Telecom's split decision

Hedge funds rely on insight, immaculate timing and speed to make big profits on gutsy bets. But none of those characteristics apply to Elliott International's tilt at Telecom.

The New York investor is trying to force Telecom to rewrite its strategy for radically reshaping its business. In the process, Elliott is in essence taking on the government too since sweeping regulatory change forced Telecom to reinvent itself.

Elliott argues that Telecom's operational separation into network, wholesale and retail units within one company, which the company agreed with the government, is cumbersome and costly.

Moreover, it says, the three-way split is unlikely to establish a level playing field for telco competition or to deliver the massive increase in investment Telecom and the sector needs to lift New Zealand's telecommunications performance.

It proposes instead a structural separation of Telecom into two separate companies - one network and wholesale and the other retail. This, it says, would be easier, cheaper and more effective.

Telecom made a half-hearted stab at the same argument in April 2007. But that was a last, desperate attempt by its old leadership to thwart the government's proposal for operational separation.

But the old guard was soon on the way out, enabling the debate to progress rapidly and constructively. A crucial turning point came in July 2007 when Telecom appointed Paul Reynolds as chief executive. One of the leading architects of BT's operational separation, he argued New Zealand could improve on the British experience.

Rather than engage in a costly and complicated separation of the legacy phone system, it should be left to "wither on the vine". Instead, Telecom's new arm's-length network should invest the time and money in the next generation of technology with most of the separation powers focused on it.

This strategy became the heart of the separation agreement Telecom finally agreed with the government. A very detailed document running to 160 pages lays out an extensive range of legally binding obligations on Telecom for the likes of investment, service levels and behaviour.

It includes, for example, Telecom's commitment to install an additional 2500km of fibre-optic cable and 3600 roadside cabinets to deliver broadband to towns with more than 500 lines. Telecom says this will bring fibre to much smaller communities than many telcos are achieving overseas.

To begin to meet these obligations, Telecom cranked up its New Zealand capital spending to $875m in the year ended this June from $686m a year earlier. Investment will be around $1 billion this financial year and similar again the following year.

While Telecom and the government didn't finalise the undertakings until March, the direction they were heading was very clear this time last year when Elliott became a Telecom shareholder.

Undaunted, Elliott lobbied for its structural proposal in meetings with Telecom and in submissions to the government last November and in January. But both papers were flawed because they dodged the central issue: where to draw the separation line.

The hedge fund made it sound easy to hive off the network and wholesale functions into one company and retail into the other. It admitted that even this simplistic view still had its regulatory complexity. Government and regulators would still have to prescribe and monitor the relationship between the network and wholesale activities within the one company.

But Elliott failed to address a far deeper issue: what constitutes the core network? The definition can run from just the major nodes and backbone of the system all the way to the lines into customer premises or indeed some place between.

Telecom argues that the definition changes with each new wave of technology and investment. Therefore, it would be unwise to force an arbitrary structural split into separate companies now. It would most likely be over-run by new technology later. Operational separation is more effective because it can be adjusted as technology changes.

Telecom and the government also dispute Elliott's assertion that structural separation is easier, quicker and cheaper. Telecom says it would require deeper surgery and bigger rebuilding of systems to achieve truly separate businesses. Moreover, two companies would duplicate to some extent the back office, senior management and board services shared by Telecom's three units under operational separation.

The hedge fund also argued in its November submission that the costs of operational separation were unjustified.

But even as it was making that case, Telecom was already ramping up its capital expenditure to the best part of $3b over three years, far more than the government thought initially that operational separation would trigger.

This work goes far beyond Telecom's catch-up on years of under-investment. Reynolds and his new team have embarked on nothing less than a fundamental rebuild of the business and the national network.

Yet, this is an "unclear and outdated strategy", Elliott said on Monday when it announced its push to get its two nominees elected to Telecom's board. But if it is seeking to build shareholder support for its candidates, it will have to be far more convincing on those crucial points. And it is up against a very articulate Telecom chief executive.

Elliott has one thing going for it. Telecom's share price is languishing at a 15-year low and the company says recovery of profits will take time. Its results for the year ended June, announced 10 days ago, were in line with the guidance it had given the market. Operating profits were down 2.2% from a year earlier and it said they were likely to fall a further 4-6% this year.

Last year, expenditure rose 3.4% while revenues fell 1.7%, testament to the challenge of spending big on technology that drives service up but prices down. But the technology will also drive huge cost savings and the opportunity to deliver a seamless array of services to customers.

To pull off this new and potentially profitable business model, Telecom has to radically change its culture from arrogant dominator of the sector to constructive collaborator.

But Elliott is making life more complicated for Telecom. The hedge fund might whip up some support from other quick-flick investors facing losses on their investment. Elliott said it bought its 3% stake about a year ago. That suggests a price close to the 52-week high of $4.60 and thus a paper loss of 27% on the current share price.

So far, though, Elliott's campaign has started badly. The material it released on Monday showed its lack of insight into Telecom, it misread where Telecom and the government were heading, it mistimed its investment and it then responded slowly.

Most damaging of all, its two candidates for the board, Mark Tume and Mark Cross, spent the week stressing their independence and distancing themselves from Elliott's agenda.

Judged by its performance to date, Elliott will fail to reverse Telecom's strategy. But the company and its shareholders could still derive some longer-term benefit from the hedge fund's effort. It is making Telecom even more articulate about and committed to its goals, thus hopefully improving the odds of meeting them.

- © Fairfax NZ News