Government Goes Medieval on Telecom New Zealand

By Vitaliy Katsenelson, CFA 

May 5, 2006 – The Motley Fool

A political risk is present in shares of any government-regulated company, but it came to fruition for Telecom New Zealand (NYSE: NZT) when the New Zealand government unbundled the local loop. Unbundling a local loop is a fancy phrase for requiring an incumbent telecom provider to open its networks to competition at cost. But maybe, just maybe, it created a very unique buying opportunity for Telecom New Zealand’s shares.

The competitive telecom landscape in New Zealand is very different from the rest of the world. Let’s review.

New Zealand is a very small country with a population of four million people. Hidden on two mountainous islands in the South Pacific, its geography has created a very unique competitive environment for the telecom services. Cable competition — which has been gradually eating away at American counterparts Verizon (NYSE: VZ) and AT&T (NYSE: T) — is virtually nonexistent in New Zealand, since cable proved to be an uneconomical route because of the relatively small market size and large, rough terrain. For the same reasons, Telecom New Zealand has only one competitor on the wireless side — Vodafone, where both companies split the wireless market share in half.

The telecommunication business is not much different from a cargo plane trying to take off on the runway. The heavier the cargo that the plane carries (the fixed costs) the longer the runway (number of customers) required for the plane’s successful takeoff. Scale is a must in the telecom business, and ability to achieve the scale is tremendously limited by the relatively small market size. There is only space for one runway in New Zealand’s telecom landscape. And the size of any new runways is limited by the success of the existing players.

Over the last couple years, Telecom New Zealand has been cutting prices on DSL services, which fueled DSL subscriber growth exceeding 100% a year. In March, Telecom New Zealand cut DSL prices to the point that it rivals much inferior dial-up. This move should only accelerate DSL subscriber growth over the next couple years, since dropping dial-up for DSL becomes a no-brainer decision.

Despite the apparent urgency of the government’s action, it will take several years for the decision to come into effect, since a lot of details have to be ironed out. This will give Telecom New Zealand plenty of time to increase its DSL penetration to at least 50% of the consumer market — from today’s 20% or probably even higher — since Telecom New Zealand will try to capitalize on this window of opportunity and step up its DSL marketing efforts.

Any new entrant going after the DSL or voice market will have to spend a considerable amount of money to put its equipment in Telecom New Zealand’s network operating center, and then it will have to try capture a significant market share of a relatively small market (where incumbent Telecom New Zealand already has a large market share) to recoup that cost. In reality, very few players are willing to take such risks. Telstra — an Australian counterpart — already has operations in New Zealand and is speculated to enter the market once it is deregulated. However, it appears that it has its hands full with its core Australian operations. Smaller players are likely to make some waves, but their success will be very limited, since they lack the scale to compete with Telecom New Zealand.

NZT shows resilienceThe decision to unbundle the local loop made little sense, though it was expected by many (including the company). What was not expected is the decision to force Telecom New Zealand to provide naked DSL. Naked DSL means that Telecom New Zealand is obligated to offer DSL services even to the customers that don’t subscribe to the dial tone and pay for line rental. This means that competitors will be able to offer VOIP service over the company’s phone lines. However, things may not be as bad as they seem:

  1. Telecom New Zealand is working on its own VOIP solution, and it will have a several-year head start to sell it to its customers before competition enters the market.
  2. As soon as the call comes off the Internet on Telecom New Zealand’s last mile (which Telecom New Zealand owns) a competitor VOIP provider has to pay for it.
  3. In France, a year and a half after Naked DSL was introduced, only 8% of the customers have taken the offer and canceled their phone line.

Though it appears that Telecom New Zealand is powerless to fight the government on this ruling, it holds a lot of political leverage:

  1. As the largest company in New Zealand, it accounts for close to a quarter of the New Zealand stock market’s capitalization. A significant drop of Telecom New Zealand shares over the last couple days had a tremendous impact on the NZ stock market.
  2. It is the largest employer in New Zealand. The new law may force the company to cut costs — and potentially start some unpopular layoffs. I believe Telecom New Zealand will have no problems with blaming politicians for the layoffs.
  3. The company has made it clear that if the new laws are instituted it will stop investing in New Zealand, since it won’t be to recoup its investment with the new laws. It will not invest in a new fiber-to-home network — the future of telecom. And if a regulated incumbent abstains from making this multibillion dollar investment, nobody else will. This will derail the increase in available broadband speed in New Zealand, which is, ironically, the outcome politicians are trying to accomplish.

Future still looks brightIn spite of apparent certainty that the new ruling brings, investors just had a small peek at the worst possible outcome of proposed regulation. But it’s always darkest before the dawn, and I believe the news flow will not get any darker. Today’s valuation factors in a very high market share loss, which is very unlikely.

The stock success is largely driven by its super-sized dividend. The core ($1.93) dividend appears to be secure. If Telecom New Zealand decides to rollout the next-generation network, it can finance it from existing cash flows (after paying for capital expenditures and core dividends it still has a couple hundred million in U.S. dollars leftover), cost cutting, and possibly from lowering or cutting the special dividend of about $0.27 a share. (Since the special dividend was an added bonus, I never counted it in my analysis.)

Once the political landscape softens, which I believe it will, Telecom New Zealand will be making an investment into a next-generation fiber network, which has a hidden kicker — it will allow the company to bring television services to New Zealand customers. This may extend top line growth for Telecom New Zealand for years to come.

All that said, politicians are infamous for making decisions that improve their chances of being reelected, but hurt the general public in process. Let’s hope the consequences of this political decision won’t be hurting consumers years later — when today’s politicians are likely to be out of office, sipping margaritas on the beach.