Long-term good health of Telecom shares will require skilful management

The ability of management to expand and find new sources of profitable revenue will be crucial to the long-term success of Telecom Eireann as a publicly quoted company.

As the dominant player in a market where it was - until relatively recently - a monopoly service provider, Telecom is expected to lose some market share in coming years to competitors and margins are expected to tighten as competition intensifies. But the company has the advantage of operating in a strong economy where the market for telecommunications is growing and developing rapidly.

In assessing the future outlook for Telecom, there are a number of positive factors and potential risks which must be considered.

Among the positive factors are the following:

Telecom is operating in a strong and growing economy and the company should benefit from the impact of strong growth on the demand for telecommunications services.

The Irish market is at a relatively early stage of development: telephone penetration is lower than the European average. According to a recent report by Davy Stockbrokers, there were 41 land lines for every 100 people in Ireland in March 1998 compared with a European average of more than 52 lines per 100 people. Figures for Internet, mobile phones and other services users are below European averages. This means that there is significant scope for telecoms companies to expand revenue.

Profits available to shareholders, and therefore earnings per share, will be boosted by the fall in the Irish rate of corporation tax.

Employee costs will be reduced as a result of the restructuring plan agreed with the unions representing employees, boosting profits.

But risk factors include:

Telecom is facing increasing competition in all its service areas. Since the market was fully deregulated on December 1st, 1998, competition has increased and this trend is set to continue both in the traditional services areas and with the expected arrival of new forms of telecommunications and alternative technologies. For Telecom the effect will be loss of market share and tightening profit margins on existing operations and the need to make significant investments in updating and changing technologies.

The sale of the cable television company, Cablelink, to NTL is expected to lead to further competition with NTL expected to invest in upgrading cables to enable it to offer a one-package service of telephone, Internet and TV to customers.

The appointment of a telecoms market regulator means that Telecom Eireann's prices are now subject to control by the regulator. The price cap could affect the company's competitiveness in the fixed line services market, according to the Telecom prospectus.

Other issues under consideration by the regulator, which will affect the future financial performance of Telecom, include the rates it charges competitors for interconnections with its fixed line networks, the extent to which it will be obliged to share infrastructure with other operators and the prices it will be allowed to charge for this. Another key decision is whether it will be required to give other network operators access to its local network infrastructure - known as "unbundling the local loop" - which would allow new operators direct access to customers.

Meteor, the mobile phone operator which was awarded the third licence, is expected to commence operations later this year, increasing competition in the market and pushing down profit margins.

In the mobile phone market, the ability of the Telecom subsidiary, Eircell, to expand could be constrained by lack of capacity available to it on the GSM system.

Historical Financial Performance: Telecom's financial performance over the past three years shows slowing growth in turnover and profits. The benefit of good growth in business has been somewhat reduced by falling charges to customers, as prices are driven down by increasing competition. The Telecom prospectus gives financial results for the company for the past three years.

Turnover increased by 11 per cent in the year to April 2nd, 1998, followed by a 6 per cent rise to €1,823 million for the year to April 1st, 1999. This slowdown in turnover growth reflects the reduction in prices charged to customers as Telecom launched pre-emptive strikes in advance of full market deregulation.

For the same reason growth in gross profits slowed down with an 8.7 per cent rise between 1997 and 1998 followed by a 2.9 per cent increase to €1,537 million in the year to April 1st, 1999.

Operating profits increased by 4.4 per cent between April 1997 and April 1998, but fell by 55 per cent to €137 million in the year to April 1st, 1999, when restructuring and exceptional costs, including flotation costs, totalling €258 million, were included. When the exceptional costs are stripped out, the operating profits were flat at €311 million.

Earnings per share over the three-year period - when exceptional costs and goodwill write-offs are excluded - increased from 7.8 cents in April 1997, to 9.0 cents in April 1998, and 9.7 cents in April 1999. The dividend per share over the three years was 0.9 cents, 2.6 cents and 2.4 cents.

Prospective Earnings: Forecasts for future performance are thin on the ground with the company and brokers involved in the flotation precluded from making forecasts in advance of the flotation.

Based on the historic results to April 1st, 1999, and the tentative flotation price range quoted in the Telecom prospectus of €3.35 to €4.15, it is possible to calculate earnings per share and price earnings (P/E) figures. These are two of the main measures used by investors in assessing a share price.

Using the earnings per share figure - adjusted for exceptional costs and goodwill - of 9.7 cents, would put Telecom on a price earnings ratio of 34.5 times earnings at the lowest indicative float price of €3.35. The P/E would rise to 38.7 times at the mid-share price level and to 42.8 times at the top price level of €4.15.

These P/E levels compare with a weighted average level of 36 times earnings in the European market, though P/E levels vary widely. At historic P/E levels, Telecom is certainly not coming to the market at a bargain basement price.

Some brokers are suggesting that Telecom Eireann could maintain a P/E level higher than the European average given the strength of the Irish economy, the scope for revenue growth and because of the positive impact on profits of the falling corporation tax rate. Another reason a higher rating could be maintained would be the potential that Telecom Eireann could become a take-over target for larger multinational telecoms operators.

Davy Stockbrokers have adjusted the April 1999 results to get an earnings per share figure of 12.3 cents, apparently through adding back non-exceptional restructuring and transformation costs of €83.9 million - the analyst involved was unavailable for comment. At this level the price earnings ratios at the low, mid and high indicative share prices are on less challenging P/Es of 27.2, 30.5 and 33.7 times earnings respectively.

For the current year Davy is forecasting adjusted earnings per share of 14.5 cents giving price earnings ratios of 23.1 times earnings, 25.9 and 28.6 times earnings at the low, mid and high indicative share prices.

On another measure of value - enterprise value divided by earnings before interest, tax, depreciation, and amortisation - at the low, medium and high indicative share price levels, Telecom would be on 10.3 times, 11.5 times or 12.6 times earnings. At this level the company looks expensive compared with a European average of just under nine times earnings.

Prospective shareholders will also be interested in the likely dividend which the company will pay out of its annual profits. Telecom has announced a pay-out range of 40 per cent to 50 per cent of net earnings. This gives a prospective dividend yield of 1.5 per cent to 2.1 per cent, in line with the weighted European average level of 1.9 per cent.

There is no doubt that the Telecom share offering will be priced to rise when the flotation is launched on July 14th. The share price is expected to rise in early trading boosted by technical factors such as the shortage of shares available to Irish institutions which will want to have a weighting in the shares reflecting Telecom's weighting in the ISEQ Index of about 11 per cent, and to foreign institutions.

In the medium to long term the financial performance of the company and its share price will depend on the ability of the Telecom management to achieve profitable revenue growth. This will require an ability to increase revenue from data traffic and mobile telephony as turnover from its fixed line network and other services business segments slows in increasingly competitive markets.

Telecom has been operating in a deregulated market for just over a year and that market is changing and developing rapidly. In the prospectus the company said it is devoting significant resources to identifying and developing new business opportunities in Ireland and in Great Britain and Northern Ireland. It has identified multi-media and interactive services which include e-commerce as areas of future growth and is actively seeking new opportunities in these areas.

Telecom wants to expand vertically so that customers can be offered a full service from equipment to provision of the associated services and to capture as much as possible of the increasingly important data traffic. Moves in this direction so far have included the acquisition of a 50.1 per cent stake in Trinity Commerce, the Internet arm of Trinity Technology Group, and negotiations with Horizon, one of the State's largest independent providers of computer services and information technology products.

The telecoms sector is the flavour of the moment on European markets and the Irish sector is particularly attractive because of the strong economy and the positive Irish demographics. But not all of the companies operating in the sector will be successful, especially as competition intensifies.

The long-term outlook for Telecom shares will depend largely on the ability of the management to maintain the company's strong market position and to continue to achieve profitable revenue growth.