paid close to the top of the
2
Figures stated under US GAAP. Where US GAAP accounts were provided within
the financial statements, we used these figures in preference to those conforming to
local accounting standards to provide a common framework for international
comparisons.
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market for its investments. These investments are currently a drag on its returns.
Return on common equity (that is, after stripping interest and tax, leaving returns
3
available to shareholders) has fallen from 25% in 2000 to 22% in 2001 . However
one must consider that high returns made in 2000 may be due as much to the boom
environment of the time and so the 1999 return figure of 21% may be more
comparable. In this light, the ‘fall’ in returns does not seem as stark. Segmental
analysis would provide a useful delineation of performance by business line although
this is outside the scope of this report.
3
Return on common equity after minority interests is a measure used by Ovum
because it is easy to employ, and readily generates a useful basis of comparison.
Return on common equity is sufficiently robust to give a high level relative
performance indicator. It provides a stable base going forward, year on year. All
shares in current issue are valued at their initial price, equating with the historical cost
as per the balance sheet. Ovum considers that other measures might also be used,
and is not implying that other measures are less valid.
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FIGURE 1.1A TELSTRA FINANCIAL DATA
Telstra Corporation
Ticker
Share Price at August 22, 2001
(ASX)
TLS ASX
4.84
52 wk High
52 wk Low
3 Year Comparison with NASDAQ composite
7.34
4.82
Mkt Cap AUS$ 31.1 bn
Float
49%
3 Year stock price
Source: BigCharts
Financial Summary USD$M
30-Jun
Revenue (1)
EBITDA (3)
Net Income (5)
EBITDA Margin %
Net Margin %
12 mths
1999
8,957
4422.3
1741.4
49.4%
19.4%
12 mths
2000
9,860
4678.7
2086.5
47.4%
21.2%
12 mths
2001 CAGR
9,918
3.5%
4907.0 3.5%
1905.5
3.0%
49.5%
19.2%
Current Assets
Current Liabilities
Liquidity Ratio
2,437.7
3,408.3
0.7
2,408.7
3,914.5
0.6
3,235.0
3,960.9
0.8
Long Term Debt
Total Equity
Debt:Equity Ratio
2,521.3
8,257.8
0.3
3,316.1
8,425.5
0.4
6,088.2
9,071.4
0.7
3,351.2
(2,071.7)
(1,266.3)
13.3
3,337.5
(2,495.8)
(958.9)
(117.2)
3,364.0
(3,247.2)
47.9
164.7
Operating cashflow
Investing Flows
Financing Flows
Net CF
Debt financing (out)flows (4)
Equity financing (out)flows
(348)
0
1,271
0
1,215
0
Net Interest Charged to IS
CF Cover
270
12.4
290
11.5
359
9.4
ROCE (2)
21%
25%
22%
Source: Telstra Financial Accounts 2000, US GAAP
Using constant FX rate per accounts USD/AUD of
1.9617
(1) 2000 net of provision adj., 2001 before SAB101 adjt $779m Dr
(2) return on common equity after MI
(3) before MI and exceptionals and incl. losses of assoc, JVs
(4) movement on principal only, excl. dividends and interest
(5) net of MI. 2001 figure before change of accounting principles adjt
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FIGURE 1.1B TELSTRA FINANCIAL DATA
Telstra Profitability Trend Plot
12000
60%
USD '000s
YE 30 June
10000
50%
8000
40%
6000
30%
4000
20%
2000
10%
0
0%
1999
2000
2001
Revenue (1)
EBITDA (3)
EBITDA Margin %
Net Margin %
Net Income (5)
Telstra Liquidity Plot
100%
80%
60%
40%
20%
0%
1999
2000
Current Assets
Current Liabilities
2001
Telstra Gearing Plot
100%
80%
60%
40%
20%
0%
1999
2000
Long Term Debt
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2001
Total Equity
© Ovum 2001. Unauthorised reproduction prohibited
9
FIGURE 1.1C TELSTRA FINANCIAL DATA
Telstra Cashflow
Y/E 30 June
4,000
3,000
USD '000s
2,000
1,000
0
(1,000)
1999
2000
2001
(2,000)
(3,000)
(4,000)
Operating cashflow
4,000
Investing Flows
Financing Flows
Net CF
Telstra Interest Cover
14
3,500
12
USD '000s
3,000
10
2,500
8
2,000
6
1,500
4
1,000
2
500
0
0
1999
Operating cashflow
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2000
Net Interest Charged to IS
2001
CF Cover
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1.2 Benchmarking
The business portfolios of the carriers vary significantly and Telstra has consolidated
a large number of new investments in its results. Given this, benchmarking should be
seen for what it is; a quick method of gaining an overview of a sector and its carriers.
In terms of 1 year share price performance of the three incumbents agreed with the
ACCC, Telecom New Zealand (NZT) has had the most robust share price (at 22,
August 2001) as shown below:
Table 1.2A
Share Price / 1 year High
Telecom New Zealand
74%
Telstra
66%
4
SingTel
64%
Telstra’s ‘share price to year high’ score compares favourably with other incumbents
such as AT&T (58% score), BT (38%) and DT (28%). Indeed tier two carriers such as
Level 3 are showing scores of well under 20%, i.e. the share price for many such
carriers has fallen by well over 80% in the last 52 weeks.
The share performance in Table 1.2A does not necessarily correlate with the financial
indicators reviewed by Ovum. This may be due to the market giving higher
weightings to other factors such as geographic risk and market sentiment. We show
5
later that the share price strength shown is actually correlated with the ROCE metric,
which emphasises the relevance of value based metrics such as economic profit
rather than earnings based metrics.
Figures 1.2A-F show graphically and quantitatively the performance of the benchmark
incumbents over the three year review period. Revenue growth has been strongest in
NZT at 8.5% (3yr CAGR) with SingTel showing the smallest growth at 0.3%.
However net income in NZT had fallen by 1.3% over the same period, with SingTel
showing a 6.7% growth (driven by Government compensation payments). For both
metrics, Telstra fell in between these two extremes. Net margins and income
performance correlate well, with SingTel showing a sharp rise in margins from 38%
(2000) to 47% (2001) and NZT showing a fall from 22% (2000) to 17% (2001) –
4
The actual annual high of $3.50 at week ending 13 October appears as a one day
spike. This is treated as an anomaly and the more representative next highest annual
high of $2.94 on 27 November 2000 has been used.
5
Returns are based upon historic cost equity invested as per the balance sheet plus
reserves. Other measures may also be appropriate, however we have sought to avoid
the additional complexity of marking to market the various balance sheet elements
due to price volatility and measurement issues.
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11
influenced partly by the AAPT acquisition. Again, Telstra fell between these two
carriers with 2001 margins down 2% to 19%.
Thus the performance rankings, perversely, appear to be inversely correlated to the
share price rankings. The share price rankings may also show some correlation with
the apparent strength of the incumbents in their markets (although the presumption
that Telstra has greater dominance than NZT is indeed rebuttable).
SingTel has an extremely strong balance sheet with a liquidity ratio of 2 and a 10%
gearing (nil prior year). This means that SingTel has apparently much more cash
available than it probably needs. Indeed, it is possible that performance is being
6
dragged down by the near absence of debt . Telstra and NZT on the other hand
show increasing leverage with NZT showing the highest gearing at 1.3 (debt:equity).
Care must be taken in using the SingTel figures however, as government influence is
likely to be a material factor in the strength of SingTel’s position.
An April 2001 report from ABN Amro puts Telstra in the lowest quartile in terms of
gearing and the highest in terms of interest cover in a sample of 15 incumbents
corroborating the view that Telstra does have a strong balance sheet and good
performance.
In terms of ROCE, NZT has shown consistently the best performance at 34%-38%
over the three year review period. SingTel’s ROCE has been better than that of
Telstra on average, but not significantly so, over the three year period. Initially one
might expect SingTel’s ROCE performance to be the ‘best’ in absolute terms due to
its dominance. However we perceive government influence in SingTel’s strategic
direction as having prevented a strict focus on maximising profits and returns.
Overall, Telstra has shown a fairly stable results pattern over the three year review
period. Greater variability is seen in NZT whose high revenue growth appears to be
at the expense of its cost base. Cost of sales rose more than 2.4 times in 2000
resulting in the EBITDA and net income margin falls. This was also the period in
which AAPT was acquired and this has had a pronounced effect on the cashflow
profile (see Figure 1.2F). SingTel’s strong performance in the face of an almost
stagnant revenue base is primarily due to its strong cash position, yielding investment
income up one third from 2000 and government compensation for deregulation. This
represented 44% of operating cashflows and approximately 25% of EBITDA and net
income in 2001. Considering the variety of operating conditions, we see Telstra as
6
Financial theory (see especially Modigliani and Miller) shows that the tax
advantages of debt result in a lower overall cost of finance as the proportion of debt
increases relative to equity. We note that this proposition may not be valid for
SingTel if its major source of finance is the government, as traditional market
mechanisms may not apply.
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being in a strong position relative to its peers, especially considering the current
global
climate.
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13
FIGURE 1.2A BENCHMARK RATIOS
Singapore Telecommunications Ltd
Ticker
SingTel
Share Price at August 22, 2001
1.89
SGX
52 wk High
52 wk Low
Share Price Chart
Source: Singapore Exchange
Financial Summary SGD $M
31-Mar
Revenue
EBITDA (4)
Net Income (3)
3.50
1.65
EBITDA Margin %
Net Margin %
12 mths
1999
2,704
1560.3
1059.1
57.7%
39.2%
12 mths
2000
2,694
1681.7
1018.2
62.4%
37.8%
12 mths
2001
2,727
1635.2
1286.9
60.0%
47.2%
Current Assets
Current Liabilities
Liquidity Ratio
4,069.8
1,612.1
2.5
3,818.4
1,263.2
3.0
4,408.9
2,108.0
2.1
Long Term Debt
Equity
Debt:Equity Ratio
55.4
4,433.7
0.0
0.0
4,764.6
0.0
553.7
4,715.4
0.1
Operating cashflow
Investing Flows
Financing Flows
Net CF
1,149.3
(366.7)
(343.5)
439.1
1,173.1
(762.9)
(728.3)
(318.1)
1,956.5
(1,690.0)
(396.8)
(130.3)
Debt financing (out)flows (2)
Equity financing (out)flows
(37)
0
(0)
376
498
(78)
Net Interest Charged to IS
CF Cover
153
7.5
122
9.6
111
17.7
ROCE (1)
24%
21%
29%
Mkt Cap
SGD 29.2 bn
CAGR
0.3%
1.6%
6.7%
Source: SingTel Financial Accounts 2001, Singapore GAAP
Using constant FX rate at 31/3/01 USD/SGD of
1.8060
Only Level 1 ADRs in circulation hence no US GAAP reporting requirements
(1) return on common equity after MI
(2) excluding SGD17.8m inflow, 2001 from sale and leaseback
movement on principal only, excl. dividends and interest
(3) after tax, MI and before extraordinary items
(4) before MI and exceptionals and incl. losses of assoc, JVs
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14
FIGURE 1.2B BENCHMARK RATIOS
Singtel Profitability Trend Plot
3000
70%
2500
60%
50%
YE 31 Mar
2000
40%
1500
30%
1000
20%
500
10%
0
0%
1999
2000
Revenue
EBITDA Margin %
2001
EBITDA (4)
Net Margin %
Net Income (3)
Singtel Liquidity Plot
100%
80%
60%
40%
20%
0%
1999
2000
Current Assets
2001
Current Liabilities
Singtel Gearing Plot
100%
80%
60%
40%
20%
0%
1999
2000
Long Term Debt
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2001
Equity
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15
FIGURE 1.2C BENCHMARK RATIOS
Operating/Net $'000
Singtel Cashflow
YE 31 Mar
2,500
2,000
1,500
1,000
500
0
(500)
(1,000)
(1,500)
(2,000)
1999
2000
Operating cashflow
Investing Flows
2001
Financing Flows
Net CF
Singtel Interest Cover
2,500.0
20x
18x
16x
14x
12x
10x
8x
6x
4x
2x
0x
USD '000s
2,000.0
1,500.0
1,000.0
500.0
0.0
1999
2000
Operating cashflow
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Net Interest Charged to IS
2001
CF Cover
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16
FIGURE 1.2D BENCHMARK RATIOS
Telecom Corporation of New Zealand Ltd.
Ticker
TEL NZSE
NZT NYSE
17.562
52 wk High
52 wk Low
Share Price at August 22, 2001
(NYSE USD data. Source:Multex)
Stock vs. NYSE Composite (NYA)
23.94
15.88
Mkt Cap
USD 30.8 bn
NYSE Price, Volume Chart
Source: Stockpoint Inc. - NYSE Listing
NZSE Share Price Chart
Source: Telecom NZ - NZSE Listing
Financial Summary USD $M
12 mths
31 March
1998
1,594
873.7
357.8
54.8%
22.5%
12 mths
31 March
1999
1,618
870.0
360.2
53.8%
22.3%
12 mths
30 June
2000
2,038
890.1
343.8
43.7%
16.9%
Current Assets
Current Liabilities
Liquidity Ratio
579.2
793.5
0.7
698.8
949.2
0.7
776.6
1,285.0
0.6
Long Term Debt
Equity
Debt:Equity Ratio
605.9
942.7
0.6
521.5
953.9
0.5
1,341.8
1,013.9
1.3
720.8
(462.0)
(259.3)
(0.5)
738.2
(364.9)
(373.3)
0.0
724.6
(1,226.9)
526.2
23.9
90
(34)
971
(25)
Revenue
EBITDA (4)
Net Income (3)
EBITDA Margin %
Net Margin %
Operating cashflow
Investing Flows
Financing Flows
Net CF
Debt financing (out)flows (1)
Equity financing (out)flows
84
51
Net Interest Charged to IS
CF Cover
61
11.8
53
13.8
86
8.4
ROCE (2)
38%
38%
34%
Source: Telecom NZ Financial Accounts 2000, US GAAP
Using constant FX rate at per 2000 accounts USD/NZD:
(1) movement on principal only, excl. dividends and interest
(2) return on common equity after MI on a historic cost basis
(3) after tax, MI and before extraordinary items
(4) before MI and exceptionals and incl. losses of assoc, JVs
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CAGR
8.5%
0.6%
(1.3)%
2.1323
© Ovum 2001. Unauthorised reproduction prohibited
17
FIGURE 1.2E BENCHMARK RATIOS
USD '000s
Telecom NZ Profitability Trend Plot
2,500
60%
2,000
50%
40%
1,500
30%
1,000
20%
500
10%
0
0%
31 March 1998
31 March 1999
Revenue
EBITDA Margin %
30 June 2000
EBITDA (4)
Net Margin %
Net Income (3)
Telecom NZ Liquidity Plot
100%
80%
60%
40%
20%
0%
31 March 1998
31 March 1999
Current Assets
30 June 2000
Current Liabilities
Telecom NZ Gearing Plot
100%
80%
60%
40%
20%
0%
31 March 1998
31 March 1999
Long Term Debt
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30 June 2000
Equity
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18
FIGURE 1.2F BENCHMARK RATIOS
Telecom NZ Cashflow
1,000
USD '000s
500
0
31 March 1998
31 March 1999
30 June 2000
(500)
(1,000)
(1,500)
Operating cashflow
Investing Flows
Financing Flows
Net CF
USD '000s
Telecom NZ Interest Cover
850
750
650
550
450
350
250
150
50
(50)
(150)
16x
14x
12x
10x
8x
6x
4x
2x
31 March 1998
Operating cashflow
CHYH04
31 March 1999
30 June 2000
Net Interest Charged to IS
0x
CF Cover
© Ovum 2001. Unauthorised reproduction prohibited
19
2. Economic Profit
2.1 Basis of Preparation
We are seeking to convert accounting measures of profitability as shown in company
annual reports into high level economic measures.
A number of measures are routinely reported and used by analysts to provide a
picture of the profitability of a firm. Fundamentally, a number of measures are used
because accounting measures of profitability are only approximations for the level of
economic profitability.
The source of the imbalance between accounting and economic profits is essentially
timing. Economic profits are ordinarily measured as the net present value of cash
flows from an investment – if the net present value of expected cash flows is greater
than zero, then economic profits are made from that investment (the economic return
is greater than the opportunity cost of capital). Accounting profits, on the other hand,
are a measure of the current profits from a number of a prior investment decisions,
each at various stages of their investment lives. So, for example, a major investment
of a firm that does not return much money in its initial stages will show large
accounting losses, even if the net present value of the investment is positive.
While there is no immediately satisfying way to correctly measure economic profits
(as the information required is simply either very difficult to calculate, or simply not
available), measures of accounting profit can provide reasonable approximations as
long as:
(a) a reasonable run of data is available to ensure that single-year results are not
unduly relied on;
(b) the value of assets reported by the firm (historical cost less accounting
depreciation) is a reasonable first approximation of the market value of the assets
(the net present value of future cash flows).
We have prepared a high level economic profit estimate using audited information
from Telstra’s 2001 financial accounts. Rather than deriving operating cash profit
from NOPAT (net operating profit after tax), we have used operating cashflow as the
base, being the most efficient method given the available information and the
technical equivalence of the result.
There are insufficient data to breakdown the economic profit working between lines of
business.
Essentially the rationale behind economic profit (residual income) is that profit earned
must reflect the cost of all the capital that was employed in making that profit; not just
the debt component (i.e. not just subtracting interest).
We know that Total Assets = Interest Bearing Liabilities (IBL's) + Non-Interest Bearing
Liabilities (NIBL's) plus Equity.
Therefore, Total Assets – NIBL's must equal IBL's + Equity.
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20
Using total assets less NIBL's as the total volume of capital results in including both
fixed and working capital. The cost of this capital is the weighted average of the Debt
and Equity components.
A product of the volume and price of capital gives the capital charge. Subtracting this
capital charge from profits gives the economic profit estimate as shown in the
working. The capital charge and the profit figure are both pre tax in the working
shown in Figure 2.2A.
2.2 Interpretation of Results
We have adopted a broad range of WACC figures for the purposes of this study. The
WACC figures used are 10%, 13% and 16% being pre-tax and nominal. The reasons
why this particular range appears to be appropriate are set out below. The range was
agreed as appropriate with the ACCC before being applied. It should be noted that
Ovum undertook no detailed work in order to validate or determine this range. This is
outside the scope of the study. In addition, the ACCC has made it clear that in
endorsing the range as broadly appropriate for this study it is making no judgements
relating to its use for other purposes.
The median figure of 13% fits Ovum’s own estimate of a typical pre tax WACC of
13.5% for a European incumbent with a fixed, mobile and internet business mix.
7
Morgan Stanley Dean Witter has used a WACC of 13.9% in their calculations which
provides a useful sanity check. Of course, the actual WACC for any carrier will be
dependent on its exact business portfolio and factors such as any governmental
share issue and repurchase restrictions that may affect business risk and the
enterprise beta. In the UK Oftel, in its consultative document on retail price control,
has used a WACC of 13.5% for BT, up from a previous figure of 12.5% to reflect the
impact of increased competition. BT, KPN and DT are believed to have the highest
8
telecom sector betas according to a report from Julius Bär AG . This suggests an
upper limit of 13.5% for Telstra’s WACC. Notably, Telstra has a higher wireless
market share than BT and we make no judgements as to any differences in customer
quality, two factors which could materially impact on the WACC number. We also
note that the applicability of WACC figures across jurisdictions needs to be handled
with care.
The economic profit figures on their own are absolute and provide an initial indication
of the increase in shareholder value that Telstra is estimated to have achieved. In
order to provide a gauge of how large this value may be in relative terms, we have
rebased the economic profit by dividing by the invested capital base (EP/ IC). The
data derived within the scope of this report does not allow us to conclude absolutely
whether the returns made over the opportunity cost of capital (WACC x IC) are
significant within the market context. We note however, that at a 16% WACC the
EP/IC metric is 5% i.e. economic profit represents an additional shareholder return of
7
Morgan Stanley quote a post-tax WACC. We have estimated a tax rate of 36% to
convert to a pre-tax WACC.
8
June 19, 2001, Julius Bär (Deutschland) AG, “Deutsche Telekom: Poised for
Turnaround’.
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5% of capital. This rises to an additional return of 8% at a 13% WACC and an 11%
return at a 10% WACC.
We stated above that we cannot conclude whether these excess returns are
significant within the market context. In principle long term returns in excess of the
WACC are excessive (we have not performed a historic analysis to this end). Our
view is that most incumbents achieve returns in excess of their WACC. That Telstra
is no better or worse in this regard, merely underlines the point that there are
structural factors (e.g. barriers to entry and scale effects), that continue to allow such
operators to extract "economic rents" - an on-going legacy of their former monopoly
status.
Additionally though, rates of return can be greater than the WACC due to pressure to
generate profits in excess of the WACC and arguably, higher expected project risk.
This indicates the possibility of the WACC being understated with respect to
increased risk e.g. increased overseas expansion, more volatile financial markets,
etc. as the business and market shifts to a less stable environment.
As part of our research a number of analysts were interviewed to provide their insight
into the relative strengths of Telstra in the international arena. The conclusion of this
was that Telstra provided a strong proposition compared to its European and US
counterparts. The results of the economic profit and accounting analysis with SingTel
and NZT benchmarks are consistent with this view, although we have not explicitly
benchmarked other operators.
FIGURE 2.2A: ECONOMIC PROFIT ESTIMATE
Telstra Economic Profit Estimate
WACC
10%
13%
16%
Operating Cashflow (1)
Adjustments and Reversals
Interest Costs
Dividends Received
Telstra Share Scheme
Depreciation Net of GW
Lease Costs (2)
Income tax paid (4)
NOPBT
ROIC
AUS $M
6,599
743
(16)
725
(2,828)
530
1,455
7,208
21%
CoC
3,443
4,476
5,508
EP
3,765
2,732
1,700
Operating Working Capital
Net Current Assets
Reverse Interest Bearing Liabilities
Reverse Tax and other Provisions
Operating Invested Capital
Add: Net Property Plant and Equipment
Add: Other Operating Assets Net of Operating Liabilities
Add: Value of Operating Leases
EP/IC
11%
8%
5%
AUS $M
(3,026)
2,604
3,774
3,352
22,803
2,467
25,270
Other Invested Capital
Goodwill (3)
Intangibles (3)
Investments
Non Operating Assets (2)
Total Invested Capital
1,548
1,464
143
2,650
5,805
34,427
Notes
(1) Rather than adjusting operating profit, NOPBT is derived from operating cashflows
(2) Operating lease costs (from expenditure commitments note) are reversed and capitalised using a 5x multiplier (best guess
figure)
(3) Strictly, goodwill and other intangibles like all capital should be stated at market value (MV). Book value is used as a
proxy. With the recent writedowns in investments it may be that book values are now closer to fair value
(4) Profit before tax is calculated to be consistent with the WACC rates which are pre tax, nominal.
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3. Limitations and Suggestions for Further
Work
Ovum’s analysis has been based upon information sourced from third party reports,
corporate sources (such as annual reports) and our own internal research. We
cannot confirm the accuracy of any information obtained from third parties, however
where such information has been used then, to the best of our knowledge such
information appears at least consistent with our own views. We have also made a
number of estimates, assumptions and inferences in generating our analysis based
upon our professional judgement and experience.
Although not exhaustive, we have highlighted below some of the limitations in our
work with suggestions for possible further work:
The SingTel numbers are prepared under local Singapore GAAP with no US GAAP
numbers. Commercial pressures on SingTel are likely to be very different to NZT and
Telstra due to the high degree of government influence. This reduces the
comparability of SingTel’s results. Further work could recast SingTel’s results under
US GAAP to aid comparisons with Telstra and other carriers. This is likely to be
difficult given the level of detail available in the public domain. Also, increasing the
number of comparisons by analysing other incumbents would provide a more solid
base from which to benchmark Telstra.
The economic profit derivation will be much more robust with greater clarity and
granularity of data. Management information would be ideal and it is this level of detail
that firms such as McKinsey and Stern Stewart use to analyse the economic profit of
their clients under product terms such as ‘Residual Income’ and ‘EVA®’. As majority
shareholders, much of this information may be available to the government of
Australia and possibly the ACCC.
We have made a number of estimates in our economic profit analysis. For example
we use a best estimate for capitalised leases, R&D has not been explicitly valued and
tax on non-operating items has not been factored out. It is possible that these
estimates and simplifications will not significantly affect what is a high level analysis.
However, dealing with these issues explicitly using detailed management information
will confirm this hypothesis. The most significant approximation used in this report is
the use of book values as a proxy for market values.
An analysis of Telstra’s core business units on a line by line basis would yield a great
deal of insight into the relative performance of these lines. This would entail separate
WACC derivations for each business unit and a detailed consideration of the
allocation method for invested capital values between units. Such a line of business
analysis will prove extremely useful and allow an explicit focus on core (legacy)
businesses where Telstra is expected to hold most power. It will also allow a strip out
of non-core and overseas segments whose performance may otherwise be masking
the underlying performance behaviour of the core business lines.
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Appendix – Information Sources
Telstra 2001 and 2000 financial accounts
Telecom New Zealand 2001 and 2000 financial accounts
SingTel 2001 and 2000 financial accounts
Ovum internal research
Corporate websites
Straits Times (Singapore)
Bank of New York website [http://www.bankofny.com/] for ADR information
Broker and I-Bank reports
Local stock exchange websites
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