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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 CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 3 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. CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 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) CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 5 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. CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 6 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. CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 7 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 CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 8 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 CHYH04 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 CHYH04 2000 Net Interest Charged to IS 2001 CF Cover © Ovum 2001. Unauthorised reproduction prohibited 10 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. CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 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. CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 12 being in a strong position relative to its peers, especially considering the current global climate. CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 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 CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 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 CHYH04 2001 Equity © Ovum 2001. Unauthorised reproduction prohibited 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 CHYH04 Net Interest Charged to IS 2001 CF Cover © Ovum 2001. Unauthorised reproduction prohibited 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 CHYH04 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 CHYH04 30 June 2000 Equity © Ovum 2001. Unauthorised reproduction prohibited 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. CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 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’. CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 21 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. CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 22 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. CHYH04 © Ovum 2001. Unauthorised reproduction prohibited 23 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 CHYH04 © Ovum 2001. Unauthorised reproduction prohibited