Comments on the structural separation of Telstra
A critical issue for the Australian telecommunications industry is whether Telstra should be structurally separated into several separate firms in order to promote competition. There are many arguments being voiced both for and against certain forms of separation. However, from a strategic perspective, BuddeComm contends that structural separation of the business into perhaps several new firms is preferable to a functional separation, where separate business units operate and interact according to certain pro-competition rules. This report provides a case for structural separation and analyses the consequences of separation to shareholders.
Most financial analysts in Australia contend that structural separation of Telstra will destroy shareholder value for the company’s owners and that, with the shareholders in mind, Telstra’s service provision, content and infrastructure assets shouldn’t be separated as a result of proposed regulatory reforms to be enacted later this year.
There are many arguments being voiced both for and against certain forms of separation. However, from a strategic perspective, BuddeComm contends that structural separation of the business into perhaps several new firms is preferable to a functional separation, where separate business units operate and interact according to certain pro-competition rules. However, financial models employed by the investment industry indicate it is unlikely that structurally separate firms will result in a situation where the market value of the parts exceeds the previous value of Telstra as a whole.
Let us assume a structural separation will destroy existing shareholders’ value to an extent that is not already priced into the firm’s market value. In that case, a simplistic financial view, from the State’s perspective, would be to, among other things, weigh the impact to its investment in a National Broadband Network Corporation, or NBN Co, against its holdings of Telstra via the Future Fund. If Federal funds provide A$10 – 11Bn to the NBN Co, how will this compare to a rough valuation of the Telstra stock held by the State at today’s prices? 1
Of course one cannot simply compare the weight of gold stacked on each side of the scale; an attempt must be made to appraise and quantify the risks each entity poses to the other – a great challenge for several of our nation’s finest minds, at the Treasury and elsewhere.
Notes: 1. The Australian State owns around 16% of Telstra, worth around A$6Bn in mid 2009. The Government has committed to spending providing around A$11Bn of capital and operational funding over the coming years.
A Case for structural separation
Despite the long-term potential of alternative uses of the planned Fibre-to-the-Home network, such as applications to support E-Health, E- Education or E-Government, in the nearer term, evidence from advanced telecommunications economies indicates media consumption is still a key driver of fibre use. As such, the biggest threat to initial take-up of wholesale services provided by a NBN Co may come from an existing competitor with dominant market share and vertically integrated infrastructure and content assets.
It is generally considered economically preferable for regulation to focus on minimal unnecessary interference within the market, and in Australia there is a broad consensus that industries such as Telecommunications should be left to the private sector unless there are serious deficiencies in the private market. Therefore, the aim of reform should be to correct deficiencies to the market in such a way as to limit the extent of the State’s involvement as well as the period over which the State retains significant ownership of Telecommunications assets.
The vertical integration of a firm such as Telstra does pose a significant threat to the financial viability of a National Broadband Network operator in the early stages of its existence. Mechanisms to bundle services with infrastructure support monopolistic behaviour on the part of those firms. Given the natural advantages Telstra enjoys, and its dominant market share, the firm could well impede the development of the National Broadband Network. Without significant take-up of services, the NBN operator may well draw heavily from the public purse in the medium term, which may prove unpalatable to the public.
While the Government has committed to supporting the NBN operator in the short to medium term, in the long term it seeks to return the firm to full private ownership. While the sentiment is applauded, it must be backed up with reform that makes the outcome likely. Structural separation could prove a far better manner to achieve this goal than a functional separation arrangement in which Telstra simply has to operate separate business units for infrastructure, media and service provision. In order for functional separation to operate properly, in other words better than it does today, the Government could well be required to impose a greater number of smaller-scale rules on the firm, with a significant enforcement regime emerging as a result. In contrast, structural separation enables the government to realign the industry along pro-competition regulations without the need to devote significant resources towards providing different regulations for an incumbent than for other industry players.
Subscribers to this view, especially if they don’t happen to own any Telstra stock, may then support regulatory reform which includes measures to bring about the separation of Telstra in its current form. One could imagine as many as three separate units, such as Telstra Media, Telstra Telephony Services and Telstra Infrastructure.
Shareholder value under structural separation
Most financial analysts predict destruction of shareholder value for Telstra owners should the company be separated into parts. The capital currently employed by Telstra supports significant revenue. In the short to medium term at least, separate firms are not likely to generate similar cash flows to those an integrated Telstra would generate with the same amount of capital invested. The threat of separation may have created downside risk to future earnings.
Perhaps more importantly, in terms of business operations, structural separation is problematic given the degree of systems and process integration across business units. Separated entities would have to devote significant capital and human resources towards efforts to disentangle from one another.
However, many in the industry have several reasons to see great potential in the longer term for the separate firms that may emerge should structural separation take place.
Telstra has the largest telecommunications engineering capability in the local industry and in several respects the quality of this capability can be considered best practise within the domestic context. Telstra is supported in its efforts through deep relationships with the world’s best multinational firms. Given the geographic extent of the country, the quality of voice and data telephony services in remote areas is world-class (though of course there are concerns relating to high costs.) Experience in operating a network of such scale and complexity leaves Telstra’s infrastructure and network operating divisions well placed to extract economies of scale which lower operating costs and improve the return on future capital investment. As a business entity focussed entirely on network operations, the unit would be free of internal political constraints which often result in inefficient investment and create difficulties in executing development projects.
Telstra’s “Services”-oriented business units are relatively successful compared to their industry peers, despite being embedded in a large, broadly commercially focused semi-bureaucracy. Consider Telstra’s provision of content services. The performance of BigPond compares very favourably with the media services provided by Optus, Vodafone and 3 in Australia. BigPond’s and Foxtel’s plans for IPTV may well fuel further consumer take-up of bandwidth-intensive web-based services and the firm provides a large variety of other popular web services for computers and mobile phones. It has proven relatively nimble in responding to the rapidly changing market for digital media. A merger of digital media units such as combining the content producing sections of Big Pond with Foxtel and Sensis could create a formidable digital media company.
As a telephony service provider, Telstra has an impressive record. Despite fierce competition and generally charging premium prices relative to other service providers, Telstra maintains a dominant position in the retail market for internet access and mobile phone services. Though existing within a vertically integrated firm provides certain advantages, BuddeComm does not believe this is the only reason Telstra’s market share has barely been eroded in several key product segments.
Telstra services are also well marketed and the firm has effectively shed its statist image, especially among youth segments of the market. It has demonstrated its ability to compete in low-margin markets such as prepaid mobile services while simultaneously commanding enviable market share among business users and high-value consumers.
Of course it is easy to imagine that these possibly separate business units may thrive as distinct entities. However, they could just as easily wither in the heat of competition.
Lastly, perhaps one potential scenario should be considered – a forced or voluntary divestment of Telstra’s network operating business units and certain infrastructure assets into a separate firm, followed by an equity-for-asset swap with a newly formed National Broadband Corporation. Effectively a merger of sorts, this would enable the government to go some way to achieving its goal of creating a public/private partnership focussed on infrastructure provision and open access to a regulated wholesale provider. (It could also less charitably be viewed as expropriation of private property.)
In conclusion, BuddeComm supports regulatory reform to separate Telstra, while acknowledging that the risks associated with such arrangements may have depressed the corporation’s share value. The current share price may to an extent already reflect a market belief that structural separation is likely. Ultimately, structural separation of Telstra may create several world-class telephony firms from a single parent and could generate shareholder value in the long term.
Structural separation may enable the Government to better act in the public interest by reducing risks to public investment in a NBN Co. This reduces the risks of long-term political involvement in commercial activity and lightens the bureaucratic burden arising from industry regulation of a “functionally separate” incumbent. However, acting in the public interest may set the Government at odds with private shareholders. The reality is that shareholders accept that business risks of many varieties may impact on their investments, and any investment of public funds in infrastructure development places the current and future taxpayer funds at risk too. That, it seems, is the price of progress.
Dominic Hebert – Senior Research Analyst – BuddeComm
For further information please see the following related reports:
- Telstra – Corporate Strategies Analysis – 2009
- Telstra Corporation Limited – Company Overview and Operating Statistics
- Australia – National Broadband Network – Overview & Analysis
- Australia – National Broadband Network – Critical Considerations
June 10th, 2009 at 6:50 pm
The first paragraph contains this sentence “BuddeComm contends that structural separation of the business into perhaps several new firms is preferable to a functional separation”
I can find no definition of either “structural separation” or “functional separation”. Consequently the rest of the article is as far as I’m concerned a almost a complete mystery.
There is one other sentence that I did understand “Given the geographic extent of the country, the quality of voice and data telephony services in remote areas is world-class”. I can only assume that the author has never ventured more than a kilometre of two from the major population centres or transport corridors.
I can take the author to locations within 50K of the eastern seaboard of NSW where the only viable and affordable data service is 256/64kps satellite with its inherent latency delays, where there’s been no wireless phones since the demise of analogue; where the quality over copper has barely advanced since the days of party lines, and where the reliability of the that service has gone backwards because he maps that purport to show where Telecom/Telstra laid the lines bears no relationship to reality, errors of 50 metres or more are not uncommon.
I can only assume that the services are better elsewhere – can anyone testify what they are like say 200k due south of Halls Creek in WA – I’d regard that as remote!
June 11th, 2009 at 2:09 pm
Dear RightPaddock
Apologies for the lack of clarity with respect to the central concepts in my article.
Structural separation refers to legislation which will force Telstra to split into perhaps several new firms. The most likely scenario here is Telstra is separated into two businesses. The first may be a network operating business which maintains and operates the physical telecommunications infrastructure and the related systems and provides access to the network to other businesses on a wholesale basis. The second could be a telephony services business which provides retail customers with internet, mobile and fixed line voice services. A third business focussed on digital media comprising of Foxtel, Sensis and the BigPond web services.
Functional separation is where separate business units operate under the same corporate structure but are forced to interact according to certain pro-competition rules. An example of this is that Telstra’s wholesale business unit may not favour Telstra’s retail business over a 3rd party such as Optus or iiNet when connecting up a broadband subscriber to the Telstra network.
Note that functional separation for Telstra is technically already in place. The Government is currently considering whether legislation should be introduced to structurally separate Telstra.
As to whether telephony services in the remote parts of Australia are indeed world-class, this is of course a highly contentious issue and is difficult to factually address. I do concede that there are many areas in rural Australia that suffer from a lack of mobile telephony services, (I am not talking about the fact that services are expensive). However I’m afraid world-class in this respect is not a bar the world is setting very high! Given the size of the population in remote areas and the geographic area that requires coverage Australia does far better than than most.
Consider Canada for instance, which is another good performer with a similar sized land mass and a small population. According to the ITU World Telecommunications indicators mobile phone coverage in Australia extends to nearly 99% of the population whereas in Canada coverage is only provided to 98% of the population. Of course statistics are often questionable and there’s no doubt there’s room for improvement. in certain areas in Australia. However we should not lose sight of the fact that we are still relatively well off, certainly compared to the world as a whole, and even when compared to other advanced economies with similar demographics.
Thanks for your comments though and, if you happen to reside in a poorly served area, hopefully the wireless broadband rolled out as part of the National Broadband Network will bring you some relief, eventually!.
June 16th, 2009 at 4:27 pm
I thought there would be mention of future benefits to Australia as a whole of structural separation. Precedences exist within the oil/gas and minerals sectors when to improve the economic benefits of the whole country access has been given to assets (pipelines and rail networks) of private companies.
I work in the communications industry, most times abroad, because Telstra has stifled innovation within Australia. Example – in 2004 Telstra had to buy half of 3′s 3G mobile network because it didn’t invest in it’s own. It has practiced a scorched earth policy where it has been forced to give up territory. It was only through the last Liberal, free-market?, govt.’s wish to maximise the T3 share sale that they mortgaged the future of the communications industry.
Incumbents around the world have frustrated innovation and held onto the last mile – i.e the customer. Incremental change doesn’t work and Telstra’s network should be separated & they should be paid compenstation. It is a natural monopoly. The free market doesn’t always work best as the GFC is demonstrating.
June 16th, 2009 at 4:28 pm
Just who in the hell do you people think you are. Do you really imagine that you can demand the destruction of Telstra to suit your own business purposes? Telstra was sold to the Australian people with certain regulation which Telstra will comply with.
To rip and tear at Telstra to assist opponents that are underperforming is against all free and open market principles. Competition is about investing and leaving consumers decide who will survive, not the decisions of bias businessmen.
If Telstra win the competition war and are endorsed by the Australian public, how can those who oppose Telstra conspire to, by leglislation, deviously create a false market result that advantages parties that suit their own selfish business purposes.
June 16th, 2009 at 6:57 pm
Sydney, the problem lies in your 1st paragraph:
“Telstra was sold to the Australian people with certain regulation which Telstra WILL comply with.”
It has been 11 years and we are still waiting for them to comply.
They offer retail services cheaper than wholesale through the use of freebies and giveaways, so as to be able to publish a higher price than is actually paid. This is called “gaming the system”. They also held up ADSL by capping at 1500/256 for far too long, thus training people that 256/64 is “broadband”, ie that slow is normal. They then refused to turn on their own ADSL2 (thus getting a good jump on the market) until competitors installed their own DSLAMs (a repeat of the cable duopoly) and STILL install RIMs and other port-limiting technology thus shutting many customers into the “telstra” world.
Having retail and network/wholesale seperate would solve all these problems.
If you’re worried about the effect on your investment, ask British Telecom (BT / OpenNetworks) as to whether it was a good or bad thing. They fought it as much as Telstra, then discovered it was actually better than remaining as a single entity!
Remember, NO company or person has the right to hold this country to ransom, and those that do will eventually fail. The choice is Telstra’s to make, but over the last 11 years they have made the wrong decision and may soon pay the penalty for that.
There is still time for them to mend their ways, but the clock is ticking.
June 19th, 2009 at 12:10 am
Q: Whether Telstra is separated or not, how will new value be created through use of the network?
A: Through innovation. e.g. Apple’s iPhone achieved what Nokia failed to do in 8 years: people accessing the web from their phone.
Q: What can Telstra do to promote innovation?
A: Not much so far! Telstra hasn’t been able to implement a satisfactory way to search for a phone number! Its whitepages search is an embarrassment to Australia. Telstra should start by sacking Bruce Ackhurst and for the next step, hire a smart programmer fresh out of high school to fix whitepages search.
June 24th, 2009 at 7:52 am
[...] Comments on the structural separation of Telstra: Dominic Hebert at BuddeComm discusses the prospects of a potential structural separation of Telstra’s business. It takes a different perspective from what usually the proponents of structural separation prefer: the corporation’s share value. A good read. [...]
April 30th, 2010 at 9:25 am
Telstra’s “Services”-oriented business units are relatively successful compared to their industry peers, despite being embedded in a large, broadly commercially focused semi-bureaucracy. Consider Telstra’s provision of content services. The performance of BigPond compares very favourably with the media services provided by Optus, Vodafone and 3 in Australia.
Thanks great informative article keep posting !!