Telecom New Zealand: Bull or Bear?
Friday June 30By Vitaliy Katsenelson, CFA
Every trade has a buyer and seller taking opposite sides. They often have different risk tolerances, time horizons, and beliefs about the direction of a stock. And before purchasing any stock, investors should build a good bull case that refutes the bear case. In that spirit, I’ll spend the next few paragraphs making both a bullish and a bearish case for Telecom New Zealand (NYSE: NZT
), and I’ll let the reader decide which argument is more convincing.
In the past couple of days, Motley Fool Income Investor recommendation Telecom New Zealand announced that it will voluntarily separate its operations into retail and wholesale units.
The company will have two independent units. Wholesale would still be a regulated monopoly, not unlike Telecom New Zealand today, selling retail providers access to its network. Telecom’s retail operation would be one of the providers (likely an unregulated one) buying services for the same price as the rest of the retail competition from the wholesale division. This is a very logical route for the company to take.
I have to hand it to Telecom’s management. This is a brilliant move on many fronts, and here is why:
It will preemptively get the New Zealand government off its tail. It is hard to go medieval on a company that is trying to promote competition and become friendly.
This separation of wholesale and retail operations was a very likely outcome of the Kiwi government’s future actions. Now it will be done on mostly Telecom New Zealand’s terms, not the government’s. Similar to a child that eats a forbidden cookie, as a parent you would not punish the child as hard if he or she comes to you first and suggests a punishment. Telecom New Zealand did just that.
Once the telecom market was opened to competition, a new type of strategy was needed to effectively compete in the “new” marketplace. Separating and managing retail and wholesale operations will allow the company to manage each division appropriately: Wholesale operations will likely be managed for asset and free cash flow maximization — attempting to get as much as possible from the existing assets. It is still a regulated monopoly with somewhat limited revenue upside, after all. And since competition instead of government will be breathing down the neck of its retail operations, a relatively new development for this company that has operated (at least on the wired side) in a competition-free vacuum, the retail operations will require a very different approach — a marketing touch.
Other considerationsThe threat of competition may be overblown. If the deregulation happened in any other place, new competition would likely bring down the prices and compete away “the monopolistic profits” from the incumbent. However, New Zealand is not the rest of the world. The country’s unique geography — two mountainous islands in the middle of the South Pacific and a relatively small population of 4 million people — is likely to prohibit new entrants from achieving a much-needed scale to become formidable competition.
The relatively small market size will very unlikely invite the big fish. Telstra (NYSE: TLS
) is busy with its problems in Australia, and Vodafone (NYSE: VOD
), a wireless competitor in New Zealand, doesn’t have wired business outside Germany, though this could change, and it is a viable risk. (I discussed this issue in a previous article.) The smaller competitors will likely play a similar role that Apple (Nasdaq: AAPL
) played so well for Microsoft (Nasdaq: MSFT
) for a long period of time — its existence and small market share in the desktop market has kept the government (mostly) off Microsoft’s back.
The government has absolutely no intention of destroying Telecom New Zealand it is one of the country’s largest employers, and the stock represents close to 25% of its stock market’s entire market capitalization. The government wanted to introduce some competition into the marketplace and lower the broadband prices, and it has achieved that. Politicians can safely declare a victory and move to the next page on their agenda.
The separation will not change company’s cost structure. However, it probably will incur some upfront costs going through the separation, which will amount to tens of millions — a drop in the bucket for this giant. The business will not really change that much, as wholesale and retail divisions are already operating on quasi-separated basis.
Telecom New Zealand will likely come out of this debacle stronger than it came into it. The appearance of competition will keep politicians off its back, and it will have two operating companies that appropriately will have two different sets of managements and very different competitive strategies.
Most importantly, the dividend should be intact. In the worst case, the reduction to the dividend will be very small. Telecom’s dividend is set to be 85% of its net income. The net-income figure used in the dividend calculation is a somewhat subjective measure as one-time charges and noncash items are added back in it. Despite all of the negativity surrounding this company, it still generates (and will likely to continue to do so) an enormous amount of free cash flow, it has a strong balance sheet, and it is underleveraged.
Even after the company pays for capital expenditures and its enormous dividend (yielding nearly 10% at today’s price), it still has several hundred million dollars of discretionary cash flows. Therefore, even if the company is faced with unplanned expenses that come with separation, its abundant and very stable cash flow should cover them without needing to dip into the dividend. The next couple of years will be bumpy for Telecom New Zealand, but the current stock price appears to appropriately discount the drop-off in profitability.
Now, the bear case
New Zealand government has so far shown complete disregard to what will happen to Telecom New Zealand. Even though it is the largest employer and the largest company on the New Zealand stock exchange, the government’s core focus has been to reignite economic growth (assuming that lowering the prices for telecommunications services would accomplish that), even if it meant driving Telecom New Zealand stock into the ground.
The actions of the New Zealand government have been fairly draconian to date — the latest ruling allowing Vodafone wireless customers free calls to Telecom New Zealand customers speaks volumes to that effect. It was hard to see the light at the end of this tunnel, and with uncertainty written all over the stock, it is hard to know what other bad news will emerge. And since the latest news from New Zealand only got worse with time, investors naturally expect more bad news.
Before this latest ruling in its favor, Vodafone was just a bystander competing with the incumbent in the wireless segment, happily enjoying its cozy duopoly in the New Zealand wireless market. This latest news is another piece of the puzzle explaining the Telecom New Zealand stock’s precipitous decline. Though the small competitors are unlikely to have a significant impact on Telecom’s market share, Vodafone’s existing significant market presence in the New Zealand wireless market may provide the needed scale to compete with Telecom in the soon-to-be-unbundled land line and DSL businesses. Vodafone could start by bundling a DSL and voice over Internet protocol (VoIP) products with a wireless service plan.
However, Telecom New Zealand is likely to make it a very difficult task for Vodafone. Since it will take about 18 months to two years for the laws to be passed and all regulatory kinks to be worked out, Telecom New Zealand will use this window of opportunity to roll out a very aggressive marketing campaign in an attempt to capture as much market share in DSL, and switch customers to a feature reach VoIP product.
Once it captures a very large market share in the DSL and VoIP markets, it will take a very sweet offer from competitors for customers to leave Telecom New Zealand. This will be a smart move on Telecom’s part; however, it is also likely to put additional pressure on earnings, at least over the next two years as marketing (i.e. TV, radio, and print advertising) doesn’t come cheap.
There is still an issue of land-line customers dropping that service for the soon-to-be much cheaper wireless service. The cellular service is not an optimal substitute for a landline service for the majority of customers; for a household with several family members, every person would need to have a cell phone otherwise, if someone leaves the house and takes the cell phone, the rest of the family will be phoneless. We are likely to see the highest migration to the cell-phone service among college students, singles, and families without children. Satellite-TV subscribers and customers that have a security system will still require a landline, though it doesn’t necessarily have to be a Telecom New Zealand line. In addition, phone calls outside the local area should still be expensive, unless the government changes pricing structure there as well.
The separation of regulated wholesale business and unregulated retail business may work out well for the company. However, success or failure lies in a small but very important detail: the price the government will allow the wholesale division to charge for its services. If the price is high enough, then even if the company loses market share in the retail space, it will still be able to be a very profitable business on a combined basis (retail and wholesale). So far, the government has not shown its kind side to Telecom New Zealand. A sliver of bright light is that the pricing will be decided not by politicians but by a regulator that doesn’t (at least in theory) have a political agenda.
Neither American nor New Zealand investors like uncertainty, and the uncertainty over the company’s future profitability has driven this stock off the cliff. Future regulation, the state of future competition, company profitability, and the dividend are uncertain at this point. The government’s behavior to date has surprised most investors, including myself. Will the government go even more draconian on the company? Though logic tells me “no,” logic was not a very useful tool in predicting the New Zealand government’s actions over the past couple of months. I ask myself: what did I miss? Why didn’t I foresee the large stock decline?
The answer (not an excuse, but a mere observation) has to do with the timing of the news cycle. On a standalone basis, the events that transpired over last couple of months are not earth-shattering, considering the unique natures of New Zealand’s geography and industry structure. However, once all of these events are put together, their impact on the company’s future profitability could be very significant.
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