Telstra has finally sealed its doom

opinion Telstra‘s management will come to regret its $11 billion deal with NBN Co signed this afternoon as the most disastrous decision it has ever made in the telco’s long and tortured history in Australia’s telecommunications sector.

The decision is so bad that it will eventually come to dwarf the hiring of chief executive Sol Trujillo and the 2005 chop in retail broadband rates below wholesale prices in terms of the infamy in which it will come to be regarded within Telstra’s ranks.

The reasons for this are simple.

Firstly the agreement — in a single fatal stroke — attempts to transform the fundamental nature of Telstra’s business changing it from an engineering company which primarily builds and operates telecommunications networks into a retail service provider focused on delivering the best customer service and value-add products in Australia’s telco sector.

This is simply not a role to which Telstra is well suited.

When Telstra has finished migrating its fixed-line telephone and broadband customers onto the National Broadband Network it will find they have little incentive to continue to give it their business.

Despite the onset of strong competition in the telco sector many Telstra customers (especially families and businesses) have remained with Telstra for years because they do not want to go through the hassle of untangling their complex telecommunications arrangements (fixed-line broadband and telephony mobile phones mobile broadband and so on) into separate carriers.

But the technological disruption associated with the migration of their services to the NBN will provide Telstra customers with a once in a lifetime reason to look at rival providers. When they do they will find that there is almost no reason to remain with Telstra.

The NBN is the great leveller for Australia’s telecommunications sector. It will remove any ability for Australian telcos to compete for customers’ money by building better network infrastructure (an advantage Telstra has historically exploited to the maximum). Instead telcos will be forced to compete on the grounds of having better prices customer service or value-added services.

It is a fact as plain as day that Telstra cannot compete with the likes of smaller telcos like iiNet Internode or even Optus when it comes to customer service. Despite the best efforts of its chief executive David Thodey Telstra’s customer service continues to stink.

After all … when you call iiNet’s customer service centre you don’t get transferred around endlessly between different departments.

Telstra will never suffer itself to compete on price — the very idea is an abomination in its internal thinking. And value-added services are increasingly becoming the province of third-party companies especially when it comes to content — one need only look at the growing number of IPTV and video on demand services launching this year from the TV networks and third parties to see that trend in action.

One possible exception to this disastrous trend for Telstra may be the corporate sector where Telstra has expertise that smaller telcos may struggled to match. But even in that area the big T will suffer — the likes of Optus AAPT and Macquarie Telecom have been carving chunks off Telstra’s dominance in that market for years.

Yes the Federal Government may be providing Telstra with some $9 billion to migrate its customers to the NBN but Telstra will need every penny of that money — because many of those customers will flip Telstra the bird as soon as they join the NBN and hitch their fate to the likes of iiNet instead.

Even if you discount the likely flood of biblical proportions of Telstra customers leaving the ship when the NBN migration takes place however the telco has another major problem. What is it going to spend its $11 billion windfall from the Federal Government on?

Telstra already struggles to find enough places to invest its money.

Despite the fact that Telstra re-engineered almost every single aspect of its network infrastructure during the years from 2005 through 2009 (spending billions and billions under the strategy of then-CEO Trujillo) the company’s net profits barely took a hit and have already almost recovered according to its latest annual reaching $4.08 billion for the year to 30 June 2009 compared with $4.31 billion in mid-2005.

Likewise its free cash flow dipped in 2007 to $2.9 billion down from $5.2 billion in 2005 – but has recovered quickly to reach $4.36 billion last year. In 2010 Telstra is predicting it will generate free cash flow of $6 billion.

Now obviously this is a high-level glossing over of the situation – Telstra’s financial situation is a complex minefield — and we haven’t gone into any real level of analysis into the company’s complicated balance sheet (or more accurately complicated cascading series of balance sheets that descends into a nighmare of detail that gives even seasoned telco financial analysts migraines).

But the fact remains that Telstra currently generates a stack of cash every year and keeps much of it sitting around … at 30 June last year it had $1.38 billion in cash sitting in the bank and a further $.8 billion in current assets. It’s a lovely little stockpile — and it just keeps on growing.

Traditionally Telstra has invested much of its overflow in its fixed-line networks. Building out fixed infrastructure is quite expensive as Communications Minister Stephen Conroy is discovering with the $43 billion (plus Telstra’s $11 for a total of $54 billion) NBN policy.

But Telstra’s agreement with NBN Co means that that avenue will no longer be open to it.

Some will argue — rightfully — that Telstra will now focus on building mobile infrastructure instead of fixed — a favourite target of Trujillo due to the ACCC’s light regulation touch there which came about due to the strong levels of mobile competition being posed by Optus Vodafone and Hutchison.

But mobile networks are cheap. Telstra famously spent just $1 billion on its contract with Ericsson to build its flagship Next G network. Even if you assume the big T spent a further $1 billion in internal effort and has spent another cool billion enhancing Next G’s speed over the past few years Next G still looks cheap compared with similar fixed-line investments.

All of this begs the question of where Telstra will invest its growing cash pile — including the Government’s $11 billion purse.

Any area that I can think of that Telstra could invest in would take the company clearly outside the area of its core competencies. And this is a very dangerous thing for a company as large and fixed in its ways as Telstra. Former monopolies do not easily or quickly change their stripes.

Telstra is pretty much prohibited from acquiring other telcos in Australia and consolidating its market presence – any acquisition of scale would likely get knocked back by the ACCC and raise a political outcry besides.

Unlike SingTel Telstra has never really demonstrated any real aptitude for investing in international telecommunications markets. Its CSL New World investment in Hong Kong grew steadily in the year to 30 June 2009 but the revenue growth in that year is not significant when compared to Telstra’s wider operations — a measly $72 million.

The company’s NZ subsidiary TelstraClear actually went backwards by $15 million in 2009. If I were to say why that happened I would guess it’s because the business again is just not large enough for Telstra’s Australian management to pay it the correct level of attention.

Another option for Telstra is to expand into markets adjacent to its own. The most likely one would be new media/content – a field Telstra has long toyed with. Its long-running interest in its Foxtel joint venture is one example of this attention — as were Trujillo’s new media acquisitions in China and even the speculation that Telstra could one make a play for the Fairfax empire.

The problem with the idea that Telstra might become a media giant is unfortunately that if it attempts to do so it will suffer the same difficulties that the telco did with its $333 million buyout of Australian IT services group KAZ in mid-2004.

As David Thodey well knows — because he oversaw the KAZ business for years in his role as group managing director for Telstra’s Enterprise and Government division — Telstra was never able to integrate KAZ into its operations and was ultimately forced to sell it because the nature of the IT services market is fundamentally different from Telstra’s strength in network construction and operation.

Just last year Telstra sold KAZ to Fujitsu and abandoned its attempt to play in a market that after all was much more adjacent and compatible to Telstra’s core strengths than a new media or content business would be the company’s encouraging efforts in IPTV and video on demand notwithstanding.

This situation would be even worse if Telstra attempted to invest in a market — say mining — that is drastically removed from its strengths.

This has always been the problem with Thodey’s leadership of Telstra. In the more than a year since the former IBM executive took the reins of Australia’s telecommunications warhorse he has failed to clearly articulate to shareholders where Telstra’s future revenue growth could come from. Today’s $11 billion deal with NBN Co has just made that problem a thousand times worse.

Now let’s not pretend Telstra’s NBN Co deal has no upside.

For the Government the deal is fantastic — it resolves Telstra’s integrated retail/wholesale nature while also ensuring a speedy and convenient fibre rollout through the use of Telstra’s ducts and delivering the NBN a guaranteed massive customer base.

Telstra’s rivals must be jumping for joy at the idea that they will finally be able to compete with the telco on an even footing and of course customers will benefit from getting fibre broadband faster and with more competition.

Telstra may be the great tottering grand-daddy from which Australia’s entire telecommunications sector was spawned. But pity is not always offered for those that make gross mistakes of judgment. Thodey’s hubristic belief that he can heal Telstra’s acrimonious relationships with the public and Government will likely come back to bite him and Telstra itself.

As a certain Reverend Mother Gaius Helen Mohiam said in Frank Herbert’s classic sci-fi novel Dune: “The boy may be worth saving but for the father nothing.”