Telstra should plan for separation

Summary:If Telstra is serious about engaging with the Federal Government over the National Broadband Network it should immediately start the work needed to break itself in two.

commentary If Telstra is serious about engaging with the Federal Government over the National Broadband Network it should immediately start the work needed to break itself in two.

Breaking Telstra into a core network company and a media/comms company has plenty of merit. In fact, Telstra directors would have a fiduciary responsibility to investigate it. Based on recent sum-of-the-parts valuations, the exercise could unleash about $9 billion in value or about 70 cents a share. Telstra shareholders would also end up with shares in two companies.

Breaking Telstra into a core network company and a media/comms company has plenty of merit

They would own a utility-style stock with predictable cash flows and a growth stock with enormous opportunities for expansion in multimedia on the back of the NBN.

There are several successful precedents in the energy sector that prove shareholder value can be unlocked from separating utility-style businesses from customer service businesses. AGL is a prime example of a company that split its core infrastructure assets from its retail businesses. AGL's infrastructure assets were merged with Alinta.

Other transactions in the energy area, along with the AGL example, provide powerful evidence that institutions will support a company with reliable but low growth returns.

One of the driving forces behind the de-merger activity in the energy sector was the large differential between the cost of capital for monopoly assets and the cost of capital for competitive assets. This cost of capital arbitrage still exists, although to a lesser extent than when AGL de-merged its infrastructure.

There are three good reasons why Telstra chief executive David Thodey ought to flick the switch for separation of the Telstra network business into a new company.

Firstly, it will give Telstra control over its own destiny. We know the Federal Government wants it to happen so why wait to be forced? Having control over the process will allow Telstra to dictate the corporate structure, finesse the technical elements and provide the company with the ammunition for a conversation about realistic access pricing.

Secondly, a break-up would win the company a lot of friends in Canberra. It would help minimise the cost of the NBN. The Telstra core network company could stand alone and work in partnership with the NBN or sell assets to the NBN in return for equity or cash. The creation of a core network company avoids the problems associated with conflicts of interest inherent in an integrated telco structure.

Thirdly, the valuation impact would almost certainly be positive. Citi Research telco analyst Phil Campbell says that, based on sum-of-the-parts valuations, Telstra is worth about $53.8 billion or $4.30 a share, which is about 20 per cent higher than the current price.

Campbell says Telstra's core network has an enterprise value of about $41 billion. His enterprise values for the other major businesses are: mobile $16 billion, Sensis $10 billion, CSL in Hong Kong $1.2 billion, Telstra Clear in New Zealand $314 million and Foxtel $1.87 billion.

After including other smaller businesses, the media/comms arm of Telstra has an enterprise value of about $30 billion. Subtract the debt and pension plan liabilities of $17.4 billion and you get a sum-of-the-parts valuation of $53.8 billion.

The allocation of the debt between the two separate businesses is a thorny problem but not insurmountable. In fact, one could argue that the market's tolerance for debt in utility-style stocks will work in Telstra's favour.

The creation of a core network company avoids the problems associated with conflicts of interest inherent in an integrated telco structure.

Telstra's so-called monopoly assets could probably handle a debt to equity ratio of about 50 to 60 per cent. That is less than what was tolerated before the credit crisis two years ago, but it is more than enough to make the media/comms company virtually debt free.

Telstra's debt to equity ratio for the whole company is 30 per cent. If as a result of separation the entire $17 billion in debt is lumped in with the core network assets then the valuation of the media/comms arm would soar because of its huge free cash flows and capacity to expand.

Another option would be to follow the advice of a Business Spectator reader, and use this year's additional free cash flow of $1.6 billion to repay debt.

It is clear from comments made last week by Telstra chief financial officer John Stanhope that there is a love of the status quo in the company. Stanhope said functional separation would cost the company about 4 cents a share or about $500 million. He later said separation could cost between $800 million and $1 billion.

He said "extreme separation" could take five years or more to implement and would be a major disruption for Telstra inside the company. He said it would also disrupt customers. It could not be any more disruptive than the recent IT transformation. That came in $200 million over budget, failed to deliver the promised benefits in accordance with milestones, and caused so much disruption it damaged the Telstra brand.

There are obviously many technical and structural obstacles that would have to be overcome before a split of the company could be completed. There may also be taxation issues. Also, utility style companies are not the flavour of the month on the stock market. Most utility companies have not been part of the recent strong rally on the share market.

But then again they were not affected as badly as other stocks during the market downturn. Those defensive characteristics could prove attractive to many investors.

Business Spectator

This article by Business Spectator's Tony Boyd is reproduced on ZDNet.com.au courtesy of a reciprocal publishing agreement.

Topics: Government, Government : AU, Legal, Telcos, Telstra

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