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In a Small World, NZT Stands Alone



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Editor's Note: This article is divided into two parts. The first part was originally published in the Financial Times in July. The second part is an exclusive Minyanville update of the original article.

The stocks of American local telephone companies are down substantially from their heyday of the late 1990s and they have been facing problems on many fronts, including fierce competition from cable operators.

But not all phone companies are created equal. In the middle of the South Pacific, Telecom Corp of New Zealand, or NZT, competes in a quite different environment. A unique geography and a relatively small market are responsible for a very atypical competitive environment. New Zealand's two forgotten islands are roughly the size of Colorado, with a population of 4 million people.

Cellular: There are only two players in the wireless market, Telecom of New Zealand and Vodafone (VOD), competing in a cozy duopoly environment. The relatively small market size and fairly large terrain can only support a few wireless market players. Economies of scale are crucial in this business. It would be very difficult for a new player to enter the market at a scale large enough to compete effectively against the incumbents in such a small market.

Both NZT and Vodafone are aware that they have it as good as it gets, and are likely to milk the good thing for as long as they can. In fact, in its earning press release NZT hints (to investors as much to Vodafone) that its only aspiration is to grow along with its roughly 50 percent market share.

Although New Zealand's wireless market is quite saturated, with a 80% installed base (this number is likely to be overstated by prepaid customers), the growth is coming from the provision of previously unavailable but very popular data services: texting, instant messaging, ringtones downloads and so on. Data accounted for 15% of wireless revenues and grew 90% in the last quarter - it is likely to remain strong in the future.

Broadband: The story only gets better. Cable service is basically non-existent in New Zealand, paid television services are offered through satellite, making NZT a de facto monopoly in the wired line and broadband spaces. It introduced a DSL product in a meaningful way only last year (although DSL is available in 92 per cent of the country), and it is one of the main drivers of revenue growth.

NZT has a more than 50% market share of the very competitive dial-up market. It has been making a graceful exit from that arena by switching customers from dial-up to DSL (a much higher margin product). NZT's DSL penetration is still a relatively small 13%, thus this segment will be growing at a fast pace for a long time as consumers switch to a faster, more convenient internet connection.

Wireless services are much more expensive in New Zealand than in the US, hence you do not see the level of defections from landlines to cellphones as observed in the US. In the absence of cable competition, there is little rivalry left in the residential line business. Revenue in this segment declined 1%, due in part to the decrease in number of second phone lines as customers switch to DSL.

NZT subsidizes the DSL modems and cell phones it provides to customers, the cost of which is expensed right away, not depreciated. NZT's earnings growth over last year was hindered by the explosive growth of the DSL and wireless business. As these costs gradually filter through, NZT's margins should expand back to typical levels and its operating profitability should start keeping pace with its top line.
The weakest link in NZT's performance is its long-distance business, which declined 11 per cent. Long distance is a shrinking market. However, it has been in decline for a while and as it gets smaller the rate of decline should decelerate and it should have less impact on the bottom line as its base shrinks.

Telecom New Zealand easily passes the quality, value, and growth test.
Quality: NZT has strong and sustainable competitive advantages, which show in its above industry margins and return on capital of 18%, twice that of Verizon or SBC Communications (SBC). Its debt is rated A by S&P and debt payoff ratios are respectable considering the stable and recurring nature of NZT's cash flows.

Value: NZT trades at about 13 times earnings and about 12 times free cash flows. Based on our discounted cash flow model, there is no growth priced into the stock, an unlikely scenario. In addition,
NZT's secure dividend yield of 7% should serve as a cushion in the market that has delivered no returns for the last seven years.

Growth: NZT generates ample cash flows to invest for growth, pay a dividend and pay down debt. As the declining long distance business gets smaller and fast growing DSL and cellular businesses get larger, NZT's bottom line growth should accelerate to about 5% a year.
Adding a 7 percent dividend on top of that produces a respectable rate total return and that is without factoring in any price earnings expansion, which is warranted.

NZT has another unique feature: because it is a foreign-listed ADR, it could also work well as a hedge against the falling dollar.
The author is a portfolio manager with Denver-based Investment Management Associates and teaches equity research at the University of Colorado. His firm owns shares in New Zealand Telecom.

Part 2: A follow up on my NZT article in Financial Times - exclusively for MV readers.

Net entry into wireless market: Telstra, an Australian telecom giant, was speculating that it may enter New Zealand's wireless market for awhile now. I believe it is very unlikely. Telstra uses this (empty) threat as a bargaining chip in its negotiations with Vodafone, whose service it resells.

Telstra spent a considerable sum of money to enter New Zealand awhile ago, however, it failed miserably in reselling Vodafone's service, gaining only 50,000 customers. The cost of entering New Zealand would be substantial for Telstra, ranging somewhere between $400 and $800 million depending on the coverage it chooses to achieve.

However, the reward is somewhat limited as market penetration by existing players is very high and market size is relatively small -- four million people. As I mentioned in the FT article, scale is extremely important in this business. One cannot just dip a toe into the wireless business, substantial investment in infrastructure, customer service, and marketing is required - creating a large fixed cost. It is very likely that entry into the NZ market will be negatively perceived by Telstra's shareholders. Also, even though the NZ market appears lucrative at this point, that appearance would likely change as Vodafone and NZT would fiercely resist a new entrant- I am sure Telstra is aware of that.

This risk has declined further on Monday (virtually to zero) when TelstraClear (the NZ subsidiary of Telstra) announced restructuring of its unprofitable operations in New Zealand. It makes no sense for TelstraClear to create another unprofitable operation in New Zealand.

Debt: On the surface, it appears that NZT is overly leveraged. However, interest-coverage ratios are very respectable considering very stable and predictable cash flow, which matters a lot more than debt-to-assets ratio. Also debt coverage is showing that NZT in a good shape.

Debt Coverage/Payoff (Yrs to Payoff) Jun04 Jun03 Jun02 Jun01 Jun00
Total Debt /Operating Cash Flows - (Yrs) 2.52 3.11 4.15 3.12 2.80
Total Debt /Free Cash Flows - (Yrs) 3.99 4.93 9.54 17.29 5.65

Interest Coverage

Operating Cash Flows /Interest Expense 4.58 3.80 3.07 3.68 5.14
Free Cash Flow/Interest Expense 2.90 2.40 1.34 0.66 2.55
EBIT/Interest Expense 4.14 3.63 3.30 3.33 4.56

Debt/Assets 56.5% 62.9% 68.1% 61.1% 54.2%

The Level of debt that the company should take will be dependent on many factors: predictability of its cash flows (very predictable for NZT as majority of sales are recurring), cyclicality of the business (not very cyclical), sensitivity of costs to commodity prices (i.e. oil prices for airlines; not the case for NZT), degree of operational leverage (a proportion of fixed to total costs, the large is operational leverage the less debt company should have). Also, interest and debt coverage ratios are improving. S&P tends to agree with this assessment rating NZT's debt as "A."

VoIP (Voice-over Internet Protocol): is another risk, this one will not go away anytime soon. However, it is likely to remain at the headline level and will not have a substantial impact on NZT's profitability.

Traditional VoIP's (i.e. Vonage) value proposition decreases as long distance rates continue to decline, and rates have been on a double digit decline for a long time.

As Professor Fil Zucchi pointed out to me, while he was showing me our nation's capital, phone lines still are a must for dish subscribers as they serve as an uplink to connect dish receivers (and TiVo) to content providers. This is where NZ again is different from American counterparts. Cable is very undeveloped in NZ and is likely to stay that way as television services are provided mainly through satellite. Consumers will still need to have a phone line, thus services such as Skype that are making headlines on a daily basis are unlikely to have any impact on NZT's bottom line. (Side Note: How long will it take for eBay to write off the Skype acquisition?)

Dollar hedge explained: NZT's dividends are paid in NZ dollars; they are converted by the ADR administrator bank (typically Bank of NY) to U.S, dollars at the prevailing NZ/U.S. exchange rate. If the U.S dollar declines in value relative to the NZ dollar, the NZ dollar will be buying more U.S. dollars, resulting in a higher dividend to U.S. ADR shareholders. Thus a hypothetical 10% decline in the U.S. dollar would cause U.S. dividend yield to go up from 7% to 7.7%.

Warning sings: A strengthening dollar has the opposite impact, hurting NZT's yield. The latest NZ economic numbers showed an increase of trade deficit to 8% of GDP, a substantial increase from 4.8% last year - this may cause the NZ dollar to decline against the U.S. dollar. However, NZ interest rates are still much higher than in U.S., (90-day bank-bill yields 7.11%) thus they may serve as a counterbalance to increasing trade deficit.

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