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Telstra Financial and EconomicProfit Analysis

A Report to the ACCC

Imy RahamanJim Holmes

Version 3.3

31 October 2001CYHO4

CHYH04 © Ovum 2001. Unauthorised reproduction prohibited

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ContentsContents ........................................................................................................................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 preparean analysis on the financial performance of Telstra using financial benchmarks and ahigh level economic profit analysis.

The report provides a base of factual quantitative information sourced from acombination 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 quantitativeassessment supplemented by brief interviews with our telecom analysts in Australiaand Europe.

The financial analysis consists of a review of the Telstra Group and benchmarkingagainst SingTel and Telecom New Zealand (NZT) as proposed by the ACCC.

The economic profit analysis consists of a high level deconstruction of the 2001accounts. A broad range of WACC rates has been agreed between the ACCC andOvum for the purposes of this report. We provide commentary on the WACC rate inthis report.


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Executive SummaryTelstra maintains a dominant position in many Australian telecommunicationsmarkets. Its AUS20bn in revenues still dwarf its competitors’ revenues - for instanceOptus at about one quarter. Performance has remained robust despite the marketdownturn 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 thetelecoms downturn, Telstra and its investment partners may see an increasinglytough outlook for their joint ventures and other overseas interests given their negativeperformance in the last financial year. Pricing pressure is likely to increase not justbecause Telstra’s subscribers are the main targets of competitive operators, but alsoas 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 possiblyimploding (e.g. OneTel) and larger business consumers may look to the stableincumbent as a relatively safe haven.

We have concluded that Telstra’s financial performance compares favourably with thecomparison carriers, SingTel and NZT. We also conclude that Telstra’s economicprofitability does not appear, prima facie, excessive when compared to returnsachieved by other incumbents. However when returns are benchmarked against ourinitial estimates for Telstra’s WACC, returns greater than the WACC appear to beachieved. In our view, incumbents can and do achieve returns in excess of theirWACC; an on-going legacy of their former monopoly status. Telstra is no better orworse in this regard than its peers. This merely underlines the case that there arestructural factors that continue to allow such operators to extract such "economicrents”.

Telstra has financed its acquisitions – particularly recent overseas acquisitions –through increasing its debt exposure, resulting in its gearing1 increasing 12percentage points to 40% in 2001. Even at this level, Telstra’s gearing is within thelimits suggested by industry comparisons.

Although the limits of our study do suggest further areas of fruitful enquiry, we canconclude that we have been able to find no support for the proposition that Telstra isreceiving a poor return on investment on-shore and is therefore being driven to investoff-shore as a result.

Finally, from our discussions with industry analysts we conclude that Telstra is in astrong position compared with many of its European and US counterparts. We areunable 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 TelstraOver the three year period of review, Telstra has shown flat EBITDA margins ofapproximately 48% on a rising revenue base, although the revenue growth rate hasbeen falling. This can clearly be seen in Figures 1.1A-B2. The falling revenue growth(average 3.5%, 3 year compound average growth rate (CAGR)) may be partlyattributable to increased price pressure and subscriber base erosion. However, it isinteresting to note that this levelling off in growth has occurred within a highlyacquisitive period in which Telstra has increased its debt burden from 30% of its totalcapital base in 1999 to 40% in 2001.

Telstra’s liquidity position (i.e. its ability to meet short term debt obligations) hasimproved 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 initself. 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 levelsunlike some of Telstra’s global counterparts. The low 3G debt burden has helpedreduce pressure on gearing and this is corroborated by the cashflow analysis (interestpayments are well covered by new financing and operating inflows). Although stillhigh, interest cover fell from 12.4 in 1999 to 9.4 in 2001 reflecting the gradual shift inthe balance sheet towards more debt.

As expected for an incumbent carrier, operating cashflows have been stable andstrong at AUD6.6bn/USD3.3bn for the previous three years. This inflow is beingeaten by significant dividend outflows (peaking in 2000 at AUD 4.4bn, roughly doublethe previous and following year’s payments) and the stable capex spend of overAUD4bn. The most striking outflow over the three year review has been theinvestment spend. In 1999 Telstra’s cash outflows for investments were AUD112m.2000 investment outflows were five times this. 2001 was five times again atAUD3.2bn/USD1.6bn. Total capital expenditure outflows have risen from AUD4.4bnin 1999 to AUD7.6bn in 2001 on a stable operating cashflow base of AUD6.6bn. Aswith 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 onemust note the present context in which the incumbents AT&T and BT are reversingtheir acquisition strategies. Telstra has taken AUD1.3bn in losses in 2000-01 ondisposal and write downs of its investment portfolio. This amount is comparable tothe total book value of investments on the 2001 balance sheet with only a minority ofthe losses and write-downs relating to prior year acquisitions. The exit of otherincumbents from the Asia Pacific Region together with the recent writedowns providesome 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 withinthe financial statements, we used these figures in preference to those conforming tolocal accounting standards to provide a common framework for internationalcomparisons.


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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 returnsavailable to shareholders) has fallen from 25% in 2000 to 22% in 20013. Howeverone must consider that high returns made in 2000 may be due as much to the boomenvironment of the time and so the 1999 return figure of 21% may be morecomparable. In this light, the ‘fall’ in returns does not seem as stark. Segmentalanalysis would provide a useful delineation of performance by business line althoughthis is outside the scope of this report.

3 Return on common equity after minority interests is a measure used by Ovumbecause 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 relativeperformance indicator. It provides a stable base going forward, year on year. Allshares in current issue are valued at their initial price, equating with the historical costas 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 TLS ASXShare Price at August 22, 2001 4.84 52 wk High 7.34 Mkt Cap AUS$ 31.1 bn(ASX) 52 wk Low 4.82 Float 49%

3 Year Comparison with NASDAQ composite 3 Year stock price

Source: BigCharts

Financial Summary USD$M 12 mths 12 mths 12 mths30-Jun 1999 2000 2001 CAGRRevenue (1) 8,957 9,860 9,918 3.5%EBITDA (3) 4422.3 4678.7 4907.0 3.5%Net Income (5) 1741.4 2086.5 1905.5 3.0%EBITDA Margin % 49.4% 47.4% 49.5%Net Margin % 19.4% 21.2% 19.2%

Current Assets 2,437.7 2,408.7 3,235.0Current Liabilities 3,408.3 3,914.5 3,960.9Liquidity Ratio 0.7 0.6 0.8

Long Term Debt 2,521.3 3,316.1 6,088.2Total Equity 8,257.8 8,425.5 9,071.4Debt:Equity Ratio 0.3 0.4 0.7

Operating cashflow 3,351.2 3,337.5 3,364.0Investing Flows (2,071.7) (2,495.8) (3,247.2)Financing Flows (1,266.3) (958.9) 47.9Net CF 13.3 (117.2) 164.7

Debt financing (out)flows (4) (348) 1,271 1,215Equity financing (out)flows 0 0 0

Net Interest Charged to IS 270 290 359CF Cover 12.4 11.5 9.4

ROCE (2) 21% 25% 22%

Source: Telstra Financial Accounts 2000, US GAAPUsing 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 Liquidity Plot

0%

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1999 2000 2001

Current Assets Current Liabilities

Telstra Profitability Trend Plot

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Telstra Gearing Plot

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FIGURE 1.1C TELSTRA FINANCIAL DATA

Telstra Cashflow

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Operating cashflow Net Interest Charged to IS CF Cover


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1.2 BenchmarkingThe business portfolios of the carriers vary significantly and Telstra has consolidateda large number of new investments in its results. Given this, benchmarking should beseen 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 theACCC, 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%

SingTel4 64%

Telstra’s ‘share price to year high’ score compares favourably with other incumbentssuch as AT&T (58% score), BT (38%) and DT (28%). Indeed tier two carriers such asLevel 3 are showing scores of well under 20%, i.e. the share price for many suchcarriers has fallen by well over 80% in the last 52 weeks.

The share performance in Table 1.2A does not necessarily correlate with the financialindicators reviewed by Ovum. This may be due to the market giving higherweightings to other factors such as geographic risk and market sentiment. We showlater that the share price strength shown is actually correlated with the ROCE5 metric,which emphasises the relevance of value based metrics such as economic profitrather than earnings based metrics.

Figures 1.2A-F show graphically and quantitatively the performance of the benchmarkincumbents over the three year review period. Revenue growth has been strongest inNZT 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 SingTelshowing a 6.7% growth (driven by Government compensation payments). For bothmetrics, Telstra fell in between these two extremes. Net margins and incomeperformance 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 dayspike. This is treated as an anomaly and the more representative next highest annualhigh of $2.94 on 27 November 2000 has been used.5 Returns are based upon historic cost equity invested as per the balance sheet plusreserves. Other measures may also be appropriate, however we have sought to avoidthe additional complexity of marking to market the various balance sheet elementsdue to price volatility and measurement issues.


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influenced partly by the AAPT acquisition. Again, Telstra fell between these twocarriers with 2001 margins down 2% to 19%.

Thus the performance rankings, perversely, appear to be inversely correlated to theshare price rankings. The share price rankings may also show some correlation withthe apparent strength of the incumbents in their markets (although the presumptionthat 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 cashavailable than it probably needs. Indeed, it is possible that performance is beingdragged down by the near absence of debt6. Telstra and NZT on the other handshow 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 islikely 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 ofgearing and the highest in terms of interest cover in a sample of 15 incumbentscorroborating the view that Telstra does have a strong balance sheet and goodperformance.

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 ofTelstra on average, but not significantly so, over the three year period. Initially onemight expect SingTel’s ROCE performance to be the ‘best’ in absolute terms due toits dominance. However we perceive government influence in SingTel’s strategicdirection as having prevented a strict focus on maximising profits and returns.

Overall, Telstra has shown a fairly stable results pattern over the three year reviewperiod. Greater variability is seen in NZT whose high revenue growth appears to beat the expense of its cost base. Cost of sales rose more than 2.4 times in 2000resulting in the EBITDA and net income margin falls. This was also the period inwhich AAPT was acquired and this has had a pronounced effect on the cashflowprofile (see Figure 1.2F). SingTel’s strong performance in the face of an almoststagnant revenue base is primarily due to its strong cash position, yielding investmentincome up one third from 2000 and government compensation for deregulation. Thisrepresented 44% of operating cashflows and approximately 25% of EBITDA and netincome in 2001. Considering the variety of operating conditions, we see Telstra as

6 Financial theory (see especially Modigliani and Miller) shows that the taxadvantages of debt result in a lower overall cost of finance as the proportion of debtincreases relative to equity. We note that this proposition may not be valid forSingTel if its major source of finance is the government, as traditional marketmechanisms may not apply.


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being in a strong position relative to its peers, especially considering the currentglobal climate.


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FIGURE 1.2A BENCHMARK RATIOS

Singapore Telecommunications Ltd

Ticker SingTel SGXShare Price at August 22, 2001 1.89 52 wk High 3.50 Mkt Cap SGD 29.2 bn

52 wk Low 1.65

Share Price Chart Source: Singapore Exchange

Financial Summary SGD $M 12 mths 12 mths 12 mths31-Mar 1999 2000 2001 CAGRRevenue 2,704 2,694 2,727 0.3%EBITDA (4) 1560.3 1681.7 1635.2 1.6%Net Income (3) 1059.1 1018.2 1286.9 6.7%EBITDA Margin % 57.7% 62.4% 60.0%Net Margin % 39.2% 37.8% 47.2%

Current Assets 4,069.8 3,818.4 4,408.9Current Liabilities 1,612.1 1,263.2 2,108.0Liquidity Ratio 2.5 3.0 2.1

Long Term Debt 55.4 0.0 553.7Equity 4,433.7 4,764.6 4,715.4Debt:Equity Ratio 0.0 0.0 0.1

Operating cashflow 1,149.3 1,173.1 1,956.5Investing Flows (366.7) (762.9) (1,690.0)Financing Flows (343.5) (728.3) (396.8)Net CF 439.1 (318.1) (130.3)

Debt financing (out)flows (2) (37) (0) 498Equity financing (out)flows 0 376 (78)


ROCE (1) 24% 21% 29%

Source: SingTel Financial Accounts 2001, Singapore GAAPUsing constant FX rate at 31/3/01 USD/SGD of 1.8060Only 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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FIGURE 1.2B BENCHMARK RATIOS

Singtel Liquidity Plot

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1999 2000 2001


Singtel Gearing Plot

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1999 2000 2001

Long Term Debt Equity

Singtel Profitability Trend Plot

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ar

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FIGURE 1.2C BENCHMARK RATIOS

Singtel Cashflow

(2,000)(1,500)(1,000)

(500)0

5001,0001,5002,0002,500

1999 2000 2001

YE 31 Mar

Ope

ratin

g/N

et $

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Singtel Interest Cover

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0x2x4x6x8x10x12x14x16x18x20x



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FIGURE 1.2D BENCHMARK RATIOS

Telecom Corporation of New Zealand Ltd.

Ticker TEL NZSENZT NYSE

Share Price at August 22, 2001 17.562 52 wk High 23.94 Mkt Cap USD 30.8 bn(NYSE USD data. Source:Multex) 52 wk Low 15.88

Stock vs. NYSE Composite (NYA) NYSE Price, Volume Chart

Source: Stockpoint Inc. - NYSE Listing

NZSE Share Price Chart

Source: Telecom NZ - NZSE Listing

Financial Summary USD $M 12 mths 12 mths 12 mths31 March

199831 March

199930 June

2000 CAGRRevenue 1,594 1,618 2,038 8.5%EBITDA (4) 873.7 870.0 890.1 0.6%Net Income (3) 357.8 360.2 343.8 (1.3)%EBITDA Margin % 54.8% 53.8% 43.7%Net Margin % 22.5% 22.3% 16.9%

Current Assets 579.2 698.8 776.6Current Liabilities 793.5 949.2 1,285.0Liquidity Ratio 0.7 0.7 0.6

Long Term Debt 605.9 521.5 1,341.8Equity 942.7 953.9 1,013.9Debt:Equity Ratio 0.6 0.5 1.3

Operating cashflow 720.8 738.2 724.6Investing Flows (462.0) (364.9) (1,226.9)Financing Flows (259.3) (373.3) 526.2Net CF (0.5) 0.0 23.9

Debt financing (out)flows (1) 84 90 971Equity financing (out)flows 51 (34) (25)


ROCE (2) 38% 38% 34%

Source: Telecom NZ Financial Accounts 2000, US GAAPUsing constant FX rate at per 2000 accounts USD/NZD: 2.1323(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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FIGURE 1.2E BENCHMARK RATIOS

Telecom NZ Profitability Trend Plot

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31 March 1998 31 March 1999 30 June 2000

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Revenue EBITDA (4) Net Income (3)EBITDA Margin % Net Margin %

Telecom NZ Liquidity Plot

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31 March 1998 31 March 1999 30 June 2000


Telecom NZ Gearing Plot

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31 March 1998 31 March 1999 30 June 2000Long Term Debt Equity


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FIGURE 1.2F BENCHMARK RATIOS

Telecom NZ Cashflow

(1,500)

(1,000)

(500)

0

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31 March 1998 31 March 1999 30 June 2000

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Telecom NZ Interest Cover

(150)(50)50

150250350450550650750850

31 March 1998 31 March 1999 30 June 2000

USD

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2. Economic Profit

2.1 Basis of PreparationWe are seeking to convert accounting measures of profitability as shown in companyannual reports into high level economic measures.

A number of measures are routinely reported and used by analysts to provide apicture of the profitability of a firm. Fundamentally, a number of measures are usedbecause accounting measures of profitability are only approximations for the level ofeconomic profitability.

The source of the imbalance between accounting and economic profits is essentiallytiming. Economic profits are ordinarily measured as the net present value of cashflows from an investment – if the net present value of expected cash flows is greaterthan zero, then economic profits are made from that investment (the economic returnis 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 investmentof a firm that does not return much money in its initial stages will show largeaccounting 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 notavailable), measures of accounting profit can provide reasonable approximations aslong as:

(a) a reasonable run of data is available to ensure that single-year results are notunduly relied on;

(b) the value of assets reported by the firm (historical cost less accountingdepreciation) 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 informationfrom Telstra’s 2001 financial accounts. Rather than deriving operating cash profitfrom NOPAT (net operating profit after tax), we have used operating cashflow as thebase, being the most efficient method given the available information and thetechnical equivalence of the result.

There are insufficient data to breakdown the economic profit working between lines ofbusiness.

Essentially the rationale behind economic profit (residual income) is that profit earnedmust reflect the cost of all the capital that was employed in making that profit; not justthe debt component (i.e. not just subtracting interest).

We know that Total Assets = Interest Bearing Liabilities (IBL's) + Non-Interest BearingLiabilities (NIBL's) plus Equity.

Therefore, Total Assets – NIBL's must equal IBL's + Equity.


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Using total assets less NIBL's as the total volume of capital results in including bothfixed and working capital. The cost of this capital is the weighted average of the Debtand Equity components.

A product of the volume and price of capital gives the capital charge. Subtracting thiscapital charge from profits gives the economic profit estimate as shown in theworking. The capital charge and the profit figure are both pre tax in the workingshown in Figure 2.2A.

2.2 Interpretation of ResultsWe have adopted a broad range of WACC figures for the purposes of this study. TheWACC figures used are 10%, 13% and 16% being pre-tax and nominal. The reasonswhy this particular range appears to be appropriate are set out below. The range wasagreed as appropriate with the ACCC before being applied. It should be noted thatOvum undertook no detailed work in order to validate or determine this range. This isoutside the scope of the study. In addition, the ACCC has made it clear that inendorsing the range as broadly appropriate for this study it is making no judgementsrelating to its use for other purposes.

The median figure of 13% fits Ovum’s own estimate of a typical pre tax WACC of13.5% for a European incumbent with a fixed, mobile and internet business mix.Morgan Stanley Dean Witter has used a WACC of 13.9%7 in their calculations whichprovides a useful sanity check. Of course, the actual WACC for any carrier will bedependent on its exact business portfolio and factors such as any governmentalshare issue and repurchase restrictions that may affect business risk and theenterprise 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 theimpact of increased competition. BT, KPN and DT are believed to have the highesttelecom sector betas according to a report from Julius Bär AG8. This suggests anupper limit of 13.5% for Telstra’s WACC. Notably, Telstra has a higher wirelessmarket share than BT and we make no judgements as to any differences in customerquality, two factors which could materially impact on the WACC number. We alsonote that the applicability of WACC figures across jurisdictions needs to be handledwith care.

The economic profit figures on their own are absolute and provide an initial indicationof the increase in shareholder value that Telstra is estimated to have achieved. Inorder to provide a gauge of how large this value may be in relative terms, we haverebased the economic profit by dividing by the invested capital base (EP/ IC). Thedata derived within the scope of this report does not allow us to conclude absolutelywhether the returns made over the opportunity cost of capital (WACC x IC) aresignificant within the market context. We note however, that at a 16% WACC theEP/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% toconvert to a pre-tax WACC.8 June 19, 2001, Julius Bär (Deutschland) AG, “Deutsche Telekom: Poised forTurnaround’.


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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 aresignificant within the market context. In principle long term returns in excess of theWACC are excessive (we have not performed a historic analysis to this end). Ourview is that most incumbents achieve returns in excess of their WACC. That Telstrais no better or worse in this regard, merely underlines the point that there arestructural factors (e.g. barriers to entry and scale effects), that continue to allow suchoperators to extract "economic rents" - an on-going legacy of their former monopolystatus.

Additionally though, rates of return can be greater than the WACC due to pressure togenerate profits in excess of the WACC and arguably, higher expected project risk.This indicates the possibility of the WACC being understated with respect toincreased 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 insightinto the relative strengths of Telstra in the international arena. The conclusion of thiswas that Telstra provided a strong proposition compared to its European and UScounterparts. The results of the economic profit and accounting analysis with SingTeland NZT benchmarks are consistent with this view, although we have not explicitlybenchmarked other operators.

FIGURE 2.2A: ECONOMIC PROFIT ESTIMATE

WACC CoC EP EP/IC10% 3,443 3,765 11%13% 4,476 2,732 8%16% 5,508 1,700 5%

AUS $M Operating Working Capital AUS $MOperating Cashflow (1) 6,599 Net Current Assets (3,026)

Reverse Interest Bearing Liabilities 2,604Adjustments and Reversals Reverse Tax and other Provisions 3,774Interest Costs 743 3,352Dividends Received (16) Operating Invested CapitalTelstra Share Scheme 725 Add: Net Property Plant and Equipment 22,803Depreciation Net of GW (2,828) Add: Other Operating Assets Net of Operating Liabilities 2,467Lease Costs (2) 530 Add: Value of Operating LeasesIncome tax paid (4) 1,455 25,270

Other Invested CapitalNOPBT 7,208 Goodwill (3) 1,548

Intangibles (3) 1,464ROIC 21% Investments 143

Non Operating Assets (2) 2,6505,805

Total Invested Capital 34,427

Telstra Economic Profit Estimate

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 FurtherWorkOvum’s analysis has been based upon information sourced from third party reports,corporate sources (such as annual reports) and our own internal research. Wecannot confirm the accuracy of any information obtained from third parties, howeverwhere such information has been used then, to the best of our knowledge suchinformation appears at least consistent with our own views. We have also made anumber of estimates, assumptions and inferences in generating our analysis basedupon our professional judgement and experience.

Although not exhaustive, we have highlighted below some of the limitations in ourwork with suggestions for possible further work:

The SingTel numbers are prepared under local Singapore GAAP with no US GAAPnumbers. Commercial pressures on SingTel are likely to be very different to NZT andTelstra due to the high degree of government influence. This reduces thecomparability of SingTel’s results. Further work could recast SingTel’s results underUS GAAP to aid comparisons with Telstra and other carriers. This is likely to bedifficult given the level of detail available in the public domain. Also, increasing thenumber of comparisons by analysing other incumbents would provide a more solidbase from which to benchmark Telstra.

The economic profit derivation will be much more robust with greater clarity andgranularity of data. Management information would be ideal and it is this level of detailthat firms such as McKinsey and Stern Stewart use to analyse the economic profit oftheir clients under product terms such as ‘Residual Income’ and ‘EVA®’. As majorityshareholders, much of this information may be available to the government ofAustralia and possibly the ACCC.

We have made a number of estimates in our economic profit analysis. For examplewe use a best estimate for capitalised leases, R&D has not been explicitly valued andtax on non-operating items has not been factored out. It is possible that theseestimates and simplifications will not significantly affect what is a high level analysis.However, dealing with these issues explicitly using detailed management informationwill confirm this hypothesis. The most significant approximation used in this report isthe 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 greatdeal of insight into the relative performance of these lines. This would entail separateWACC derivations for each business unit and a detailed consideration of theallocation method for invested capital values between units. Such a line of businessanalysis 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 outof non-core and overseas segments whose performance may otherwise be maskingthe underlying performance behaviour of the core business lines.


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Appendix – Information SourcesTelstra 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

Documents

Telstra Financial and Economic Profit Analysis Report.pdf · Telstra Financial and Economic Profit Analysis ... (average 3.5%, 3 year compound ... improved somewhat over the last