TELSTRA GROUP LIMITED — Call Transcript 2005

Nov 14, 2005

15 November 2005

The Manager

Company Announcements Office Australian Stock Exchange 4^th Floor, 20 Bridge Street SYDNEY NSW 2000

Office of the Company Secretary

Level 41 242 Exhibition Street MELBOURNE VIC 3000 AUSTRALIA

Telephone 03 9634 6400 Facsimile 03 9632 3215

ELECTRONIC LODGEMENT

Dear Sir or Madam

Transcript of presentation by CFO at the Telstra Investor Day

In accordance with the listing rules, I attach a copy of the transcript of the presentation by John Stanhope, Chief Financial Officer at today's Telstra Investor Day, for release to the market.

Yours sincerely

North brake

Douglas Gration Company Secretary

Telstra Corporation Limited ACN 051 775 556 ABN 33 051 775 556

Telstra Corporation Limited

John Stanhope's CFO presentation

15 November 2005

SOL TRUJILLO: Great. Thank you, Bruce.

So leverage is key, as we think about how we use Telstra's assets. Obviously you are now seeing the leverage happen between Sensis and the rest of Telstra, how you think about it relative to BigPond and how you think about it within the mobile context. We are going to be doing more of that and now you are seeing the first wave of the power of Telstra.

Well, we are at the stage now where those of you that have been saying, okay, this is a great story, a lot happening, it's differentiation, it's innovation stuff, it's next generation stuff, all kinds of significant investments, customer experience enhanced, but what does this all mean? What does it all translate to in terms of financials? And we have John Stanhope here, our CFO, to talk to you about that story. John.

JOHN STANHOPE: Thank you very much, Sol, and good afternoon, everybody. I sort of feel like I should get you all up to do star jumps or something like that, you have been sitting still for quite some time.

We appreciate your presence here today and listening to our story. Bruce has told us how to take the pain out of wedding planning: I was hoping Bruce might tell me how to take out the pain out after the wedding. No I'm only kidding: I'm very happily married.

Seriously, on a very serious note, so what does this all mean in terms of the possible financial outcomes? First, let me say I will be talking about forward looking financial estimates here, and I know my slides have just been handed out here. So we are looking at three and five years out. This is unusual and so I do alert you to our cautionary statement or our disclaimer that was up on the screen as we started the day. But we are doing this to help you understand the likely or the possible financial outcomes from this new strategy.

I will cover why the new strategy is not optional. I will cover the impact that the new strategy - market-based management, integrating services, the one factory, etc., all the things that you have heard about today - will have on the profit and loss, on capital expenditure, cashflow, balance sheet financial ratios and capital management for the company. I will explain what financial parameters we intend to operate within going forward. I will announce our intentions regarding the capital management program and the future dividend policy.

I will talk about shareholder value improvement and how management will be incented to achieve the implementation of the strategy that you've just heard about. I will also cover the 2005/06 earnings impact and any variation to our 5 September quidance. Today, I will show you what is financially possible with a reasonable requiatory environment; that is, a fully integrated outcome. This is all about saving Telstra from what I call a death by a thousand cuts which would be or is the status quo. It's about transforming this company.

So let me just begin - and I know Sol touched on this before - with a little bit of history that clearly shows why we must embark on a new strategy and why it is not optional. Revenue has been at low growth rates for three years and is declining. Within this, PSTN revenue decline is accelerating and mobiles revenues are under pressure. The product revenue trends reflect declines and the impact on revenues from price controls and competition. Just for example, mobile yields have fallen by an average annual decline of 10 per cent since 2001/02. PSTN yields are also declining. And this will likely continue unless we do something, and so this is just not a sustainable position.

When we look at expenses growth, goods and purchases are growing resulting from the change in the product mix that Sol alluded to before, and labour costs are growing because of the high cost of maintaining and supporting complex legacy IT systems, complex products and services and all the things that you have heard about from my colleagues, and of course this cannot continue. This business simply cannot continue to have expenses growing faster than revenues.

The combination of the revenue and expenses trajectory has impacted the earnings as shown on this slide. Declining earnings growth is also not of course sustainable over the long term. Clearly, action has to be and will be taken to change this trajectory.

So let's look at the financial projections from the application of our new strategy. Firstly, the P&L, beginning with revenues. At the top level, that is the Telstra group level, we believe after a three year period revenues can grow between 2 and 5 per cent compound annual growth rate. Over a five year period, we believe we can maintain this growth level also to between 2 per cent and 2 and a half per cent compound annual growth rate, and you saw that before in Sol's earlier presentation.

This of course does assume a reasonable regulatory environment for us to operate within. But the key message on this slide is the difference between the status quo or the death by a thousand cuts and our new strategy, a differential compound average growth rate or annual growth rate of up to around 3 and a half per cent or around \$12 billion over five vears.

Let us just have a look at the major product outlet. I'll touch on the three there that vou are aware are our major products. In this scenario, we believe we can arrest the current fixed revenue decline through integrating services, subscription pricing, customer segmentation and all the things you heard about today from minus 7 to minus 10 per cent in 2005/06 to minus 6 per cent to minus 8 per cent over three years and minus 5 to minus 7 per cent over five years.

Again, note the status guo expectation is between 11 or minus 11 and minus 13 per cent over a five year period. We believe we can grow internet revenues between 28 and 30 per cent over three years and between 21 and 33 per cent over five years. We believe mobile revenues will grow between 5 and 7 per cent over five years. In Broadband, it is very much about growing the customer base and selling value-added services that you heard Justin mention earlier. In the

mobile business, it is about adding content and growing wireless data and as a result. ARPUs we believe can increase. Again the difference the new strategy will deliver is substantial.

Let's just take a look at the PSTN revenue outlook. We expect - this is really the mix between all our dependence if you like on the PSTN suite of products and services. We expect the mix of PSTN to total revenue to change from about 34 per cent to 24 per cent over three years and to about 20 per cent over five years and vou've heard earlier how we intend to do that. This is something of course you would expect as we move towards becoming a broadband integrated services company.

Let's just now have a look at expenses. We will have to spend more in the early years of the plan. I quess you would expect that after what you've heard today. and I will illustrate the expected run rate or I do here on this slide. As you can see, expenses are high in the next two years and then begin to fall as we implement the one factory and simplify products and services. The slide shows a decline of 2.1 per cent over the period 2006 to 2010.

What I've done on this slide and I've done it deliberately, is I've excluded the 2005/06 year to make the point that we will need to spend upfront and there is. and you'll learn more about this in a minute, some acceleration of depreciation and amortisation and of course that spend upfront has a marked impact. But this is to set the path for the future and establish a financial base to go forward.

Over the next three year period we expect expenses to grow in the range 2 to 3 per cent and in the range 1 to 2 per cent over five years. Again, this assumes a reasonable regulatory environment. The higher three year compound annual growth rate reflects the upfront costs I mentioned earlier. But given that labour price we think will grow around 3 per cent per annum and that CPI is estimated to grow around 2.9, 3 per cent per annum, there is a real expense reduction here of between minus 1 - around minus 1 per cent over three years and minus 1 to minus 2 per cent over five years.

Again the main point of this slide illustrates the difference between the new strategy and if we keep going how we are, a difference of a five year compound annual growth rate of between 1.6 and 0.6 per cent or a lower spend over the five years of approximately \$1.3 billion even after the upfront spending required to set a new cost base and this includes the acceleration of depreciation. It excludes redundancy payments that have to be made.

Obviously a much better picture if you exclude those sort of elements. Let us just take a look at the operational expenses by type. The main drivers for expense movements over the five years are and continue to be goods and services purchased at 3 to 4 per cent compound annual growth rate. And you would expect this consistent with the growth in volumes. We have been talking about large volume growth here and to underpin a 2 to 2 and a half per cent revenue growth that there will be the cost of goods sold associated, but you can see from this slide that over a five year period we expect to keep labour and other costs reasonably flat while we absorb labour price increases and CPI increases as well.

You've heard a little bit about the head count changes. It is anticipated that across the three year period, our full-time equivalent employees will reduce between

6,000 to 8,000. And this does as you heard from Sol earlier include contractors. This will be driven by the network and IT changes outlined earlier to meet contestability in the changing market as we deliver more effective service to our customers. We will follow all our staff and union communication requirements as and when we know the details.

We will make a provision for redundancy and restructuring in the 2005/06 year again as and when we have the detail required to satisfy accounting requirements. We expect we will have that sufficient detail to do a provision as at 30 June '06. The impact of this will become a little more clearer when I address the 2005/06 earnings guidance.

Okay, let me move on to the earnings trajectory. So obviously the combination of these movements in revenue and expenses results in an earnings trajectory as you see on this slide or the slides you have in front of you. Not surprisingly, earnings EBITDA and EBIT in 2005/06 are expected to decline and 2006/07 levels are expected to remain similar to levels achieved in 2004/05 and then begin to grow again from 2007/08. Again, the important point on this slide is the difference between the status quo and our new strategy.

The compound annual growth rate differentials over five years are for EBITDA between 8 and 10 per cent and for EBIT, 15 to 17 per cent. This is a difference of about \$13 billion EBITDA and about \$11 billion for EBIT, fairly significant from a status quo death by a thousand cuts scenario versus this strategy, the possibilities that this strategy can deliver.

So, EBITDA and EBIT outlook. Our expectations of EBITDA growth over three years is in the range 2 to 3 per cent and over five years, 3 to 4 per cent, all compound annual growth rates. EBITDA margins go we believe from 48 per cent. or certainly that's a firm number in 2004/05 to around 47 to 48 per cent over three years and around 50 to 51 per cent over five years. As you've seen and heard throughout the day, we intend to reverse the situation where now revenue will exceed expense growth.

Our expectations of EBIT growth over three years is in the range of minus 1 to about flat in the three years but over the five years, in the range 3 to 4 per cent compound annual growth rate. EBIT margins go from 32 per cent 2004/05 to an expectation of around 28 to 29 per cent in year three and to above 33 per cent in year five. The EBIT decline over the three years is impacted by the growth in depreciation and amortisation driven by a couple of things, one being the acceleration in 2005/06 and 2006/07 year and some write offs.

So, I've talked about depreciation and amortisation a little bit here so let me deal with that in a little bit more detail. We expect depreciation and amortisation to grow as we invest significantly over the next few years. The growth trajectory is in the range of 7 to 10 per cent over three years and 4 to 6 per cent over five years and of course I'm referring to compound annual growth rates again. I won't keep saying it but these percentages are compound annual growth rates.

The 2005/06 and 2006/07 years are impacted specifically by acceleration of depreciation and some write-offs and I'll explain again in a little bit more detail about that in the 2005/06 earnings Scales. Of course, assets will be added as we build next generation network and transform the IT base as well.

Let me just talk about net profit after tax. Our best estimate of net profit after tax over the three year period is between minus 3 and minus 2 per cent obviously impacted by the depreciation and amortisation, over five years, a growth of 3 per cent or between 3 and 4 per cent. Again, it's not just the impact of accelerated depreciation. Of course we do have to spend in the early years as well. Again, to labour the point. I quess, when you look at this slide and it stands out quite significantly, it is the differential between the status guo and the new strategy financial outcomes that is what we should be focussed on here. Over the five years the compound annual growth rate differential for net profit after tax growth is between 21 to 24 per cent, very, very substantial indeed.

Let me talk about capital expenditure now. As you know, we have been spending CAPEX over the last few years at these sorts of rates, domestic CAPEX averaging about \$3.1billion, offshore CAPEX averaging about \$200 million; investing CAPEX, averaging about \$400 million. We had a couple of peaks in the early years as we did the ventures into Hong Kong but the total CAPEX over the last few years has been averaging about \$3.7 billion.

This is about to change as you might expect as we embark on a major network and IT platform transformation. Let us just take a bit of a look at the cumulative CAPEX forecast. It is estimated with the implementation of this new strategy that we would require to spend an average of about \$4.5 billion per annum or \$23 billion over five years to bring the network and IT platforms up to a high quality even in a status quo environment. The new strategy will require a total capital expenditure of up to \$25 to \$26 billion.

So what we are talking about here over the five year period from a status quo environment is a \$2 to \$3 billion increment in CAPEX in net terms. Our total five year domestic CAPEX spend will be in the order of \$21 billion compared with the previous expectations of \$18 billion or so over the five years. Again, I must say it assumes a reasonable requlatory environment. We will not invest if it is not economic to do so and understandably a lot of you people in this room as our shareholders would not want us to do so.

You might say this doesn't seem like a lot of incremental CAPEX for what we have said will be delivered. It's just important to understand, and I think Greg described it fairly well and it is shown on this slide, that is in the right-hand box of this slide. that the initiative - the gross spend of the initiatives is somewhere between \$14 to \$15 billion but we do expect to save up to \$11 to \$12 billion by not spending on the many legacy systems, be they network or IT that we have today.

So that's how the netting off occurs to get us to the increment over the five year period of \$2 to \$3 billion. So what does this do for our CAPEX to sales ratio? The CAPEX to sales ratio over the five year period as you can see on the slide it peaks at 25 per cent in year 2006 and 2007 as we invest in the platforms, both network and IT, and reduces to about 12 per cent in 2009/10. And we believe we are able to operate at around 12 per cent levels in the future because of the benefit and the reuseability of the new platforms both network and IT.

So, let me show you the drivers of the increment in the CAPEX. The next generation network including what we have described we are doing with wireless is about \$3.4 billion. IT platforms is about \$700 million to \$1.2 billion. Network

fixes, this is replacing some of the pair gain systems and so on, \$800 million. to \$1 billion to give us a total of \$4.5 to \$5.6 billion and incremental savings or savings out of this of \$2.5 billion to \$2.6 which gives the net outcome of an increment of \$2 to \$3 billion. These investments of course are essential for the achievement of the revenue, expense and earnings outcomes.

Let me just now move to cashflow. Obviously with what is happening with the profit and loss run rate and the CAPEX requirements, cashflow will be impacted substantially in the 2005/06/07 years when most of the CAPEX is required. Free cashflow begins to build again as you can see on the slide from 2007/08. You can see the possible movements in the free cashflow year over year. I should tell you the definition of free cashflow here is sort of the pre-IFRS definition so it's operating cashflow less investing cashflow interest and tax but before dividends. I know some of you are used to that definition from us.

So that's what we think is possible in terms of cashflows from the new strategic plan, operating cashflow falls in 2005/06 with reduced EBITDA before growing again in the later years. High CAPEX of course impacts the cashflow in the earlier vears as I mentioned.

So, what does it mean in terms of the net cashflow with this fully integration or full integration plan versus what might have been or what would be if we remained on the path we are on today. And this slide shows the net cashflow difference between a status quo in our view and the new plan. This generates a cumulative additional \$7.7 billion cashflow over the five years to 2009/2010 versus the status quo or as I say the death by a thousand cuts.

So what does this mean for net debt movements? Understandably, the cashflow will cause lower or debt requirements in the early years. These net debt levels assume no capital return in 2006/07. That is the \$1.5 billion suggested in the June 2004 announcement is assumed here not to be paid. Of course, this sort of debt pattern will require a yearly borrowing program to match the requirements certainly in the first couple of years.

Let's have a look now at the balance sheet financial ratios. The impact of the P&L movements and the CAPEX requirements will have an effect on the balance sheet and therefore our financial radios. It is important for me to emphasise again here that the return matrix can only be achieved in a reasonable requiatory environment. If it is not reasonable, we will have to continue to invest to keep patching the network and the systems and revenues will decline. Obviously that means a declining return on investment path which is not something that we want as a company nor should you want as shareholders.

The key ratio specified on the slide assuming this regulatory outcome is reasonable, return on assets which is expected to grow from 21 to 23 per cent over five years return on equity which is expected to grow from 31 to 35 per cent over five years, EBITDA interest cover will drop during the period but emerges strong again in the year 2005. Debt servicing, that is EBITDA to net debt, will also drop during the period but again emerge as strong in year 5. Cashflow return on invested capital is expected to grow from between 27 and 33 per cent. Asset turns we will expect also will improve. Return on investment will improve from 28 to 29 per cent over the five year period and the definitions of these ratios are shown on page 36 of the slide pack that's been sent out or you can obtain a copy as it has

been lodged with the ASX.

Let me just talk about capital management now. As you would expect, the new strategic plan has implications for our financial parameters and capital management. The new parameters the board have agreed to and management have set are, it is our intention to pay 28 cents, this is ordinary dividend of 28 cents, for the next three years and then review. But of course, this is subject to the board's half vearly declaration and review of the business and regulatory environment.

We have decided to change our parameters to debt servicing of between 1.7 and 2.1 times net debt gearing of 55 to 75 per cent and interest cover, that is interest cover, EBITDA cover, of greater than seven times. We believe these parameters are consistent with a A, single A flat, call it what you like, S&P credit rating and we believe that that's where we will probably sit given our transformational strategy. but let me hasten to add, of course, credit ratings are a matter for the credit rating agencies so what will be will be, but that's our estimate.

The board has decided to pay the remaining six cents special dividend in 2005/06 with the interim dividend that is next year to complete the \$1.5 billion capital return for the 2005/06 year. The board has decided not to proceed with the \$1.5 billion capital return in 2006/07. It is considered more appropriate to invest this money to implement the new strategy which is about delivering long-term shareholder value and to discontinue borrowing to fund special dividends and buy-backs.

Given lower profit levels also in the early years not returning capital to shareholders will most likely allow us to continue to fully frank ordinary dividends over the three and five year period. We believe this is also an important consideration for our many Australian retail investors.

So, how will management be incented to deliver all this that you've had put in front of you today? We will have a very different management incentive plan. The proposed arrangements for the management incentive scheme comprise both a short term and long-term component. These incorporate both financial elements and targets to achieve transformational objectives. I think we are taking off.

This slide and the following slide gives some examples of the matrix. For example, the reduction in the number of systems is a key transformational objective: that we achieve the compound annual growth rates I've shown you is a clear metric that we must achieve. Of course, there will be many micro-measures, KPIs, metrics, call them what you like, that aggregate to these major milestones that we must achieve to be compensated and remunerated, and also let me remind you that with regard to the total shareholder returns, target for the CEO, myself and other senior executives, it's already set at \$4.78 a share price.

So let me just talk a little bit about shareholder value. So finally, from a new strategy perspective, it's important that this is about creating long-term shareholder value. At the end of the day, all this work and all this investment is aimed at growing the business, growth that will come from satisfying our customers like never before. Satisfied customers delighting in the use of our products and services will drive growth in the business. Growth in the business will grow shareholder value

Our expectation is that this new strategy will move shareholder value from a status quo value significantly when we successfully implement this new strategy. Just lastly, before I get on to the earnings guidance. I hope you have noticed the asterisk on each slide. This is because we can only achieve the shareholder value improvement and the improvements in financial performance if we have a regulatory environment that allows it. Today we are talking to you about what is possible.

There is a detailed session next week on regulatory issues and invitations will go out as to what location that will be at and at what time that will be so, you have a better understanding of what we are talking about and continue to talk about with respect to requlation.

Let me just move on to the 2005/06 earnings outlook because this is very important. Our earnings quidance for 2005/06 - well, first let me just track back to you will recall that 5 September the CEO and I issued quidance that EBIT would decline in 2005/06 in a range minus 7 to minus 10 per cent. Let me just say that nothing has changed in the underlying fundamentals of the business to change that quidance. But of course, we are about to start to implement the new strategy in this fiscal year. So, our earnings guidance for 2005/06 is now that EBIT will decline in the range minus 19 per cent to minus 24 per cent, or if we make provision for redundancy which is a likely outcome, between minus 25 to minus 30 per cent.

Let me just talk about the main drivers for the variation to this quidance. The main drivers for the variations to quidance are there are some elements of revenue acceleration that we are putting in place during 2005/06 and that will have an incremental EBIT impact of about \$30 million. And you can see that as the small portion on the slide. We will also be implementing some initiatives to take some costs out in 2005/06 and that has about a \$50 million savings and that's the second bar on the slide.

Additional depreciation and amortisation, due to various things, of about \$549 million is factored into the quidance. \$272 million of that is related to the next generation network, that is, accelerating the depreciation for pair gain systems taking them out of the system over a period of time so we will be accelerating the depreciation of those and it includes C (inaudible) and elements in the network that today are the blockers to Broadband.

It also includes about \$110 to \$120 million acceleration and depreciation for CML as we take CDMA out of the network in a - the life is shortened as we take it out of the network. There's about \$50 million in there for accelerated depreciation or amortisation in the case of business support systems and operational support systems.

There's about \$1 million depreciation or acceleration for other elements of the network being rationalised and rehabilitated and lastly, some write-offs of about \$13 million for projects which are stopping. There is additional redundancy in 2005/06, over and above what we had in plan that recognises a number of extra staff reductions in 2005/06.

The other thing I mentioned was the number of minus 25 per cent in earnings EBIT to 30 per cent. We will likely take a provision of \$450 to \$500 million and that gets us to that sort of earnings decline. Whether we establish a provision for redundancy will depend on satisfying the accounting rules and staff and union communication requirements prior to 30 June. One thing I should add, should we not get a favourable regulatory outcome and not proceed with next generation network, the quidance range drops. You say why is that so? Because we won't accelerate taking out the pair gain systems. So, it will drop about 4 per cent. So just keep that in mind, that the earnings guidance would be something like minus 15 to minus 20 per cent without the R&R provision or minus 21 to minus 26 with the provision.

This has finished up being a fairly difficult task. We will answer questions on the financials and other questions about the strategy shortly. Thank you for your attention. I will now hand back to Sol. Thank you.