Telstra and the National Broadband Network are both in perilous waters with no relief in sight. Telstra's share price is at record lows despite delivering an upbeat strategy and reiterating its ability to keep on paying an annual dividend of 28 cents. The current public commentary on NBN trivialises the importance of network infrastructure in Australia. As a consequence NBN is caught in a maelstrom of political machinations which may delay or stall its roll-out. The following analysis and proposed solution is written with an incomplete knowledge of the current internal situations within Telstra and NBN but it is written with a comprehensive knowledge of the industry as a whole, where it has come from and where it is going. So, with honour and respect to the current players, I offer the following ...
Telstra
For several years now Telstra has been battling proposals from the government, regulators and competitors to separate its wholesale and retail businesses. The business model debated has been a wholesale network company, Netco, and a retail services company, Servco. The arguments in favour have been for fairer and more effective competition in the market place. The arguments against, mostly from Telstra but supported by corporate advisors, have been that it would be time consuming and expensive and that it would be detrimental to shareholder value.
The intriguing aspect of Telstra's latest business strategy is that it has effectively redefined itself as Servco, the service company in that odious model debated over the years. Netco, the network company, once the mainstay of Telstra's business, is off the map as far as Telstra is concerned. Has Telstra tacitly accepted the inevitability of a split?
Telstra's new strategy is to invest in improving customer service, products and marketing. But a glaring gap is the absence of any investment in the customer access network which is the major source of service faults and low data speeds. The current copper network is old and highly susceptible to water, lightning and human intervention. After any storm the fault rate soars and takes some time to settle back down again. The copper network has not received any capital investment beyond extensions and repairs for a decade or more. Sol Trujillo revived an earlier plan to upgrade to a fibre-to-the-node architecture but was unable to implement it. And now, with NBN on the scene, Telstra has little intention or incentive to invest in the access network at all. And yet the planned improvement in customer service cannot be achieved without it.
As a tactical solution to access, Telstra has shifted customers onto its cable and wireless networks. However, neither network is economic in the long term for fixed network access and neither can deliver the speeds particularly at peak times. The government has also intervened, concerned that the NBN business case will suffer if too many customers are transferred.
The pall over Telstra's share price is clearly the absence, for the foreseeable future, of a Netco to deliver reliable network services. David Thodey has recently said as much himself.
The weakness of Telstra's position with regard to NBN is that it has negotiated a price of $11 billion for NBN to use Telstra's fixed network assets. This price may look good but it doesn't solve Telstra's immediate problems and it is based on highly uncertain long term predictions of NBN's business – the worst of all worlds. As the project proceeds, or doesn't proceed, Telstra will have no choice but to plough a large part of this money back into repair and operations of the copper network, a cost of well over $1 billion per year. For a company wanting to focus on future services this is a major look backwards. What is more, the $11 billion doesn't help shareholders one scrap, except to prop up the dividend at unrealistic levels for another year or so.
When the Howard government inquired into splitting Telstra in 2002, the share price was comfortably over $4.50. As the debate heated up it sank to a low of $4.00. By mid 2003, when the threat of a split receded, the share price fully recovered to $4.50 and more. Was this the market perception of the financial impact of a such a split? One would suspect that it was less a valid value judgement than a reaction to uncertainty.
In 2010 Telstra finds itself in the same position: its price is severely depressed because of uncertainty - depressed way below the 2002 low point. Confidence must be restored. A government initiated split is still on the cards. Will it increase confidence or drive Telstra down further? Of course, it could be done badly, simply by splitting Telstra as it is and leaving a rump Servco and a rump Netco. Telstra shareholders would have reason to be shocked if this were the outcome.
But circumstances have changed hugely since 2002. Technology has changed in every sector of the industry, the competition is very different, but demand for greater speed, capacity, capability and quality continues unabated. By responding to the new environment in different ways, Telstra can be restored to vitality.
NBN
The National Broadband Network has been established to build a national fibre-to-the-home network over about ten years. This was the government's solution to an impasse with Telstra over its proposal to invest in a fibre-to-the-node access network but conditional on the government conceding to Telstra on a number of regulatory constraints.
NBN is on a path to becoming a Netco, but it is not going to invest in the access network to meet Telstra's, or users', immediate needs. Its mandate is long term. Its technology solution is also long term. In normal circumstances a major upgrade to the access network would be funded from Telstra's cash flows and be implemented in a more staged and commercial fashion. Progressive decommissioning of the copper network would also be factored into the business plan so that operational savings flowed back into the project. This is not normal circumstances. Funding, roll-out and pricing will be dictated by political considerations and are likely to be very fickle especially given the uncertain balance of power in Canberra.
NBN is an obvious political target partly because at the time of its proposal its costs were said to be $43 billion, a throw away number, entirely unsubstantiated, but big enough for mud to stick. The current estimated project cost is a rather lower. In fact even $43 billion is not out of line with Telstra's average annual capital expenditure of over $4 billion over the last ten years. If NBN's plans were subject to normal commercial discipline the project could be financially quite viable.
The NBN business case is bedeviled by long term predictions of price and demand. It is easy to predict that data speeds and capacities are going to keep on increasing. But at what take up rate and at what price? Decades of experience with technology products demonstrate that as performance and capability increase, prices, including inflation, stay steady, ie, real prices decrease. The NBN business case is based on a wholesale price similar to today's retail prices. This is very optimistic. Perceived high prices will delay take up, increase costs and cause a political backlash. NBN has to cut its cloth to fit. Politicians have to set up the legislative and regulatory framework and then step away. The single proviso would be that they have to be prepared to provide special funding for political requirements which would otherwise be uneconomic. This might apply to remote areas, to uniform pricing or to delaying the decommissioning of the copper network.
NBN has not taken over Telstra's fixed network assets but has a broadly defined agreement to use some of the network assets for a total price of $11 billion. NBN is likely to duplicate much of what already exists, particularly inter-city and regional fibre links, which serve no purpose in upgrading the access network.
Whether NBN survives its political crisis or not there is going to be an extended period when there is no entity investing in or sustaining the access network as customers now need it.
The Solution
Telstra's latest strategy suggests the solution: roll Telstra's wholesale and network activities into NBN to provide it with the cash flows necessary to develop the customer access network to meet immediate needs in the most effective way and to transition to fibre-to-the-home as and when it is warranted.
The essential ingredients are that NBN is put on a sound commercial footing and that Telstra shareholders get a slice of the action in both companies and their assets are set on a path for growth.
The historical objection that such a split would be too expensive and time consuming has lost its punch since 2002 – if it ever had any punch. In the late 1990s when such a split was considered within Telstra it could have been achieved quite simply by separating the Network Technology Group and Wholesale Group from the Retail Groups. The question of what technology platforms went where was not a determining factor. Since then telecommunications has rapidly shifted to a universal services platform based on Internet Protocol (IP) at the network level. The network "layer" is recognised in all models of telecommunications and the Internet, separating the functions of connections and networks on the one side from applications and services on the other. For example, Telstra's flag-ship "T-suite" of products and services is a set of applications which operate on an IP network.
Amongst Telstra's legacy technologies its local and long distance switched voice products are producing good but declining revenues and AXE exchanges will eventually be phased out. The clear split now is for NBN to be responsible for the universal IP network platform and for Telstra, and other telcos, to be responsible for retail IP services. NBN would take over the legacy network platforms including AXE and would receive wholesale revenues from them until they are phased out, thus providing the immediate source of funds for its network investments. The split of revenues and margins for legacy products would be determined to give both companies a viable transition to an IP future. The details of the split must be determined independently to ensure that the ultimate beneficiaries are shareholders and retail customers.
The public argument about splitting Telstra has so far been about the wholesale business and the fixed network. Telstra's mobile network has not been seen as a competition issue and has been left out of the equation. The Foxtel cable network has also been seen as another matter, fraught, but more a sacrificial pawn in a bigger game. From a shareholder's point of view, there is a good case that both should be rolled into Netco. NBN would have a wider range of technologies to deliver wholesale data access. NBN could undoubtedly achieve much higher capital utilisation of both of these assets than Telstra can with opportunities and economies for everyone. Telstra would retain its 50% share holding in Foxtel. Sooner or later Foxtel will transition to an IP based service, and fibre-to-the-home will be the ideal network platform.
Telstra claims that its superior mobile network coverage is a major differentiator in the market. This may be true but customers are buying potential which is rarely realised, not actual usage. From a shareholder's point of view that potential should be converted to reality. A remote base station is an asset and its owner should make it available for use by anyone. For a transition period Telstra can contract to NBN for exclusivity (at a premium wholesale price) but eventually it will have to compete for services that are real, not coverage that is under utilised. NBN's motivation will be to maximise that asset utilisation.
In the longer term the biggest issue for Telstra's mobile network will be to maintain the ongoing level of capital investment for economic viability. Until now it has gone through three generations of technology (with some significant intermediate upgrades as well). Soon it will need to transition to 4G. The earlier competition was based on market share of customer numbers as but as market penetration has neared 100% the focus is on market share of customer value and the value proposition is changing from voice and messaging to IP services. Sound familiar? Mobile 4G technology is about an IP platform which has much greater capacity to support long term growth in IP services.
Capital efficiency became a driving issue when 3G mobile technology was introduced. Then Australia's four mobile network operators combined forces to share two networks whilst retaining their independent retail operations. The stronger players had a major advantage over the weaker players when major capital expenditure was required. One operator has since left the market reducing competition at the retail level.
A breadth of platform technologies will provide NBN with wider sources of wholesale income and will give it more room to maximise the utilisation of its assets and hence be able to keep its wholesale prices as low as possible. Competition will do the rest at the retail level. (This is possibly Telstra's greatest fear.)
The benefits for Telstra are many. It will be freed from the capital demands and operational costs of managing networks which are rapidly becoming obsolescent. Operating at arms length from NBN it will have greater negotiating leverage. Depreciation charges which currently burden Telstra's P&L account will come in as direct costs but at a lower level because of increased asset utilisation in NBN. Telstra will also be able to focus on competitive value adding technologies such as voice on IP without worrying about internal competition with its legacy businesses. It will also be able to simplify its own management structure, processes and systems, and get its products and services to market by the fastest available route rather than wait for an internal technology supplier to agree with it on network and service priorities. It will also give Telstra an opportunity to reassess its dividend policy which has recently become a major burden for management of the company. Telstra shareholders will get their combination of capital growth and dividends from both Telstra and NBN.
Making NBN a dedicated wholesale network company and Telstra a dedicated retail services company will allow their respective boards and management teams to be much more focused and aligned to a business model consistent for each. Telstra's model will differ from its present model in that its asset base will be much smaller, its depreciation will be much smaller and it will have to focus on managing revenues and direct costs – mostly from its network service provider – and on its internal overheads including product development, marketing and sales expenses. Physical units will relate to products and usage by market segment. Telstra will need to be very fast on its feet and responsive to a dynamic retail market. NBN's business model will be much more capital intensive, focused on long term wholesale contracts, capital expenditure and depreciation. It will also take over the operations of current networks and their attendant costs. Nevertheless NBN will have to keep up with or stay ahead of demand for capacity and quality at the lowest possible unit costs. Physical units will relate to capacity, coverage and utilisation.
Politics
However much the above arguments appear to present a rational solution to the long running malaise affecting telecommunications in Australia, we all know that the real issue is politics. Politics do not bow to common sense.
The Labor government is committed to a fibre-to-the-home network. The Liberal opposition is committed to derail it. However, these are just their declared positions. The government in fact is very sensitive to the cost and the impact on the budget. And the opposition realises that many regional members support the new broadband network for their own electorates. Opposition leader, Tony Abbott, has given the demolition job to his arch-nemesis, Malcolm Turnbull, who appears to support investment in national broadband infrastructure, but not the government's model.
Telstra politics will also play a part. In the past Don McGauchie and Sol Trujillo took on the government and nearly won. However, their scorched earth policy gave us the legacy of a defrocked Telstra and an NBN with no suitor. Catherine Livingstone and David Thodey, as current Chair and CEO of Telstra respectively, are much more accommodating to the government but they will fight very strongly for what they believe it is right for Telstra and, more hopefully, for what is right for Telstra shareholders. A key issue for them is to obtain the right advice because their engineering and network resources were decimated under previous regimes and their company has now set its course on a Servco model.
Most competitors could be expected to support this enthusiastically. However, Optus and Vodaphone may well object to the mobile network component of the proposal. It would certainly open up opportunities for greater competition in the retail mobile market and consequently threaten what is now a very comfortable oligopoly. (All the more reason to make it happen.)
Telstra shareholders would now see a way out of their current predicament. Once this proposal gets a ground swell of political support, the Telstra share price will undoubtedly rise. As analysts develop their financial models the price will find a relatively stable level. Once the terms of the split have been agreed the price will change again reflecting final valuations. At each stage opportunists will move in and prices will climb beyond realistic valuations. The negotiating parties will need to be very careful not to allow a repeat of T2 when Telstra shareholders were very badly burnt. Eventually Telstra shareholders who are still in there will get shares in both companies each with a price and a prospectus describing opportunities for growth and income but also warning of the many and varied risks. (There are many arses to protect.)
Who is going to take the initiative?
Several alternative initiatives could achieve the outcome presented here.
Telstra and its shareholders have most to gain by it – restoration of the share price and a pathway to improved returns. Telstra's major institutional shareholders should be the first to take the initiative. The Future Fund, in particular, currently holds 10.9% of Telstra. However, despite its huge exposure to Telstra it has rarely been active in promoting change. Now is the golden opportunity.
Catherine Livingstone and David Thodey could do it on their own because it would play largely to the government's agenda and would resolve a very difficult issue in a time of political instability. By taking the initiative themselves they could have more control of the agenda than otherwise. Mike Quigley, as Chair and CEO of NBN, would have a view but I suspect that he would accept the proposal and he certainly has the capability to make such an NBN work.
Stephen Conroy as Minister for Broadband, Communications and the Digital Economy could also do it. But it might be interpreted as an about face on his declared position. Without the support of Telstra the politics could become even more poisonous, although politicians seem to thrive on what would kill the rest of us.
Malcolm Turnbull could do it. He is well respected in the business and technology community as well as by the majority of voters in the political centre. He would give the proposal credibility. Malcolm could expect tacit support from members from both sides of politics. The government might even accept it from him on the expectation that it would throw a useful spanner in the opposition works. How Tony Abbott would take it, who knows?
This calls for a statesman. Who is going to stand up?
