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Address to Influence 2006

David Forman

Executive Director

CCC

September 10, 2006

Over the past year, there has developed a consensus that Telstra’s imported management has massively failed. Failed to get its way in policy and regulatory circles despite a campaign unlike any seen in this country before. Some go so far as to suggest they have acted like clowns.

The agreed wisdom is that Telstra has been so hostile to the Government and ACCC, and to the foundation principles of competition policy, that the various arms of Government have lost patience. Further, all the public bleating from Telstra has left neither the Government nor regulator with any choice but to hang tough or risk looking like they were surrendering to blackmail.

Well, I beg to differ. I’d like to suggest to you that the Telstra management is achieving exactly what it is trying to achieve.

To understand why I say that, you need to look beyond what Telstra management says it wants to achieve. You need to analyse what it is actually paying itself to do.

When you do that, and then look at the outcomes of some key regulatory disputes, and then the Telstra results, you wind up with evidence that tells me we need to be worried for the future of decent, globally competitive communications in this country.

Now, I’m a simple person, and I know that the guys running Telstra must be much smarter than me. They are so smart the company is willing pay them millions of dollars a year and God knows what in expenses, just so the company can get the benefit of their brilliance. So I don’t expect to be smart enough to understand everything they do and say.

I don’t really know what they mean when they say their goals are “enhancing shareholder wealth”, or “delivering on the transformation strategy” or “enhancing the customer experience”. Those things sound like they must make sense, but it’s all a bit high level for me.

So I try to look at simple things to help me work out what motivates people to behave in the way they do.

Most of the time, people tend to do what they are paid for. So to understand Telstra management’s behaviour, I looked at the executive remuneration report in the Telstra Annual Results.

That is a quite straightforward document that I can get my head around. And low and behold, it quickly became much clearer what the Telstra management expects from itself and how it is pursuing its goals. Just to make sure that I was understanding correctly what I was reading, I asked an analyst, who asked not to be named, to examine the report. His conclusions were quite unequivocal and, I’m relieved to report, consistent with mine.

In short, Telstra’s management payment structure is heavily biased to create incentives for them to manage short term interests and goals. More specifically, they are rewarded if they increase market share, even if that is inconsistent with making better returns on investment or growing or maintaining profit margin.

Let me explain.

There are three components to the Telstra executive team’s packages – base salary, short term incentives, based on 12 month goals, and long term incentives, based on 3-5 year goals.

For Sol Trujillo, the short term incentive is equal to his base salary. But for others on the senior executive team, it is by far the biggest component of their package, equal to 140% of their base salaries.

That in itself seems at odds with the repeated claims by Telstra that they are engaged in a long term transformation program as the number one business priority. Shareholders are told that the upside for them will come in three to five years when the transformation strategy, literally, begins to pay dividends.

But in the meantime, the lion’s share of managements’ personal upside comes in 12 months cycles based on short term goals.

Furthermore, it comes in cash.

Telstra new management made some very important changes to the way the short term bonus portions of executives’ salaries are paid. The most important was that all of the short term incentive payments are paid in cash.

As I understand it, they used to get these bonuses half in cash and half in equity, vesting over three years. Under that model, the value of half the bonus went up or down with the shares, least partially tying the fortunes of management to the fortunes of the average shareholder.

The new all-cash arrangement unhitches the short term management bonus from the shareholder experience.

The biases in the incentives scheme can be seen in the divergence between actual short term bonus payments and results of the company last year. The short term bonuses paid to executives as a proportion of the maximum bonus possible was the highest for five years. Management was paid close to 80% of the possible total bonus payment. But the bottom line profit of the company fell for the first time in five years.

This seems on its face a very odd situation. But if you break down the individual performance measures that determine whether management get their bonuses, and how much bonus they get paid, the pattern of incentives emerges.

There are a number of performance indicators that are used to measure management performance, including financial performance, cost reductions, market share and the deployment of the 3G network replacing CDMA.

But what is really interesting is how success in each of those indicators is measured.

For example, company financial performance. The metric looked at is net profit, but it is not clear from what Telstra publishes if this means increasing profit margins, just increasing overall profit, or just performing to expectation.

Since the latest Telstra guidance to the market was that its underlying earnings would fall between 2 and 4 percent, that would suggest that there is obviously no expectation that all executives will run more profitable business segments. In fact, it is expected that some business segments will become less profitable.

Executives are also measured on cost reductions but, again, no cost targets are published.

There is a performance measure based on the number of sites where the new 3G 850 megahertz network is deployed, but no mention of actually migrating customers to it.

But the most interesting of all measures is broadband market share, measured as Telstra’s increase in the share of the broadband retail market, as opposed to average revenue per user or overall profit, or margin.

Put this all together and what do you have?

A recipe to buy retail market share in the broadband, even though the consequences of that on the share price could be expected to be negative – not positive – as margins are eroded quicker.

In other words, it sets up the environment for Telstra to start a retail price war. There are always losers in price wars, and the first casualties are always shareholders. As companies sacrifice margins for market share, profits fall and dividends are cut. Then shares fall. Simple formula even I can understand.

But with the Telstra executives now paid short term bonuses in cash and not equity, they are personally inoculated from that impact. In fact, the deeper the margins are cut, and the more market share that is bought, even if it is at a loss, the bigger the proportion of the market share cash payout executives get next year.

Now, for a company in Telstra’s position, there is also nothing particularly challenging about starting a price war as a business strategy. It doesn’t require great management skill or imagination.

Now, let me be clear about one thing. I am not trying to engage in a muck raking exercise or to reflect on individuals. I am raising this issue because it goes to the underlying incentives of the company and consequently how that translates into market behaviour an effects on the competitive market. The important point here is that short term focused incentives for Telstra management have long term and irreversible effects on competition.

In fact, for a company such as Telstra with market dominance that is without parallel in the developed world, gaining market share is about the easiest challenge you could set management.

Telstra is unconstrained by the types of structural policies that are the foundation of competition in just about every other country and utility industry.  As the ACCC said repeatedly until it became tired of being ignored, Telstra dominates fixed line, cable TV, mobile, wholesale, retail, content … you name. No other country allows one company to do that.

Telstra has massive margins to dilute. According to Morgan Stanley analysis in 2005, its margins were second only to China Telecom among the leading telcos in the world. Fortune magazine this year rated it the most profitable telco in the world. That can buy a lot of market share if you are willing to sacrifice it.

Further, it has a regulator that has proved reluctant to fight price squeeze cases through the courts. Even if it did take one on, Telstra could string it out for years.

You might remember that in 2005 Mr Trujillo presented a slide intended to illustrate the impending threat to Telstra’s rivers of gold from advancing technology.

The table showed as a percentage how many fixed lines various incumbent telcos had lost from the peak number they had once had. In Europe and the US, the falls ranged from just under 10 percent up to about 20%.

But Telstra was down just 2 percent.

Mr Trujillo used these numbers to show how quickly Telstra’s source of its monopoly rents – its local loop monopoly – could erode once it started.

But, perhaps unintentionally, he also made a quite different point. Telstra’s ability to fend of the effects of the introduction of competition and new technology is paralleled probably only by one or two countries in the world.

Perhaps Ireland and New Zealand have seen similar numbers. I nominate them because they are regarded as being among the least competitive markets. Not surprisingly, both are broadband basket cases.

So, increasing market share is an easy target for Telstra, simply because Telstra is so absurdly advantaged already in the market and makes such obscenely high profits by comparison with the industry in rest of the world.

Improving profit margins or return on investment or total shareholder returns would be a much tougher test for the management to set itself than just increasing market share.

Anyone who had spent time in telecoms overseas, even if they were not as smart as Mr Trujillo, could not fail to have identified three things if they had arrived in Australia in July 2005.

·        The Most benign regulatory regime of any incumbent in the world

·        A Government more interested in privatisation in 2006 than the structural and policy reform needed to develop a 21^st Century communications industry

·        An Opportunity to make substantial money

But to take full advantage of those conditions, it was important to distract people from the point that was beginning to be more widely understood in July 2005 – that Telstra is the most subsidized, molly-coddled and least threatened by competition incumbent in the world.

The need for that distraction explains why we have seen a year of the new management carrying on as though Telstra was a victim, while actually exploiting its massive power.

Step one in this campaign was to create as many regulatory fights as possible. With the government transfixed by privatisation, this was the time that the regulator was likely to be at its weakest. Putting the regulator on the back foot by making absurd statements such as that the ACCC was trying to put Telstra out of business was aimed at doing two things.

Firstly, it meant the regulator might take a softer line in the pricing and access processes it already had underway.

Secondly, it might make the regulator think twice – or three times – before responding when Telstra flexed its market power muscles and launched new assaults on competitors.

The next step was to trap competitors in a pincer movement – forcing up wholesale prices while slashing retail prices for products in markets where competitors had invested in infrastructure to allow them to compete with Telstra.

Is there any evidence to support my theory that this has been the strategy? Yes, there is in fact evidence that suggests that this strategy has been a big winner for Telstra already.

For examples, just look at Telstra’s own comments. But you have to look past the spin at the facts to get the picture.

In August 2005, Telstra infamously told the stock exchange that it was going to “lose” $800 million in revenue in the next year, just two weeks after its annual results were announced. It said part of the reason that it had to revise its guidance was that the regulator had indicated the price of the Unconditioned Local Loop in band 2 areas would be cut from $22 to $13. The total cost of that to Telstra was going to be $68 million in the year.

Remember, the ULL is where another carrier rents from Telstra the copper wire from a person’s house to the nearest exchange. It is not line rental. It is simply a piece of copper wire that gets unscrewed from Telstra’s equipment and screwed into another company’s equipment. You might think $13 a month is not a bad rental income when you think of it in those terms. It certainly seems much closer to international prices for similar services than the prices Telstra would like to charge.

Telstra’s calculation of $13 was based on ACCC statements about real demand for ULL and the appropriate methodology for determining the actual costs to Telstra of providing the service. The ACCC made this calculation because Telstra had started a process that forced the Commission to look at the costs.

The basic reasoning that the ACCC used in coming up with the $13 figure has since been tested and affirmed by the courts, after Telstra appealed a decision on a similar service.

But now wind forward a year. In its August 2006 results, Telstra caused some controversy when it said it expected to continue to be paid $22 a month for ULL rental.

Remember, it had told the stock exchange a year ago that the price was to be cut to $13, and that this was a disaster. Now it was saying the price had not only stayed at $22 for another year, but that it expected it to continue to be unchanged. Its head of regulation said any price below $20 would be a “declaration of war on shareholders” by the ACCC.

Two weeks later, Telstra made a statement to the market confirming what had been written by market analysts and journalists for the past six weeks – that the ACCC had decided to set the price at $17.70 in the first of a series of disputes between Telstra and other carriers.

Telstra said this shocking decision forced it to revise its earnings guidance down. Again.

But what has actually happened in the past year? Telstra has actually wound up with a price for ULLS that is $4.70 above what it said the regulator had indicated should be the fair price.

But Telstra had still painted itself as the loser. And said this was a reason it would not be as profitable as it expected. Even though it had cut expected profits before based on a $13 rental figure.

Another example. In 2003, the Commission said that the average price that carriers paid to Telstra to connect phone calls between their networks should fall over a period of three year to 0.7 cents per minute.

This price was to fall because Telstra had been given permission to increase line rentals. Telstra had always claimed that the cost of calls had to subsidise the fixed cost of providing the line and dial tone. This is the so called access deficit charge. With line rental going up until it covered its costs, the charge for individual phone calls would finally be based only on the costs of that call, not the cost of the cal and the subsidy.

But at the end of 2005, Telstra started to claim it was suffering a massive collapse in telephony traffic. It tried to double its call prices.

In various decisions between April and August 2006, the Commission said it believed the model that Telstra used to support these cost claims was unreliable and results in costs that were unrealistically high. So unreliable that the ACCC has begun a process of commissioning a new, independent network model.

Yet in July 2006, the Commission changed its mind about the right price for call connection, from 0.7cpm up to 1cpm. It apparently decided to accept Telstra’s arguments about its collapsing traffic.

In August 2006, Telstra announced it had in fact slowed the decline in PSTN and that the traffic lost is mostly simply migrating to other access platforms that it also owns.

Net result: Telstra enjoys years of line rental increases and above cost call termination payments from competitors, and still keeps 0.3cpm of the ADC and enjoys a massive windfall gain.

So, there is some pretty powerful evidence that the Telstra campaign for far has resulted in a massive transfer of income from the competitive carriers in the market to Telstra, based on Telstra being able to sustain prices that the regulator has determined are unreasonable. That really means Telstra continues to overcharge consumers, of course.

Using these inflated margins, Telstra has also been able to begin to systematically margin squeeze the whole industry. This is step two of the strategy I described earlier, you might remember.

Once again, the evidence is in Telstra’s own annual results.

Remember all the bleating in the past year from Telstra about how it was being forced to lose so much money on line rental prices? In 2005 the average retail revenue per line Telstra received was $338. That is the price it charged its own customers.

But last year, while it was complaining about how much it lost line rental, Telstra was willingly cutting its average price to $333 its their customers. A $6 fall.

But guess what happened to average wholesale line revenues? From $307 in 2005, they have climbed to $336. Up $29 or about 9.5 percent.

You might notice that the average revenue from a wholesale line is now greater than the retail price, prima facie evidence of a price squeeze, perhaps?

Now look at the Telstra business segment results. We are well aware of how Telstra’s profits have been slashed because the conditions are so unfair to them and force them to sell t competitors below cost.

But while profits fell in all the retail parts of the business, the profit margin for wholesale increased by 18 percent.

This is all evidence that points to my initial contention – the Telstra management has systematically set about trying to wipe out competition, even at the expense of shareholder value. And it has been succeeding.

Shareholders might think that the payoff for them will come somewhere down the track. After all, once there is no competition in the market, the monopolist can charge what it likes.

There are two reasons to think that the shareholders will never see this upside.

Firstly, Telstra’s management has predicted it will be 2009 before return on investment recovers to the same level it was in 2005. By that time, if the reports on the overseas Telstra management contracts are correct, Mr Trujillo and his compatriots will be long gone. Someone else will be running the company and trying to deal with the aftermath.

Secondly, the damage to the competitors in the market will have to be well and truly obvious before that. That is, to be blunt, other companies will be starting to disappear. And consumers will be starting to ask where their choice went.

In those circumstances, there is an inevitable consequence that will in turn have political implications. The correlation between competition and broadband price, quality and penetration is undeniable. Incumbent telcos only invest in new technologies that erode their existing revenues and margins when competition forces them to.

I recently saw a piece of analysis from the OECD that illustrated the point. It showed that the only country in the OECD that had a higher GDP per capita but lower broadband penetration than Australia was Ireland. Plenty of countries had lower GDP per capita and higher broadband penetration, however.

Ireland privatized Eircom in 1999 without getting the structure of the market right first, and has been the broadband basket case of Europe ever since. Interestingly, it has been mentioned with increasing regularity in Canberra of late.

There has been another development in Ireland in recent months that Telstra shareholders should look at. Investment band Babcock and Brown has recently taken over Eircom and declared its intention to structurally separate the business to release shareholder value.

Even with the massive market power it has enjoyed as an integrated incumbent, B&B has concluded that Eircom shareholders are getting a dud deal and would do better from breaking it into separate wholesale and retail businesses.

One thing that we can thank Mr Trujillo for is awakening more people to a couple of points that the CCC has been making for some years.

The first is that we are a laggard in broadband penetration, price and quality by international standards, and that the structure of the industry is to blame. And by that I mean the integration and domination of Telstra.

If we reach a position three years from now where Telstra is more dominant than ever, we can expect to continue to fall behind the rest of the world in broadband.

That will be politically intolerable. It will lead to demands for structural reform of the telecommunications industry to drive competition.

Again, the CCC has been advocating this for the past four years. But it is notable to me that in the past six months, the voices in favor have become a full cheer squad. Newspapers, including The Australian the AFR and the Canberra Times, in their leaders, as well as commentators within those papers, and members of the Federal Government, as well as Opposition and minor parties, have publicly called for structural separation of Telstra.

The more Telstra has demonstrated that it cannot abide competition, the more people have concluded that the nature of Telstra must be changed so that it does not have an incentive to destroy competition and return to monopoly.

So, this is my prediction for the next few years.

In the next 12 months, we will see a brutal price war in telecommunications that will be built around Telstra bundling services together in retail packages. These packages will include the monopoly services offered at prices that other carriers cannot match.

And sometime in the next few years, we will see real structural reform of Telstra driven by both policy makers and regulators, and the shareholders of Telstra itself. They will look at the legal separation model of BT in Britain and the structural separation of Eircom in Ireland and see the benefits to shareholders and investment in new infrastructure. They will look to the still unfolding separation of Telecom NZ and benchmark Australia against that.

They will conclude that Australia cannot afford to be embarrassed by being the global broadband basket case.

We should hope that it does not take the loss of the competitors in the market today to make policy makers and regulators bite the bullet and introduce these reforms.