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Introduction

Telecom New Zealand is highly profitable. In the absence of competition in some markets this raises questions of whether Telecom is earning monopoly profits. This Appendix discusses the issues, but no firm conclusions are reached.

The Court Judgments

Each of the Court judgments considered the question of whether Telecom was earning monopoly profits. The High Court identified two approaches in the evidence: by indirect inference or by direct measurement.

The former approach was provided by Telecom's economic witness, Dr Kahn, who observed that Telecom's (then) charging structure for subscriber access as between CBDs and rural areas was "symptomatic of an absence of fully effective competition."[143]

The latter approach was provided by a joint statement from the independent accounting witnesses for Clear and Telecom, who, after examining the information contained in the brief of Telecom's independent witness, stated that no firm conclusions could be drawn either way.

In these circumstances, the High Court remained "largely agnostic on the factual situation - not quite, in view of Dr Kahn's judgment which must be accorded great respect."[144] The High Court went on to examine whether any such monopoly charging would impede Clear from competing, and heard both Dr Kahn and Professor Baumol argue that it would not.

The Court of Appeal considered the incorporation of a monopoly profit component in an interconnection charge was anticompetitive, and found the BW rule was anticompetitive.

The Privy Council supported the High Court's view that the burden of proof had not been discharged as to the existence of monopoly rents. It recognised, however, that there was a risk that monopoly rents did exist.[145]

Measuring Profitability

There are a number of financial indicators which are used by financial analysts and financial markets to determine the performance of companies. Each of these indicators has its own limitations but the usual accounting approach is to measure the net profit after tax and interest deductions compared with the shareholders' equity. The advantage of this approach is that it uses the companies' published and audited figures, which have been prepared on the basis of generally accepted accounting principles (GAAP). This approach provides a measure for comparing with other local companies whose accounts are prepared on the same basis, or in the case of overseas companies, close to the same basis.

There are other measures for comparing financial performance including, for example, net return on the capital employed, or assets used[146].

It is true that there are difficulties with making such comparisons, because data prepared on the basis of historical costs and various accounting conventions may not measure economic values. The intention is not necessarily clarified, however, by taking a profit figure performance on a GAAP basis, and relating it to market value of the company at a particular point, especially if the objective is to make a comparison with other companies' profitability. For the comparison to have any validity, the data needs to be presented on a consistent basis as between companies.

Another issue with departing from the reported shareholders' equity in assessing profitability is whether other measures of shareholder gain should be taken into account. In particular, account might be taken of the capital appreciation that has occurred and the way shareholder wealth has been distributed. For example, at the time of Telecom's privatisation, the $1 shares were sold for $1.82 per share. Currently Telecom's share price is approximately $6.00 (although, since privatisation, some 20 percent of Telecom's $1 shares have been cancelled in a debt-for-equity swap). There has been a considerable capital appreciation in the value of Telecom Corporation of New Zealand to the extent that the company's sharemarket value is approximately $11.5 billion. Taking the capital return into account, this represents almost three times the purchase price paid at the time of privatisation. Dividends would further increase this return.

Telecom's Profitability

Telecom's profitability has substantially improved in recent years. Data from 1989 onwards is presented below in Table 5.

Table 5: Telecom's Return on Shareholder's Equity.

Source: Telecom, Annual Reports, various issues.
^*Note: Before 1992-93 financial year abnormal items.

However, Telecom states that if the price paid for Telecom ($4.25 billion[147]) by the shareholding consortium in 1990 was reflected in Telecom's accounts, the rate of return on shareholders' equity for 1995 would be 15.8%[148] and such a return could not be held to show evidence of very high returns.

Officials would agree that a 15.8% return would not be abnormally high. Telecom's contention that its profitability should be referenced to the price paid in 1990, in officials view, is not an appropriate method on which to base assessment of its profitability as the true return on its investment at the time should also take into account capital appreciation.

Moreover, there is no obvious reason to think that the historic cost accounts showing a 30.1% return on equity for Telecom overstate Telecom's profitability, compared to other publicly listed companies. Indeed, Jordan Sandman Were in its Telecom New Zealand Research Report of March 1995 suggest that Telecom's profits are, if anything, understated due to high depreciation rates. It should also be noted that Telecom's return on equity is still tending to increase as shown by its latest 15% increase in quarterly earnings. McIntosh Baring currently forecasts its annual return on equity to reach 37.8% in 1997.

New Zealand Comparisons

Telecom's profitability, by return on average shareholder equity as of March 1995, needs to be compared with other major New Zealand corporates. Table 6 compares Telecom's recent performance with other New Zealand companies with a market capitalisation of over $1 billion.

Table 6: New Zealand's Major Companies Return on Equity

Source: The 1995 data are forecasts from McIntosh Baring, except for Telecom. (Companies have been placed in order of their 1995 market capitalisation.)

17. Table 7 compares the returns on equity of a number of other New Zealand companies.

Table 7: Returns on Shareholder's Equity

Source: Hendry Hay, except NZ Refining data which is from Buttle Wilson.

International Comparisons

We may also compare Telecom New Zealand's performance with other telecommunications companies. Table 8 compares returns on equity of leading international telecommunications companies.

Table 8: International Telecommunications Companies

Source: Merrill Lynch Estimates, 1994 financial year, except for Hong Kong Telecom 1995 financial year.

There are special circumstances for the case of Hong Kong Telecom. Hong Kong Telecom enjoys a monopoly on international traffic until 2006. International traffic is a high proportion of the total traffic due to Hong Kong's position in the international trading community. Thus, Hong Kong's performance represents an outlier.

Service Provision Cost Information

Officials have obtained some information on the actual cost of telecommunications service provision as follows:

1. Local Call Usage Costs: The Ministry of Commerce engaged an American telecommunications consultancy (Bell Communications Research) to carry out a study of what local call usage costs might be in a competitive market, based on existing network layout of the Auckland local calling area, and best practice technology and operational procedures. Using a number of assumptions and estimates, the results suggest that the forward looking local call usage average incremental cost, for a network in the Auckland local calling area, may be about 1.3 cents per minute in peak times, based on US cost of capital and depreciation rates. This figure would have to be adjusted for New Zealand cost of capital, depreciation rates, and an appropriate contribution to fixed and common costs.
   
   In the US it is understood that an average mark-up over usage costs, to allow for fixed and common costs, would be about 40%. Applied in New Zealand, that would suggest a cost of about 1.9 cents per peak minute. However, this only provides limited guidance and more information would be needed to reach a firm conclusion. Telecom's tariff for business users is 3.55 cents per minute at peak times and 0.44 cents per minute at off peak times (discounts can apply in certain circumstances). Residential calls are uncharged because of the Kiwi Share requirement.
2. Central Business District (CBD) Telephone Access Costs: Telecom has publicly stated that its forward looking average incremental cost of providing business access lines in CBDs is about $200 per annum (p.a.)[149]. As before, an allowance would have to be made to include fixed and common costs. Telecom's charges are as low as $555 per annum (including discounts) for CBD business telephone access lines, although the average is probably closer to $600 p.a. Telecom says that one of the reasons for the difference is the need to fund its Kiwi Share obligations (KSO) costs in respect of the provision of residential telephone service.
3. Kiwi Share Cost Issues: The KSO constrains Telecom in, inter alia, what it can charge for the residential telephone service. Telecom currently estimates that the cost of providing local telephone service exceeds the revenues that it earns for that part of the service by in excess of $100 million per annum (post-tax).[150] Telecom says that this figure is not the total cost of the KSO, but is a net amount representing the overall deficit of the local telephone network after the KSO costs have been offset in part by contributions from other profitable services, such as business local calling. Telecom says that it cross-subsidises the deficit from more profitable services, such as national and international tolls and that Telecom's competitive services are effectively bearing a greater share of the deficit than is borne by competitors through their current interconnection payments.

Officials do not have sufficient information to prepare KSO cost estimates. However, they have attempted to make their own estimate of local telephone network KSO costs using available information including information from United States regulatory hearings on typical local loop access costs. This suggests that any deficit may be much smaller than Telecom states.

Conclusions

There is no doubt that Telecom's strong profitability is the result of a mixture of factors, including:

1. the fact that the company is well managed;
2. the fact that New Zealand enjoyed the strongest level of economic growth for a decade in the 1994-95 financial year (and, as such, utility companies could be expected to perform very well);
3. that the company has recently concluded a major period of capital investment in which its digitalisation and technology base has been improved considerably;
4. the improved performance of its new ventures, both in mobile cellular, and its overseas activities; and
5. the input of its American shareholders.

Despite these factors, another possible factor is the lack of competition which Telecom faces in local access. Telecom's business is still largely based around its core telecommunications business and it is reasonable to see many areas outside local access as benefiting from its local access position. These include to at least some extent, its directories, cellular, New Zealand value added and tolls businesses. The extent is inevitably a matter of judgment.

Telecom enjoys a very high rate of profitability compared with other major New Zealand firms and comparable overseas telecommunications companies. High profitability is not a problem in and of itself. Strong profitability is to be welcomed where it results from good company performance. There are a number of factors which justify Telecom's strong profitability. However, recent disputes may have impeded the development of competition. The comparisons presented here are consistent with the view that Telecom is benefiting from the absence of competition.