20-F 1 d20f.htm FORM 20-F Form 20-F
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 20-F

ANNUAL REPORT PURSUANT TO SECTION 13

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended 30 June 2006

 

Commission file number 1-10798

TELECOM CORPORATION OF NEW ZEALAND LIMITED

(Exact name of Registrant as specified in its charter)

 

 

 

New Zealand
(Jurisdiction of incorporation or organisation)
Telecom House, 68 Jervois Quay, Wellington, New Zealand
(Address of principal executive offices)

Securities registered or to be registered pursuant to Section 12(b) of the Act:

 

Title of each class

       

Name of each exchange on which registered

American Depository Shares      New York Stock Exchange
(“ADSs”, evidenced by American Depository Receipts (“ADRs”))     
Ordinary Shares, no par value      New York Stock Exchange*(“shares”)

 

* Not for trading, but only in connection with the registration of ADSs pursuant to the requirements of the Securities and Exchange Commission.

 

Securities registered or to be registered pursuant to Section 12(g) of the Act

   None

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act

   None

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the Annual Report.

 

Ordinary shares, no par value    1,960,933,948
Special rights convertible preference share, no par value    1

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

x Yes     ¨ No

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

¨ Yes    x No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to the filing requirements for the past 90 days.

x Yes ¨ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x            Accelerated filer ¨            Non-accelerated filer ¨

Indicate by check mark which financial statement item the registrant has elected to follow.

¨ Item 17  x Item 18

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

¨ Yes x No

 



Table of Contents

TABLE OF CONTENTS

 

   Interpretation    3
  

Forward-looking Statements

   8
   PART I   

Item 1

  

Identity of Directors, Senior Management and Advisors

   10

Item 2

  

Offer Statistics and Expected Timetable

   10

Item 3

  

Key Information

   11

Item 4

  

Information on the Company

   27

Item 4A

  

Unresolved Staff Comments

   77

Item 5

  

Operating and Financial Review and Prospects

   78

Item 6

  

Directors, Senior Management and Employees

   123

Item 7

  

Major Shareholders and Related Party Transactions

   145

Item 8

  

Financial Information

   150

Item 9

  

Listing

   153

Item 10

  

Additional Information

   154

Item 11

  

Quantitative and Qualitative Disclosures About Market Risk

   172

Item 12

  

Description of Securities Other Than Equity Securities

   175
   PART II   

Item 13

  

Defaults, Dividend Arrearages and Delinquencies

   176

Item 14

  

Material Modifications to the Rights of Security Holders and Use of Proceeds

   176

Item 15

  

Controls and Procedures

   177

Item 16

  

Reserved

   178

Item 16A

  

Audit Committee Financial Expert

   179

Item 16B

  

Code of Ethics

   180

Item 16C

  

Principal Accountant Fees

   181

Item 16D

  

Exemptions from the Listing Standards for Audit Committees

   183

Item 16E

  

Purchases of Equity Securities by the Issuer and Affiliated Purchaser

   184
   PART III   

Item 17

  

Financial Information

   185

Item 18

  

Financial Statements

   185

Item 19

  

Exhibits

   186

 

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INTERPRETATION

When used in this Report on Form 20-F (“Report”) references to the “Company” or “Telecom” are references to Telecom Corporation of New Zealand Limited, a company incorporated with limited liability under the New Zealand Companies Act 1993, domiciled in New Zealand, with its registered office located at Telecom House, Level 8, North Tower, 68 Jervois Quay, Wellington, telephone 64-4-8019000. References to “Telecom Group” are to Telecom Corporation of New Zealand Limited, together with its subsidiaries and associates.

Certain information required for this report is incorporated by reference from Telecom’s Financial Statements for the fiscal year ended 30 June 2006 (the “Financial Statements”). Information required to be stated as at the most recent practicable date, is stated as at 6 September 2006 unless expressly stated. References to “Notes” are references to the Notes to the consolidated financial statements. The consolidated financial statements for the fiscal years ended 30 June 2005 and 30 June 2006 are filed with this Report.

In this Report references to “US$” or “US dollars” are to United States dollars, references to “A$” are to Australian dollars and references to “$”, “NZ$”, and “NZ dollars” are to New Zealand dollars.

In this report reference to legislation is to New Zealand legislation unless specifically stated otherwise.

GLOSSARY

In addition the following terms have the following meanings:

 

“ADSL”    means Asymmetric Digital Subscriber Line, a technology for delivering a high bit rate data link to customers over ordinary copper wire.
“Affected Shares”    means those shares which the Telecom Board has specified in a notice to a holder as being held in excess of the shareholding limits established by the Constitution.
“AMPS”    means Advanced Mobile Phone Service, which is a technology for analogue mobile telephony system.
“ATM”    means Asynchronous Transmission Mode, which is a data transport technology suite that uses fixed length cells to transfer the data.
“ATS”    means Alarm Transport Service.
“BPON”    means Broadband Passive Optical Network, which is a fibre to the home technology.
“CDMA”    means Code Division Multiple Access which is a technology used in digital mobile networks.
“Computerland”    means the ICT business (Ceritas New Zealand Limited) acquired by Telecom New Zealand Limited in 2004.
“CRM”    means Customer Relationship Management systems.
“D-AMPS”    means Digital AMPS, which is a technology for digital transmission of radio signals between, for example, a mobile telephone and a radio base station.
“DDN”    means Digital Data Network.

 

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“DDS”    means Digital Data Services, which are services providing a private data transmission line for businesses. It provides a dedicated secure link for transmission of data between locations and is customised to suit individual business needs
“Depositary”    means The Bank of New York.
“DSL”    means Digital Subscriber Line, which is a family of communications technologies allowing high-speed data over existing copper-based telephony plant in the local loop.
“DSLAM”    means Digital Subscriber Line Access Multiplexers, which is network-based equipment used to deliver DSL services to customers.
“DWDM”    means Dense Wave Division Multiplexing, which is an industry term used for a data transport technology that uses multiple different wave-lengths densely grouped together on a single optical fibre.
“Economic Value Added”    means the valuation methodology which is used to determine Telecom Group performance in respect of the cash-based incentive schemes.
“EV-DO”    means Evolution Data Optimised, which is a 3G mobile technology that provides a packet data link with a maximum theoretical data speed of 2.4 Mbit/s, with speeds typically averaging 500kbit/s in practice.
“EV-DO Rev A”    means CDMA Evolution - Data Optimised Revision A. EV-DO Rev A is an enhancement of EV-DO Rel. 0, which is a mobile network technology to provide high speed packet data links..
“GPRS”    means General Packet Radio Service, which is a packet data service that allows information to be sent and received across a mobile telephone network.
“GSM”    means Global Service for Mobile Communications, which is a technology used in digital mobile networks.
“HSDPA”    means High Speed Downlink Packet Access, which is a mobile network technology to provide high speed packet data links in the downlink direction from the network to the customer’s terminal.
“ICMS”    means Integrated Customer Management System, which is Telecom’s primary customer database for both fixed line and mobile customers.
“ICT”    means Information and Communication Technologies.
“IP”    means Internet Protocol, which is a communications protocol suite used for carrying data on the internet.
“IP-VPN”    means Internet Protocol-Virtual Private Network, which is an industry term for an IP-based VPN.
“IS”    means Information Systems.
“ISDN”    means the Integrated Services Digital Network, which is a switched digital transmission network that can carry a range of digitised voice,

 

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   data and images. Basic Rate Access offers 128 Kbit/s capacity on two channels and Primary Rate Access offers 2 Mbit/s capacity on 30 channels.
“ISP”    means Internet Service Provider.
“IT”    means Information Technology, which is a generic term for any technology relating to information processing or transport.
“Kiwi Share”    means the one preference share held by the New Zealand Government in Telecom.
“Kiwi Shareholder”    means the Minister of Finance who holds the Kiwi Share on behalf of the New Zealand Government.
“LMDS”    means Local Multipoint Distribution System, which is a broadband wireless technology to provide voice and data services.
“LLU”    means Local Loop Unbundling.
“MMDS”    means Multichannel Multipoint Distribution Service, which is a broadband wireless point to multipoint specification.
“MPLS”    means Multi-Protocol Label Switching, which is an industry term for a data communications technique where labels are used to switch data packets across a network.
“MTAS”    means Mobile Terminating Access Service.
“NGN”    means Telecom’s Trans-Tasman IP-based multi-service Next Generation Network, which is a name given to a converged, voice, video and data, all IP network.
“NGT”    means Telecom’s Next Generation Telecom business model.
“NZX”    means the New Zealand Exchange.
“NZSX”    means the New Zealand Stock Market.
“PABX”    means a Private Automatic Branch Exchange, which is an automatic telephone switching system within a private enterprise.
“Pacnet”    means Packet Switch Network.
“PDH”    means Plesio-Synchronous Digital Hierarchy, which is a technology used to transfer data over digital transport networks.
“PDN”    means Public Data Network.
“PoI”    means Points of Interconnection.
“PoPs”    means Points of Presence.
“PSTN”    means the Public Switched Telephone Network, which is a nationwide dial-up telephone network used, or intended for use, in whole or in part, by the public for the purposes of providing telecommunication between telephone devices.
“PSTN OTA”    means the Public Switched Telephone Network Originating and Terminating Access Services.

 

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“SDH”    means Synchronous Digital Hierarchy, which is an industry term for a synchronous data transport network.
“SHDSL”    means Symmetric Hierarchy Digital Subscriber Line, which is a synchronous variant of DSL.
“Southern Cross”    means Southern Cross Cables Group which consists of two sister companies Southern Cross Cables Holdings Limited and Pacific Carriage Holdings Limited.
“Southern Cross Network”    means Southern Cross Cables Network.
“Targeted Access Services”    means access services to be specified and delivered according to Telecom’s planned operational separation undertakings, including (but subject to change as a result of negotiations with the New Zealand Government):
  

•      UBS services (including naked DSL) and related backhaul, as proposed to be extended by the Telecommunications Bill;

  

•      LLU and associated co-location and backhaul; and

  

•      other DSL services that fall within the relevant designations in the Telecommunications Bill.

“TDMA”    means Time Division Multiple Access Network, which is the radio spectrum sharing technique on which Telecom’s D-AMPS mobile phone network is based.
“TSLRIC”    means the Total Service Long Run Incremental Cost methodology for determining the cost of a service.
“TSO”    means the Telecommunications Service Obligation recorded in the Telecommunications Service Obligation Deed for Local Residential Telephone Service between the Crown and Telecom New Zealand Limited, dated December 2001.
“TTS”    means Telecom Transaction Service.
“UBS”    means Unbundled Bitstream Service.
“UMTS”    means Universal Mobile Telecommunications System.
“VoIP”    means Voice over Internet Protocol, which is a term used in IP telephony for managing the delivery of voice information using the IP.
“VPN”    means Virtual Private Network which is a carrier provided service in which the public network provides the equivalent of a privately established customer network.
“WAN”    means Wide Area Network, which is a geographically dispersed telecommunications network.
“WAP”    means Wireless Application Protocol, a communications protocol and application environment used in wireless networks.

 

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“W-CDMA”    means Wideband CDMA, which is an ITU recognised 3G mobile telephony technology using 5MHz channels to deliver voice and peak data rates from 64 to 384 kbps.
“WiFi”    means Wireless Fidelity, which is wireless networking technology providing wireless connectivity to the internet.
“WiMax”    means World Interoperability for Microwave Access, which is a wireless technology standard.
“1XRTT”    means 1X Radio Transmission Technology, which is a CDMA-based standard used by Telecom’s CDMA mobile network.
“3G”    means third generation mobile network as defined by the International Telecommunication Union.

 

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FORWARD-LOOKING STATEMENTS

This Report contains forward-looking statements within the meaning of Section 27A of the United States Securities Act of 1933 and Section 21E of the United States Securities Exchange Act of 1934. Such forward-looking statements are based on the beliefs of Telecom’s management, as well as on assumptions made by, and information currently available to, Telecom at the time such statements were made.

These statements include statements of Telecom’s present expectations, beliefs, future plans and strategies, anticipated developments and other matters that are not historical facts.

For example:

 

  anticipated capital expenditure for the 2007 financial year of approximately NZ$800 million;

 

  Telecom’s expectations regarding revenue mix, operating costs, margins and depreciation and interest expense;

 

  Telecom’s expectation that net debt will remain relatively stable in the 2007 financial year and that interest expense for the 2007 financial year will be at or above the level of interest expense in the 2006 financial year;

 

  Telecom’s market growth expectations for the communications, IT Services, information and entertainment sectors;

 

  Telecom’s expectations for the impact of proposed regulation in New Zealand on Telecom’s future financial performance;

 

  Telecom’s expectation that the finalisation of proposed regulation in New Zealand will take the majority of the 2007 financial year;

 

  Telecom’s expectation that the majority of customers will be on NGT offers that are provided over the NGN by December 2015;

 

  The anticipated closure of the TDMA network in March 2007;

 

  Telecom’s target of achieving 500,000 retail broadband customers by 30 June 2007;

 

  Telecom’s cash flow from operations and available borrowings are sufficient to fund Telecom’s expected capital expenditure, working capital and investment requirements;

 

  Telecom’s expectation that Southern Cross will partially repay its shareholder advances in the 2007 financial year;

 

  for the year ended 30 June 2007, Telecom expects a pay-out ratio of approximately 75% of net earnings (after adding back relevant non-cash items).

When used in this Report, the words “anticipate”, “believe”, “estimate”, “expect”, “intend”, “will”, “plan” and similar expressions, as they relate to Telecom, are intended to identify forward-looking statements.

Such forward-looking statements are not guarantees of future performance. Actual results, performance or achievements could differ materially from those projected in, or implied by, the forward-looking statements as a result of various assumptions, risks and uncertainties. In addition to the risks described under “Item 3 - Risk Factors”, other factors could cause actual results to differ materially from those described in the forward-looking statements. These factors include, but are not limited to:

 

  Telecom’s ability to successfully implement its business strategy;

 

  vigorous competition in the markets in which Telecom operates and the possible entrance of new competitors to these markets particularly in the New Zealand market for mobile phone services;

 

  increasingly extensive industry specific regulation;

 

  finalisation of the New Zealand Government’s proposed regulatory package for the telecommunications industry;

 

  rapid technological changes and convergence of telecommunications, information services and media markets and technologies;

 

  uncertainties regarding operating new systems and technologies;

 

  uncertainties about the degree of growth in the number of consumers in the markets in which Telecom operates;

 

  decreasing revenues from traditional services owing to mobile and other substitution;

 

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  network or system interruptions owing to natural hazard disasters and other events such as fire, terrorism or sabotage affecting key facilities, software faults, viruses and power supply loss or overloading;

 

  dependence on key third party suppliers for delivery of important services;

 

  uncertainties around acquisitions and investments;

 

  uncertainties around economic conditions within the countries in which Telecom operates;

 

  other factors or trends affecting the telecommunications industry generally and Telecom’s financial condition in particular.

Given the risks, uncertainties and other factors, undue reliance should not be placed on any forward-looking statement, which speaks only as of the date made. Telecom does not undertake any obligation to review or confirm analysts’ expectations or estimates or to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events. Further, the information contained in this document is a statement of Telecom’s intention as of the date of this filing and is based upon, among other things, the existing regulatory environment, industry conditions, market conditions and prices, the economy in general and Telecom management’s assumptions. Telecom’s management may change its intentions at any time and without notice based upon any changes in such factors, assumptions or otherwise.

 

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PART I

Item 1. Identity of Directors, Senior Management and Advisors

Not applicable.

Item 2. Offer Statistics and Expected Timetable

Not applicable.

 

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Item 3. Key Information

SELECTED FINANCIAL DATA

Telecom’s financial statements for the year ended 30 June 2006 have been prepared in accordance with New Zealand equivalents to International Financial Reporting Standards (“NZ IFRS”), which Telecom adopted on 1 July 2005. In complying with NZ IFRS, Telecom is also in compliance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board.

Prior to 1 July 2005, Telecom prepared its financial statements in accordance with New Zealand Generally Accepted Accounting Practice (“NZ GAAP”). The comparative financial statements for the year ended 30 June 2005 have been restated in accordance with NZ IFRS. Financial statements for years prior to this have not been restated. As allowed by the US Securities and Exchange Commission (“SEC”) rules in relation to first time adoption of IFRS, only one year of comparative financial statements are presented in this annual report on Form 20-F. The accounting policies set out in Note 1 have been applied consistently to the 2005 and 2006 financial years, with the exception of those policies relating to financial instruments under NZ IAS 32 “Financial Instruments: Disclosure and Presentation” and NZ IAS 39 “Financial Instruments: Recognition and Measurement”, which have been applied from 1 July 2005.

The selected consolidated financial data in accordance with NZ IFRS below has been derived from Telecom’s consolidated financial statements for the years ended 30 June 2006 and 2005, which have been audited by KPMG, an independent registered public accounting firm. The selected consolidated financial data in accordance with United States Generally Accepted Accounting Practice (“US GAAP”) has been derived from the notes to Telecom’s consolidated financial statements for each of the reporting periods in the five year period ended 30 June 2006, which have been audited by KPMG for the years ended 30 June 2006, 2005, 2004 and 2003 and PricewaterhouseCoopers (also an independent registered public accounting firm) for the year ended 30 June 2002. The data should be read in conjunction with, and is qualified in its entirety by reference to, the consolidated financial statements and notes. The consolidated financial statements as of 30 June 2006 and 2005, and the auditor’s report thereon, are included elsewhere in this report, see F1 – F66.

 

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     Year ended 30 June
    

2006

NZ$

   

2005

NZ$

    

(Dollars in millions,

except per share and

per ADS amounts)

Amounts in accordance with NZ IFRS:

    

Income Statement Data

    

Operating revenues and other gains

    

Local service

     1,081       1,101

Calling

     1,393       1,443

Interconnection

     204       206

Mobile

     869       835

Data

     602       602

Broadband and internet

     448       376

IT services

     346       308

Other operating revenues

     812       779

Other gains (a)

     60       154

Total Operating Revenues and other gains

     5,815       5,804

Operating expenses

    

Labour

     796       738

Intercarrier costs

     1,199       1,185

Other operating expenses

     1,563       1,479

Asset Impairments (b)

     1,301       24

Other expenses (c)

     34       35

Total Operating Expenses

     4,893       3,461

Depreciation and amortisation

     705       698

Net interest expense and other financing costs

     254       289

Income tax expense

     394       386

(Loss)/earnings after income tax

     (431 )     970

Minority interests in earnings of subsidiaries

     4       3

Net (loss)/earnings attributable to shareholders

     (435 )     967

Net (loss)/earnings per share - basic (d)

   NZ$ (0.22 )   NZ$ 0.50

Net (loss)/earnings per share - diluted (d)

   NZ$ (0.22 )   NZ$ 0.49

Net (loss)/earnings per ADS (d)

   NZ$ (1.78 )   NZ$ 3.97

Net (loss)/earnings per ADS - diluted (d)

   NZ$ (1.78 )   NZ$ 3.92

Balance Sheet Data

    

Property, plant and equipment

     3,301       3,602

Total assets

     6,203       7,504

Debt due within one year

     955       863

Long-term debt

     2,543       2,973

Total liabilities

     5,141       5,033

Total equity

     1,062       2,471

Contributed capital

     2,011       1,991

 

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     Year ended 30 June  
     2006
NZ$
   

2005

NZ$

    2004
NZ$
    2003
NZ$
   2002
NZ$
 
     (Dollars in millions, except per share and per ADS amounts)  

Amounts in accordance with US GAAP (e):

           

Income Statement Data

           

Asset impairments

   (1,419 )   (24 )   (133 )   —      (81 )

Gain on deconsolidation of Southern Cross

   526     —       —       —      —    

Net (loss)/earnings before change in accounting principle

   (61 )   978     806     758    (238 )

Cumulative effect of change in accounting principle (h)

   —       —       (511 )   —      —    

Net (loss)/earnings after change in accounting principle

   (61 )   978     295     758    (238 )

Basic (loss)/earnings per share before change in accounting principle (d)

   (0.03 )   0.50     0.42     0.40    (0.13 )

Basic (loss)/earnings per ADS before change in accounting principle (d)

   (0.24 )   4.02     3.35     3.22    (1.02 )

Basic (loss)/earnings per share after change in accounting principle (d)

   (0.03 )   0.50     0.15     0.40    (0.13 )

Basic (loss)/earnings per ADS after change in accounting principle (d)

   (0.24 )   4.02     1.22     3.22    (1.02 )

Weighted average number of ordinary shares outstanding, basic (in millions)

   1,960     1,948     1,922     1,887    1,863  

Weighted average number of ordinary shares outstanding, diluted (in millions)

   1,960     2,027     1,962     2,073    1,864  

Diluted (loss)/earnings per share after change in accounting principle

   (0.03 )   0.49     0.15     0.39    (0.13 )

Diluted (loss)/earnings per ADS after change in accounting principle (d)

   (0.24 )   3.92     1.22     3.11    (1.02 )

Balance Sheet Data:

           

Property, plant and equipment

   3,293     5,312     5,609     4,647    4,843  

Total assets

   6,114     8,702     9,176     7,778    8,147  

Total shareholders’ equity

   951     1,922     1,652     1,665    1,037  

 

     Year ended 30 June
     2006    2005    2004    2003    2002

Dividends relating to the period (accrual basis)

              

Dividends per share (f)

   NZ$ 0.455    NZ$ 0.485    NZ$ 0.270    NZ$ 0.200    NZ$ 0.200

Dividends per ADS (g)

   US$ 2.343    US$ 2.718    US$ 1.397    US$ 0.895    US$ 0.729

Dividends paid in the period (cash basis)

              

Dividends per share (f)

   NZ$ 0.535    NZ$ 0.380    NZ$ 0.225    NZ$ 0.200    NZ$ 0.200

Dividends per ADS (g)

   US$ 2.854    US$ 2.129    US$ 1.132    US$ 0.847    US$ 0.702

 

(a) In 2006, the other gain of NZ$60 million represents a gain in connection with the acquisition of a 100% shareholding in Southern Cross Cables (NZ) Limited pertaining to an acquired deferred tax benefit.

 

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In 2005, other gains of NZ$154 million are comprised of a gain of NZ$86 million on the sale of Telecom’s shares in Independent Newspapers Limited, a gain of NZ$8 million on the sale of Telecom’s stake in Intelsat, a gain of NZ$10 million on the sale of 15 Telecom retail stores to Leading Edge Group, a gain of NZ$9 million on the repurchase of NZ$300 million of convertible notes and an accrual of NZ$41 million of previously unrecognised credit support fees due from Telecom’s associate entity the Southern Cross Cables Group.

 

(b) In 2006, the impairment of NZ$1,301 million represented write-downs of Telecom’s Australian operations resulting from significant negative trends impacting these operations, principally relating to pricing arrangements with wholesale suppliers, pressure on retail prices and the deferral of project spending by major corporate customers.

In 2005, the impairment consisted of a write-down of Telecom’s TDMA network of NZ$24 million.

 

(c) Other expenses in 2006 consisted of a charge of NZ$22 million to provide for the cost of a NZ$17.5 million settlement with a competitor of a number of longstanding issues relating to the backdating of pricing for interconnection and wholesale arrangements and to adjust the TSO receivable by approximately NZ$5 million to reflect a Commerce Commission determination, and a charge of NZ$12 million to provide for contractual settlements and Fair Trading Act issues.

Other expenses in 2005 consisted of an adjustment to inter-carrier provisions of NZ$31 million and restructuring costs of NZ$4 million.

 

(d) Per share amounts have been calculated as net (loss)/earnings divided by the weighted average number of shares outstanding during the periods indicated. Per ADS amounts have been calculated based on a ratio of eight shares per ADS. Diluted earnings per share and per ADS amounts reflect the dilutive effects of options and capital securities.

 

(e) The principal differences between NZ IFRS and US GAAP that impact Telecom’s results and financial position are set out in Note 37.

 

(f) Dividends per share are presented both on the basis of the year to which they relate and on the basis of the year in which they were paid. Dividends per share exclude supplementary dividends payable to overseas shareholders.

 

(g) Dividends per ADS are calculated on a ratio of eight ordinary shares to one ADS. Dividends per ADS are stated in US dollars based on the exchange rates prevailing on the dates dividends were paid to shareholders.

 

(h) Under US GAAP Telecom was required to consolidate the Southern Cross Cables Group of companies’ balance sheet at 30 June 2004 as a result of the first time application of FASB Interpretation Number (“FIN”) 46R. This resulted in the recognition of a cumulative adjustment for a change in accounting principle of NZ$511 million in its reconciliation to US GAAP for the year ended 30 June 2004. Refer to Note 37 for further details.

 

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EXCHANGE RATES

Below is certain information concerning exchange rates between NZ dollars and US dollars (expressed in US dollars per NZ$1.00) based on the noon buying rate in New York City for cable transfers in NZ dollars as reported by the Federal Reserve Bank of New York (“Exchange Rate”).

On 6 September 2006 the Exchange Rate was 0.6485.

The high and low Exchange Rates for each month during the previous six months were as follows:

 

Month

   High    Low

March 2006

   0.6588    0.6035

April 2006

   0.6368    0.6084

May 2006

   0.6427    0.6182

June 2006

   0.6337    0.5958

July 2006

   0.6259    0.6045

August 2006

   0.6545    0.6188

The average Exchange Rates for the financial periods specified below were as follows:

 

Fiscal Year ended 30 June

   Average 1

2002

   0.4326

2003

   0.5252

2004

   0.6304

2005

   0.6980

2006

   0.6673

 

1 Determined by averaging the Exchange Rates on the last day of each month during the fiscal year.

 

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RISK FACTORS

Telecom is subject to increasingly extensive regulation and faces significant regulatory uncertainty which may impose limits on Telecom’s flexibility to manage its business and force it to offer services to competitors as well as reduce the prices it charges for its products and services. This may negatively affect its business and profitability by limiting the returns that can be generated on Telecom’s assets

Telecom operates in an increasingly regulated environment. There is telecommunications-specific regulatory legislation and generic competition legislation in both New Zealand and Australia (see “Item 4 – Market Overview—New Zealand Regulation / Australia Regulation” below).

Amendments to the New Zealand Telecommunications Act 2001 (the “Telecommunications Act”), currently in the form of the Telecommunications Amendment Bill 2006 (the “Telecommunications Bill”), are pending following the Government’s 2006 ‘stock take’ of the New Zealand telecommunications environment. While not yet in force, the scope and nature of the proposed regulatory legislative change signal the New Zealand Government’s intention to intensify competition through regulatory intervention.

Proposed changes in the Telecommunications Bill are likely to provide Telecom’s competitors with enhanced access to Telecom’s fixed network, which could have a significant and adverse effect on Telecom’s market share, competitive position and future profitability

Telecom will be required to offer unbundled access to its local loop in the form of full access on a cost basis. Unbundling of the local loop (“LLU”), in the form of full access will allow competitors to offer access services to customers without having to build local loops of their own. LLU is expected to increase competition in urban, major provincial and related suburban areas. The Telecommunications Bill provides for the proposed initial access price for LLU to be benchmarked against prices for similar services in comparable countries that use a forward-looking cost-based pricing methodology. This determination process will give broad discretion to the regulator. Uncertainty also exists around the benchmark position the regulator will adopt when determining the cost-based access price. Should the regulator select a low benchmark price this would result in lower access prices which could erode Telecom’s market share, decrease Telecom’s margins and decrease its revenues and cash flows.

The Telecommunications Bill if passed into legislation in its current form would also require Telecom to offer its wholesale customers ‘naked’ digital subscriber lines (a DSL connection without an accompanying fixed line service). Availability of naked DSL is likely to increase substitution of fixed voice access services with mobile services and VoIP services. A further uncertainty is the precise retail-minus calculation the regulator elects to use. Accordingly, these risks could have a significant and adverse effect on revenues, operating results and profitability of Telecom’s business.

Proposed changes to the Telecommunications Act may greatly increase the Commerce Commission’s information seeking powers, substantially change its role and increase its enforcement powers. Telecom expects these changes could result in increased regulatory scrutiny of its business and increased compliance costs

 

  Increased information seeking powers

The Telecommunications Bill seeks to grant the Commerce Commission significantly increased information seeking powers. Information which the Commerce Commission may request access to includes information relating to Telecom’s financial statements and records, contracts, plans and forecasts, network capacity, policies and methodologies. Access to such information about Telecom’s operations could result in further regulatory interventions in future including areas of Telecom’s business not previously subject to regulation which is likely to lead to increased compliance costs for Telecom.

 

  Changed role of the Commerce Commission

The Telecommunications Bill seeks to change the Commerce Commission’s role from one of a reactive enforcement body to a mandatory role monitoring competition and overall

 

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performance of telecommunications markets and to make information about these issues publicly available. The Commerce Commission may also be granted the ability to initiate sector reviews. This is likely to have the effect of increasing both the scope and extent of further regulatory activity.

 

  Increased enforcement powers

The Telecommunications Bill proposes introduction of a punitive regime consisting of enforcement and penalty provisions for which Telecom may be fined up to $300,000 once for each breach of these provisions. In addition, Telecom may incur a fine of up to $1 million once for each breach of the accounting separation information provisions. There are also further penalties that may be imposed for continuing breach ($50,000 a day for breach of accounting separation provisions and $10,000 for any other case). Under this regime, Telecom’s compliance costs are likely to increase.

The New Zealand Government may introduce further regulation beyond the scope of the amendments currently contained in the Telecommunications Bill. This may impose further limits on Telecom’s flexibility to manage its business, force it to offer additional services to competitors as well as reduce the prices it charges for its products and services. This may negatively affect its business and profitability by limiting the returns and margins that can be generated on Telecom’s assets

Potential for further regulation exists in the following areas:

 

  Separation of Telecom’s businesses

The Government has sought submissions on separating Telecom’s wholesale and retail business although no such provisions have been included at present in the Telecommunications Bill. The Government has asked Parliament’s Select Committee to seek submissions on this issue and to make a recommendation on whether to separate Telecom’s network wholesale and retail operations and if so, what form that separation should take. The options considered include the option of structurally separating Telecom (this would require Telecom’s wholesale and retail businesses to have separate ownership).

In view of the potential for structural separation, Telecom has proposed a form of operational separation. However, the form of separation the Government prescribes may be more onerous than the form Telecom has proposed and result in significantly increased costs and administrative overheads for Telecom. Alternatively, structural separation of Telecom’s network, wholesale and retail businesses into separate companies with separate ownership could be mandated. Neither the form of the separation model nor its timing is known. Therefore, the outcome of this issue is unknown. Either stronger operational separation to that proposed by Telecom or structural separation would result in significantly increased costs and reduction in the overall profitability of Telecom’s operations.

 

  Mobile regulation

The Government may determine that further regulation of the mobile market is required to increase the opportunities for competition. Future regulation may cover pricing, termination and roaming and may lower the threshold a new operator needs to achieve national roaming status and/or that required for existing operators to make their network infrastructure available. This may have the effect of attracting additional mobile providers to the New Zealand market. Telecom’s mobile profitability may decline as a result.

 

  Access to spectrum

The Government has signalled its intentions to consider a regulatory reallocation of spectrum rights and to introduce tighter controls for the administration of spectrum allocation and usage. In future, this may affect Telecom’s security of tenure of the spectrum ranges it needs to operate its current and future wireless business. This may have the effect of increasing Telecom’s wireless operating costs and reducing the profitability of that

 

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line of business. Further, if Telecom does not secure continued access to the spectrum, this will pose a threat to the viability of Telecom’s overall business.

 

  Migration to cost plus pricing regime

Currently, retail-minus pricing applies to all resale services, UBS, unbundled private circuits and is proposed to be applied to naked DSL. Following legislative change, the Government is proposing a policy review of the retail-minus regime. There is some risk that this could result in migration to a cost-based pricing regime for all regulated services. Migration from a retail-minus wholesale pricing construct to a cost plus construct would exacerbate price competition in retail markets and would contribute to declines in Telecom’s profitability.

 

  Loss of ability to offer geographic pricing

Future regulation may remove Telecom’s ability to geographically differentiate its pricing in response to competitors’ offerings provided from their own network. This may reduce Telecom’s ability to compete causing a decline in its market share, revenues and profitability.

 

  Telecommunications Service Obligation (“TSO”) review

As part of the Government broadband stock take announcements in May 2006, the Government announced that it intends to review the TSO. It is unclear at this stage what changes the Government is seeking to the TSO. Although changes to the TSO must currently be agreed by negotiation, there remains a risk that the Government may choose to legislate to effect change.

Telecom may be unable to successfully introduce its Next Generation Telecom (“NGT”) business model which could result in the benefits Telecom anticipates from the transformation to its new business model not being realised which would adversely affect Telecom’s expected future consolidated financial position and results of operations

Telecom believes that in order to improve its financial results and offset the impact of margin declines in its traditional communications business it needs to fundamentally redesign its business model, including the way it organises itself, the products and services that it offers to its customers, the way that these products and services are delivered and the infrastructure used to provide products and services. Telecom is in the process of developing its NGT business model, which it plans to implement over the period 2006 to 2015. The NGT is Telecom’s principal means of reducing costs and addressing the decline in earnings expected for its legacy lines of business over the medium term (to 2015). If Telecom fails to implement its NGT, fails to integrate it completely, or if the development of future product offers fails to meet customer expectations, then the benefits Telecom anticipates from the transformation to its new business model may not be realised. This would adversely affect Telecom’s future consolidated financial position and financial results from its operations.

Telecom faces a number of risks to the delivery of the expected cost savings and other benefits expected for NGT. These include:

 

  Implementation of the NGT is a large and complex programme of work spanning the next nine years (the majority of Telecom customers are expected to be on NGT offers by December 2015). The complexity, uncertainty over the availability of resources and the scale of transformation involved may make assumptions about the cost required to effect the transformation incorrect. Should this be the case Telecom may need to spend more to complete its transformation than budgeted or may not realise the anticipated costs savings which would reduce its profitability.

 

 

There is a risk that regulation may require Telecom to divert resources from the NGT programme, for example, to achieve a more onerous form of operational separation than that proposed voluntarily by Telecom by separating out its legacy systems, or structural separation. This would lead to significant cost for Telecom and divert both capital and

 

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human resource from building of the Next Generation Network (“NGN”) and the implementation of services over that network.

 

  Execution of the NGN component of the NGT is required to mitigate end of life risk associated with Telecom’s ageing legacy service platforms. In the event of delay to the projected delivery schedule for the NGT, the performance and availability of Telecom’s legacy services may deteriorate reducing the reliability of services provided from Telecom’s legacy networks, increasing Telecom’s costs and encouraging customer churn to alternative suppliers.

 

  In the event of delay to the projected delivery schedule for NGT, Telecom may need to maintain two networks, the old PSTN and the new NGN. In this event Telecom may incur significant additional operating costs and may also expose itself to the risk of customer churn.

 

  Long lead times for building of the network platform may require technology choice decisions to be made and platform implementation to commence in advance of the development of clear and final business requirements. This could place at risk Telecom’s ability to achieve the required competitive capability and impair or prevent realisation of the benefits anticipated for the introduction of its NGT.

 

  NGN technology configuration is expected to be simpler than the legacy infrastructure it replaces and will therefore have a different risk profile to Telecom’s legacy network. This may present new risks of a ‘single point of failure’ nature. Interruption to the continuity of services resulting from single point of failure risk materialising may affect larger numbers of Telecom’s customers than at present and could result in loss of calling service or other Telecom operations such as provisioning or billing.

 

  Telecom’s outsourced centralised operations’ partners (for example, Alcatel, NEC, EDS & Lucent), including associated third party suppliers, may be unable to meet the resource requirements necessary to manage both NGT technology and legacy network platforms moving forward. This may reduce the reliability of Telecom’s legacy network and/or delay the implementation of the NGN component of its NGT.

 

  The NGT requires significant change at an organisational and customer level. If Telecom’s management, processes or employees are not able to adapt to these changes or if Telecom’s customers do not accept its simplified and reduced product offerings, Telecom’s business and financial results could be materially and negatively affected.

Telecom faces vigorous competition in its markets and new entrants into its markets may intensify this competition, which could cause Telecom to continue to lose market share, reduce prices and decrease its profitability

Telecom’s competitors include Vodafone Group Inc. and its subsidiary, Vodafone New Zealand Limited (“Vodafone”), Telstra Corporation Limited (“Telstra”) and its subsidiary, TelstraClear Limited and, SingTel Optus Pty Limited, a subsidiary of SingTel Corporation. Proposed regulatory amendments are expected to intensify competition in all of Telecom’s markets by enabling existing Telecom competitors to compete more vigorously on price and on a service differentiation basis. The changed regulatory environment may also attract the entry of new competitors further increasing competition in Telecom’s domestic markets.

Potential for increased competition exists in the following areas:

 

  New Zealand Fixed Line

The changes the Government is currently proposing under the Telecommunications Bill will have the effect of facilitating increased levels of competition in Telecom’s consumer and business fixed market segments. The requirement to provide competitor’s with access to Telecom’s unbundled local loop and the naked DSL services will enable competitors to develop their own products and services in competition with Telecom, potentially in advance of Telecom’s ability to offer equivalent services. This may cause Telecom to lose market share, reduce prices and decrease its profitability.

 

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  New Zealand Mobile

Telecom’s customer share of the mobile market is currently 45%. Competition in the mobile market is likely to intensify due to a combination of factors such as:

 

    regulatory changes enabling additional operators to enter the market;

 

    the announced intention of TelstraClear to invest $50 million in a wireless network based in a major provincial centre in New Zealand;

 

    declining global market share for CDMA and resulting reduced handset availability and roaming options;

 

    the likely launch by Vodafone and TelstraClear of local calling on a mobile platform;

 

    the continuing trend towards fixed to mobile substitution (where Telecom’s fixed customers migrate all or part of their business to a competitor’s mobile service);

 

    introduction of fixed price (or capped-rate) data plans.

Combined, these factors may cause both reduced market share and profitability.

 

  New Zealand Broadband

The pace and scope of change in competition in Telecom’s broadband market could accelerate as regulatory changes grant competitors access to unconstrained UBS and naked DSL services at lower prices. While growing the overall size of the market, this may have the effect of decreasing Telecom’s share of the broadband market, reducing prices and having a negative effect on Telecom’s profitability. Vodafone, recently announced its intention to introduce a 3G mobile broadband service. It is expected the service will be available to customers by 1 October 2006. Residential and CBD coverage will be available throughout Auckland, Wellington and Christchurch, while coverage in the rest of the major towns in New Zealand will be available in the next few months. Vodafone may be able to churn existing Telecom fixed line broadband customers to its new service and compete with Telecom for acquisition of growth in the emerging broadband market. This may have the effect of decreasing Telecom’s share of the broadband market, reducing prices and having a negative effect on Telecom’s profitability. This new service, combined with Vodafone’s competition in the local access and calling markets, may allow Telecom’s customers to completely sever their relationship with Telecom, which would put at risk all of Telecom’s revenue from every customer acquired by Vodafone.

Should Telecom be required to replace the technical platform used to provide its mobile services, it may result in CDMA asset write-downs and require significant additional capital expenditure which could have a negative effect on Telecom’s profitability

The longer term sustainability of Telecom’s investment in its mobile CDMA network may be jeopardised by recent developments such as Telstra’s decision to turn off its CDMA network (currently announced as occurring in January 2008), Nokia’s announcement that they will reduce their research and development and manufacturing of CDMA devices; and Telecom’s continued dependency on its relationship with Sprint Nextel Corporation (“Sprint”) to deliver competitive handsets and data cards. If WorldMode services (CDMA and GSM) are not available as expected in early 2007, Telstra’s decision to turn off its CDMA network would remove Telecom’s New Zealand customers’ access to roaming capability in Australia and require new mobile roaming options to be provided, which are not currently available. In the event Telecom’s CDMA network may no longer be viable in the future as its mobile platform, Telecom may require significant additional capital to build new infrastructure or otherwise become less competitive in the mobile market than at present, which in turn could have a negative effect on Telecom’s profitability.

Rapid technological changes and convergence may impair the return or benefits Telecom expects from its capital investments, which in turn could adversely affect Telecom’s business, leading to accelerated write-downs of Telecom assets

Telecom’s business is capital intensive and significant investment in technology and other assets is required before new services can be released to the market. In the 2006 and 2005 financial years

 

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Telecom invested NZ$751 million and NZ$703 million, respectively, in capital expenditure principally on telecommunications and network equipment.

Telecom expects to incur substantial capital expenditure to continue implementation of its NGN to replace its legacy PSTN service platforms, develop operational support systems to complement its NGN, further develop 3G mobile technology and to continue to grow broadband and mobile market share. Consumer demand for, or acceptance of, new services utilising the NGN may be less than anticipated. As a result, increased revenue targets may not be achieved and, longer term, Telecom may incur asset impairment write-downs.

In addition, the technology choice and/or market size assumptions behind these investments may not prove to be valid, or other technologies with lower operating costs or more compelling service propositions may become available to competitors. Telecom could also make technology decisions which carry a risk that resulting services may not be competitive in the market or may substitute for one another.

The structure of the telecommunications industry is changing as a result of convergence of telecommunications, information services and media markets and technologies, which may affect Telecom’s assumptions on the profitability of its markets. Additionally, some recent alternative technologies such as VoIP and WiMax are becoming commercialised. Telecom may be unable to achieve a sustainable competitive advantage in these high growth areas. These factors could result in Telecom having to reduce the prices of its products and services in order to remain competitive. Price reductions could lead to unsatisfactory returns on Telecom’s assets and accelerated write-downs of their value, together with significant expenditures in addition to those already planned in order to remain competitive. These factors may also lead to Telecom being required to invest in new technologies earlier than originally planned.

Telecom is dependent upon its competitors’ networks in Australia

In Australia, AAPT Limited makes extensive use of Telstra’s network access services, including the PSTN, interconnection, local carriage services, unconditioned local loop, and access services. A recent change in Telstra’s attitude favouring its retail operations in preference to its wholesale operations has resulted in the loss of discounts AAPT has previously been able to secure from Telstra for purchase of fixed line services for resale. If AAPT is unable to negotiate satisfactory wholesale discounts from Telstra, AAPT’s profitability and financial performance could continue to be adversely affected.

AAPT may be unable to successfully introduce its new business model. This may prevent AAPT from achieving sustainable profitable operations which in turn may lead to further write-downs and have a negative effect on Telecom’s profitability

Telecom’s Australian operations have a history of write-downs and losses. A write-down of NZ$1,301 million was included in the financial results for the year ended 30 June 2006 with respect to Telecom’s acquisition of AAPT completed in 2001. This followed a previous substantial write-down of AAPT in the year ended 30 June 2002. Following these write-downs, Telecom’s Australian operations had a carrying value of A$270 million at 30 June 2006 and Telecom expects to invest a further NZ$145 million in capital expenditure in its Australian operations. To improve its underlying performance AAPT is replacing its core business applications, such as billing and provisioning, to support a new business strategy focused on delivery of services to the consumer and small enterprise market and to position itself more effectively as a service provider. Should AAPT be unable to effectively manage the execution of this implementation and deliver the systems required, Telecom may not realise an expected return on the capital invested, AAPT’s operating performance may fail to improve and achievement of profitable operations may be delayed or prevented. This may lead to further write-downs of the value of AAPT, a failure to realise value from future investment and impairment of Telecom’s financial performance and results of operations.

 

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Telecom is exposed to decreasing revenues from the fixed line network as a result of customers using mobile and internet services in place of fixed line services which could adversely affect Telecom’s profitability

Telecom’s fixed calling revenues declined from NZ$1,443 million for the year ended 30 June 2005 to NZ$1,393 million for the year ended 30 June 2006 due to a continuing trend of fixed to mobile and internet calling substitution. This trend is expected to continue. In addition, proposed regulatory change enabling Vodafone to offer a local calling service in New Zealand may lead to further declines in fixed line prices and revenues.

If these trends accelerate, impairment write-downs may be incurred in respect of Telecom’s fixed network assets, and revenue derived from the fixed network may continue to decline, which in turn could adversely affect Telecom’s consolidated financial position and results of operations.

Telecom is exposed to the risk of additional mobile network operators entering the New Zealand market with a 3G network

New network operators may establish mobile services in New Zealand in competition to Telecom. As an example of this, TelstraClear has recently announced plans to invest $50 million in a wireless network based in a major provincial centre in New Zealand. Telstra’s network is expected to ‘go live’ by the middle of 2007 and is reported to have potential to provide over 100,000 household and business users with voice, mobile and broadband services. In future, the Government may introduce regulatory change lowering the coverage threshold required for new mobile entrants to secure a roaming agreement with an existing operator. Any regulated change of this nature would increase the likelihood of additional network operators establishing mobile service in competition with Telecom’s service. If this were to occur, Telecom may have to reduce its prices to remain competitive, reducing the profitability of this line of business, which may in turn adversely affect Telecom’s financial position and results of operations.

Network or system interruptions may result in reduced user traffic, revenues and damage to Telecom’s reputation

Telecom’s network infrastructure, particularly in New Zealand, is geographically widespread and is vulnerable to natural hazard disasters such as earthquakes, volcanoes, floods and tsunami. Increased failure rates and increasing difficulty supporting ageing legacy technologies, in combination with reduced reliability of new IP-based technologies, may also lead to increased loss of service events and/or the inability to meet the demand requirements for legacy products or services. These events and others, such as fire, terrorism or sabotage affecting key facilities, software faults, viruses, power supply loss or overloading from abnormal traffic loads, could result in service failures to large numbers of customers for extended periods and delays in the processing of bills and the receipt of related payments.

Telecom has experienced network failures in the past. For example, in 2006, Telecom’s ISP Xtra experienced intermittent service outages spread over 3 days that interrupted email service to Xtra customers. The outages were caused by several factors, the key trigger being a failure of the uninterruptible power supply in the Data Centre hosting Xtra’s servers. This was exacerbated by server configuration errors preventing service start-up following power restoration, higher than normal volumes of demand affecting the mail servers at the time of the incident, and less than adequate business continuance capability.

In Australia, the power supply to AAPT’s Riverside Exchange in Queensland was disconnected following localised flooding in the server room. The flooding was caused by a failure of a water pump triggered during routine maintenance. While the energy supply was isolated, service to the majority of AAPT’s customers was lost for a period of 2 – 3 hours. A small number of other AAPT corporate customers experienced a more severe service loss of up to 2 days duration. A small number of customers experienced intermittent problems beyond the 2 days.

Some network and IT systems that deliver Telecom’s services, provisioning and billing systems may not be fully protected against such events. In addition, some of Telecom’s network and systems are not covered by formal disaster recovery and support arrangements.

 

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The risk of network failures can never be entirely eliminated. Any such failure may harm Telecom’s reputation and could result in customer dissatisfaction, brand damage, compensation payments and contractual penalties, and reduced traffic and revenues.

Telecom is dependent on a limited number of key third party suppliers for the delivery of important equipment, systems and software

Telecom depends upon key suppliers, including its key technology partners Alcatel, Lucent and EDS for the supply of transmission, switching, routing and data collection systems, related software and other network equipment. The recent trend towards supplier consolidation (for example, Nokia and Siemens, and the pending Alcatel and Lucent merger) may increase suppliers’ market power and reduce Telecom’s ability to obtain the best price, and terms and conditions from its relationships with suppliers. If Telecom were unable to obtain adequate supplies of equipment in a timely manner, or if there were significant increases in the costs of such supplies, Telecom’s operations would be adversely affected. This may make it more costly for Telecom to manage its networks, systems and products and may have a negative effect on its financial position and operations.

Telecom has a relationship with Sprint Nextel Corporation to source handsets and mobile applications on favourable commercial terms. Without this agreement there is a risk that Telecom’s financial performance could be adversely affected.

Telecom’s performance in the New Zealand mobile market could be disadvantaged as a result of its key competitor’s (Vodafone’s) global scale, which allows it to purchase handsets and develop applications on more favourable commercial terms. To ameliorate this risk Telecom has commercial arrangements with Sprint. These arrangements have enabled Telecom to source handsets directly from original equipment manufacturers on favourable commercial terms. In addition, Telecom is able to obtain access to mobile applications developed by Sprint. Without these arrangements in place there is a risk that Telecom’s financial performance in the mobile area could be adversely affected.

Telecom may pay too much for acquisitions and investments

Value assumptions Telecom uses to make decisions about acquisitions and investments may prove to be incorrect. In particular, the carrying value of acquisitions and investments is based on assumptions about future value, which, if not realised, could lead to asset write-downs. In accordance with NZ IFRS, Telecom is continuously reviewing asset values for impairment against fair value. Further write-downs will occur where Telecom determines that the fair value of its acquisitions or investments is less than the carrying value of those acquisitions or investments.

If a large change in the valuation of financial instruments occurs because of market movements and hedge accounting criteria are not met, this may have a material impact on earnings

Under NZ IFRS, entities are required to carry all derivative financial instruments on balance sheet at fair value with changes in fair value recognised in earnings unless the instruments meet the detailed requirements for hedge accounting. Telecom’s derivative financial instruments generally do meet these tests, however, there is a risk that they may cease to meet them in future or future instruments may not. This could have a material impact on earnings if large valuation changes were required to be recorded through the income statement.

For US GAAP purposes, Telecom is also required to recognise its derivative financial instruments at fair value in the balance sheet, however, Telecom does not apply hedge accounting to its derivative financial instruments. As a result, changes in valuation of derivative financial instruments due to market movements will cause variability in Telecom’s net earnings in accordance with US GAAP reported in the reconciliation of net earnings under IFRS to net earnings under US GAAP, which is presented in the notes to the financial statements.

 

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Telecom may be unable to obtain future financing at favourable rates to fund the development of its business

Telecom had debt borrowings totalling NZ$3,498 million at 30 June 2006, the majority of which will need to be refinanced in the future. Conditions in the financial markets could adversely affect Telecom’s ability to finance its operations. In particular, if the general level of interest rates rises, Telecom may be unable to borrow at affordable rates.

Telecom currently has long-term investment grade credit ratings for senior unsecured debt of A2 from Moody’s Investors Service and A from Standard & Poor’s Ratings Group. To the extent that Telecom’s debt ratings or the ratings of the telecommunications sector generally, are downgraded, there is a risk that its cost of funding could increase, or that Telecom’s access to domestic and international debt capital markets could be restricted.

Two of Telecom’s existing term debt issuances (issued under the Euro Medium Term Notes issue) have pricing triggers in the event of a rating downgrade. These triggers would apply if Telecom’s long-term senior unsecured ratings from Standard & Poor’s Ratings Group and Moody’s Investors Service fell below A- and A3 respectively.

Imputation credits would not continue to be available if there was a substantial change in ownership of Telecom

In general, dividends payable by Telecom are eligible for imputation credits in New Zealand based upon tax paid by Telecom, and such credits, if available, reduce the New Zealand taxes payable by recipients of such dividends. United States and other overseas holders can indirectly use these imputation credits under the Foreign Investor Tax Credit regime to reduce the financial impact of New Zealand withholding tax on cash dividends.

As at 30 June 2006, Telecom had NZ$297 million of imputation credits. However, if there are changes in the ownership of Telecom’s shares, such that there is a greater than 34% change in continuity of ownership between the derivation of imputation credits and the attaching of those credits to dividends, such credits will be lost if they have not already been used in relation to dividends. If such credits were to be lost, this could result in greater taxes on dividends until such time as Telecom’s imputation credit account is restored through future taxes paid.

The demand for Telecom’s services is influenced by economic conditions

Telecom’s business is influenced by economic conditions within the countries in which it operates, and in particular by the state of the New Zealand and Australian economies and also in the economies of their major trading partners. A significant weakening in the New Zealand or Australian economy could have a material adverse effect on Telecom’s business and results of operations.

Telecom’s unhedged borrowings may expose it to fluctuations in interest rates. Hedged borrowings expose Telecom to counterparty risk

Telecom has a mix of both floating interest rate and fixed interest rate debt securities on issue at any point in time. Telecom has a policy of converting almost all its floating interest rate exposures to fixed interest rates through the use of derivative financial instruments. As of 30 June 2006, NZ$3,032 million or 86.7% of Telecom’s debt was subject to, or had been converted to, fixed interest rates. Telecom has a policy of holding debt in foreign currencies proportionate to the value of the assets held in that currency, and of hedging its exposure to exchange rate fluctuations in respect of other foreign currency borrowings. As a consequence of entering into these derivative financial instruments, Telecom is exposed to the risk that the counterparties to such arrangements may fail to perform their obligations. To the extent that floating interest rate obligations are not converted to fixed interest rate exposures, Telecom is subject to volatility in underlying short-term interest rates.

 

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Depreciation or fluctuations of the New Zealand and Australian dollars relative to other currencies could adversely affect Telecom’s financial condition and results of operations

Telecom’s revenues and expenses are denominated predominantly in New Zealand and Australian dollars. Telecom purchases equipment, materials and supplies denominated in a variety of foreign currencies depending on the source of the goods. Movements in the value of the New Zealand and Australian dollars against other currencies can adversely affect Telecom’s financial performance.

Telecom has a policy of hedging a substantial portion of its budgeted 12 month foreign currency expenditure to reduce the volatility of each exchange rate movement on Telecom’s financial performance and results (approximately 65.0% of total forecast 12 month foreign currency exposures of approximately NZ$435 million, as at 30 June 2006, had been hedged). However, in respect of capital expenditures beyond a 12 month time horizon, and to the extent that foreign currency expenditure is unhedged, in line with Telecom’s policy, there is a risk that fluctuations in foreign currency rates may impact upon the cost to Telecom of such foreign sourced purchases.

Accordingly, there are risks that currency movements could negatively impact Telecom’s financial condition and results of operations despite Telecom’s hedging strategies. Telecom cannot provide assurance that currency fluctuations or limitations on Telecom’s ability to convert or transfer currencies would not have a material adverse effect on Telecom’s financial condition and the results of Telecom’s operations.

Loss of key Telecom, supplier and partner personnel could delay business plan initiatives or lengthen service interruptions

Many of Telecom’s service operations are specialised and are dependent on highly skilled personnel, within Telecom and its key suppliers and partners, to meet current and planned performance levels. Successful operation of Telecom’s business is dependent on its ability to attract and retain sufficient key personnel whose skills are in demand throughout the industry. Telecom cannot be sure that such key personnel can be attracted and retained.

Key operational sites may be subject to Maori land claims which may delay the implementation of network deployment, adversely affect Telecom’s ability to execute its strategies, and negatively impact financial performance

Significant holdings of land in New Zealand are subject to Treaty of Waitangi claims by Maori. Telecom may have limited options for siting new facilities because of radio coverage issues or network design considerations, and claimants, both formal and informal, have the potential to delay the implementation of network development investment plans.

The establishment of a link between adverse health effects and electromagnetic energy could expose Telecom to liability or negatively affect operations

Allegations have been made, but not proven, that mobile telecommunications equipment may pose health risks through exposure to emissions of radio frequency electromagnetic energy from such devices. Telecom complies with the radio frequency exposure levels permitted by the New Zealand standard 2772.1:1999 (NZS).

However, there is a risk that an actual or perceived health risk associated with mobile telecommunications equipment could lead to litigation, adversely affect Telecom through a reduction in the number of customers or the growth rate of mobile telecommunications services or reduced usage per customer, or hinder Telecom’s placement of new mobile telecommunications equipment.

Telecom is involved in legal proceedings which, if decided against Telecom, could have a material adverse effect on its business, financial condition, position, results of operations and/or profitability

As the principal telecommunications provider in New Zealand, Telecom is subject to numerous regulatory and competition law proceedings and is a focus of the New Zealand Commerce Commission and competitors (see “Item 4 – Market Overview - New Zealand Regulation”). Telecom

 

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is currently involved in litigation regarding regulatory decisions and the interpretation of other New Zealand statutes and regulations.

In addition, Telecom is involved in two proceedings for anti-competitive conduct brought by the Commerce Commission. If either of these proceedings are decided against Telecom, there is a prospect that it will have a significant effect on Telecom’s business, financial condition, position, results of operations or profitability.

The legal proceedings to which Telecom is a party are described in more detail under “Item 8 – Legal Proceedings”.

Identification of significant deficiencies or material weaknesses as a result of Telecom’s implementation of procedures designed to comply with Section 404 of the Sarbanes-Oxley Act of 2002 relating to the evaluation of Telecom’s internal control over financial reporting may have an adverse impact on Telecom’s financial condition and results of operations and the trading price of Telecom’s securities

Telecom devotes significant attention to establishing and maintaining effective internal controls. Telecom is in the process of documenting, reviewing and, if appropriate, improving its internal controls and procedures in connection with Section 404 of the Sarbanes Oxley Act, which will require annual management assessments of the effectiveness of Telecom’s internal control over financial reporting and a report by Telecom’s independent auditors addressing these assessments beginning 30 June 2007. Telecom has commenced testing Telecom’s internal controls in connection with the Section 404 requirements.

As a consequence of systems and procedures currently being reviewed and implemented to comply with these requirements, Telecom may uncover circumstances that may be determined to be significant deficiencies or material weaknesses, or that may otherwise result in disclosable conditions. Although Telecom intends to take prompt measures to remediate any such identified significant deficiencies or material weaknesses in Telecom’s internal controls structure, measures of this kind may involve significant effort and expense as well as significant managerial resources, and any disclosure of such significant deficiencies, material weakness or other disclosable conditions may result in a negative market reaction on Telecom’s share price and loss of confidence in Telecom’s internal controls which may in turn have an adverse impact on Telecom’s business, financial condition and results of operations.

 

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Item 4. Information on the Company

The purpose of this section is to provide a description of Telecom, the products and services it sells, the markets in which it competes, the strategies that it is pursuing within those markets and the competitive and regulatory factors that have (or are likely to have) a bearing on its ability to successfully compete in those markets, the physical assets that it employs to deliver its products and services and the important alliances and investments in other entities that Telecom has in order to achieve its business objectives.

Item 4 is organised as follows:

 

  History and Development – a description of the formation of Telecom, its legal and ownership history and its principal subsidiaries and investments;

 

  Business Overview – a description of the markets in which Telecom operates and the significant industry developments impacting those markets;

 

  Telecom Strategy Overview – an overview of the key strategies that Telecom is pursuing in light of the significant developments impacting the industry and the company;

 

  Market Overview – within each of its New Zealand and Australian businesses, a discussion of the characteristics of the markets in which Telecom operates, the customers it serves, the products and services it sells and the competitive and regulatory factors that influence the way that it competes in these markets. In particular, this section details proposed changes to the regulatory environment in which Telecom operates and their likely impacts on Telecom’s business;

 

  Telecom’s Principal Activities and Approach to the Market – an overview of the way Telecom organises itself to address its markets;

 

  Property, Plant and Equipment – a description of the physical infrastructure that Telecom employs in its business operations; and

 

  Partnering Arrangements – a description of the important partners that Telecom has aligned with in order to meet its business objectives.

HISTORY AND DEVELOPMENT

Legal Form and History

Telecom Corporation of New Zealand Limited, a company with limited liability incorporated under the Companies Act 1993, is domiciled in New Zealand and has its registered office at Telecom House, Level 8, North Tower, 68 Jervois Quay, Wellington. Telecom’s telephone number is 64-4-801 9000. Telecom is registered with the New Zealand Companies Office under the registration number 328287.

Telecom was established on 24 February 1987 by the New Zealand Government for the purpose of acquiring the telecommunications business of the New Zealand Post Office. This was done as part of a broad range of changes instituted by the New Zealand Government that were designed to place Government-owned trading agencies on an equal footing with private industry.

Ameritech Holdings Limited and Bell Atlantic Corporation Limited (which later became Verizon Communications Inc. following the merger of Bell Atlantic with GTE Corporation in July 2000) purchased Telecom from the New Zealand Government in September 1990. As part of the purchase, Ameritech and Bell Atlantic each agreed to gradually reduce their beneficial ownership in Telecom to 24.95%, which they completed in 1993 by private transactions.

In 1998 Ameritech disposed of substantially all of its Telecom shareholding and its two nominated directors resigned from the Telecom Board. In May 1999 Bell Atlantic’s nominated directors resigned from the Telecom Board. Its successor, Verizon, advised Telecom in September 2002 that it had sold substantially all of its Telecom shares.

 

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The New Zealand Government holds a single preference share in Telecom (the “Kiwi Share”) that incorporates special rights and attaches a deed defining certain minimum service obligations upon Telecom. These obligations are described more fully under the heading “Regulation” below.

Company Overview

Telecom is the largest telecommunications service provider in New Zealand (by total revenue), offering a comprehensive range of products and services to consumer and business customers.

Telecom operates in the New Zealand market through a number of wholly-owned subsidiaries, including:

 

  Telecom New Zealand Limited (access, calling, internet, broadband and IT services;

 

  Telecom Mobile Limited (wireless voice and data services);

 

  Xtra Limited (Internet Service Provider); and

 

  Yellow Pages Group Limited (White Pages® and Yellow Pages®).

Telecom’s principal Australian subsidiary, AAPT Limited, offers a variety of fixed line, data, internet and mobile services. Telecom’s other major Australian subsidiary, TCNZ Australia Pty Limited (“TCNZA”), offers telecommunications and IT services to major Australian corporate organisations.

In 2004, Telecom acquired IT service companies Gen-i Limited and Ceritas New Zealand Limited (trading as Computerland) to further extend its IT services capabilities. Gen-i and Computerland were integrated into Telecom New Zealand Limited in late 2005 and now jointly comprise a business division of Telecom New Zealand Limited, offering ICT services under the Gen-i brand. Gen-i provides IT services in both New Zealand and Australia.

Telecom’s Principal Interests in Other Companies

Southern Cross Cables Holdings Limited

In October 1998, Telecom joined with two other companies in the formation of the Southern Cross Cables Group to build, own and operate a Trans-Pacific cable network. Telecom owns 50% of Southern Cross. The Southern Cross Group consists of two sister companies, Southern Cross Cables Holdings Limited and Pacific Carriage Holdings Limited (and their subsidiaries).

Hutchison 3G Australia Limited

In May 2001, Hutchison Whampoa Limited, Hutchison Telecommunications (Australia) Limited and Telecom formed a strategic alliance. As part of this alliance Telecom acquired a 19.9% shareholding in Hutchison 3G Australia, a company established to construct and operate a 3G mobile network in Australia. In December 2004, Hutchison 3G Australia entered into an agreement with Telstra to establish a 50/50 partnership called 3GIS Pty Limited to own and operate Hutchison 3G Australia’s W-CDMA radio access network and fund future network deployment.

Capital Expenditures and Divestitures

For a discussion of Telecom’s principal capital expenditures and divestitures in the preceding two-year period, refer to “Item 5 – Liquidity and Capital Resources – Net cash used in investing activities, including capital expenditure”.

 

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BUSINESS OVERVIEW

New Zealand and Australian Marketplace and Competitive Environment - Overview

Telecom is a participant in the Australian and New Zealand communications and information technology industry. Broadly, the communications industry can be defined as fixed and mobile calling, messaging, and managed and unmanaged data services that are delivered across a variety of access, transportation and service management platforms. Owing to the changing nature of the underlying technology, the communications industry is developing significant overlaps with other previously distinct industries such as entertainment, IT Services, and information services (directories and search, classifieds and online trading, and online display).

While Australia and New Zealand have similar demographic and overall communications industry trends, key differences exist in terms of industry structure, regulation and the number of competitors and degree of consolidation. These differences can be attributed partly to the larger size of the Australian market, and partly to the different approaches to deregulation and privatisation in Australia and New Zealand.

There has recently been a wide ranging review of the telecommunications sector in New Zealand by the New Zealand Government, culminating in the Telecommunications Bill. The Telecommunications Bill proposes significant change to the legal framework governing the telecommunications sector (see “Market Overview—New Zealand Regulation” below). The Telecommunications Bill has proposed the introduction of new regulated services, being local loop unbundling and naked DSL. It also proposes an information disclosure regime including accounting separation. Further, it proposes increased powers for the regulator to seek information from Telecom and a penalty regime. In addition to this, legislative change will be followed by a range of specific, targeted policy reviews.

The Government has asked a Parliamentary Select Committee which is charged with receiving submissions on the Telecommunications Bill to receive submissions on whether to separate Telecom’s wholesale and retail operations and if so, what form that separation would take. There is no specific proposal for separation of Telecom’s wholesale and retail in the Telecommunications Bill at present. In response, Telecom has proposed entering into a form of operational separation of its retail and wholesale operations based on a framework of entering into a binding set of legal undertakings, forming an independent oversight group to monitor compliance with those undertakings and separating its wholesale and retail business operations. Consideration of legislative change is currently in progress and is unlikely to be completely resolved before the end of 2006.

Telecom’s principal competitors are affiliates of large multi-national corporations with substantial resources, including Telstra and its New Zealand subsidiary, TelstraClear, Vodafone Group Inc and its New Zealand subsidiary Vodafone New Zealand, SingTel Optus, a subsidiary of SingTel Corporation, and, increasingly, large IT service companies such as IBM. Telecom expects competition to continue to intensify with the prospect of existing participants extending their activities, as well as additional competitors entering the market. Smaller competitors are also actively marketing alternative access technologies to consumer and business customers. Further declines in prices for many products and services can be expected.

A Changing Industry Model

The traditional telecommunications industry operating model was built on a series of independent products and platforms, each supported by complex and proprietary business support and operating support systems. Generally, the industry tends to organise itself as separate fixed, wireless and internet services, which can drive complexity and limit the true integration of services from a customer perspective.

 

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Several significant trends are emerging in the industry. These trends have the potential to fundamentally alter the manner in which communications services are delivered in the future. These trends can be described as follows:

Adoption of the IP standard

IP is a communications protocol that is used to connect hosts on the internet, and has effectively become a de facto standard for transmitting data over networks. Each host (computer) has at least one IP address that uniquely identifies it from all other devices on the network. The development of IP should enable a move away from the current model of specialised devices accessing dedicated services using independent platforms, towards more versatile devices that will access multiple services across common infrastructure.

Broadband Ubiquity

Multiple high-speed broadband networks are available today, and broadband penetration is expected to accelerate over the next two to three-years. Technologies such as ADSL, gigabit Ethernet, WiFi, WiMax, LMDS, CDMA and UMTS are used today to deliver high bandwidth services. The ubiquity of broadband networks is in turn fuelling the growth in applications and services that demand high-speed connectivity and management systems. Improvements in the quality of service and inter-operability regimes should further enhance the capability to deliver video and other advanced data services on a competitive basis in the future.

Wireless Connectivity

Developments in radio network technology and “over-the-air” interfaces with fixed networks and devices have enabled significant performance improvements in high-speed wireless connectivity in recent times. Significant commercial premiums still exist for providing mobile services, and most operators are investing significantly in 3G CDMA or UMTS capability as the percentage of voice minutes and data services delivered across mobile infrastructure continues to increase.

Development of open standards and transparent network architecture

In addition to IP, the development of common authentication and transaction platforms with intelligent application interfaces will enable increased inter-operability across future networks. The open standards encourage third party application development and simplify the delivery of converged services to consumer and business customers.

The pressure and effect of the above developments has resulted in several significant outcomes that are common to all large integrated players in developed markets, namely:

 

  a decline in traditional access and voice services revenue;

 

  a migration of voice minutes and data usage from fixed to mobile networks;

 

  rapid revenue growth in broadband and mobile services;

 

  significant capital investment in broadband infrastructure and NGN capability, including the launch of 3G services by wireless operators and alternative access technologies by new entrants;

 

  pressure on operating margins and rapid price declines in key commodity line items;

 

  the advent of bundling and integrated service offerings, including consolidated billing, customer care and subscription-based pricing models;

 

  extensions of business into the adjacent industries of IT services, information services and entertainment.

Telecom believes in a future “Communications Service Provider” model, where the customer is at the “centre of the network” and will benefit from increasing service integration, and the ability to access a common set of services with any device, from any location. The development of IP, broadband and innovative multi-access terminals is changing customer behaviour, such that the customer will be able to personalise their future service offerings and self-aggregate their preferred voice, data and video content.

 

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Industry Sub-Sectors

Telecom competes in a broadly defined communications and IT industry that has a number of sub-industries and markets. Generally, Telecom defines its relevant markets in four distinct sectors:

 

  Communications – fixed and mobile voice and messaging services, managed and unmanaged data networking services and the provision of dial-up and broadband internet services;

 

  IT Services – including systems integration, infrastructure management, application development, contact centre management, business outsourcing and procurement;

 

  Information – directories, search, classifieds, online trading and auction; and

 

  Entertainment – video, music, gaming, and other interactive services across communications and IT infrastructure.

Each sector has distinct characteristics including different growth rates, competitors, market structure and regulatory environments.

Convergence is creating large overlaps in certain areas, with communications and IT services converging in the business and enterprise markets, and communications, entertainment and information services converging in the consumer markets. Within this converged industry model, many of the areas that are expected to generate the most substantial growth are areas where Telecom currently has a limited presence, particularly in the information and entertainment sectors. Conversely, Telecom’s traditional core fixed line telecommunications business is expected to be subject to continued revenue and margin pressure as a result of competitive pressure and substitution.

Telecom’s business strategy aims to respond to the trends within each sector. The fundamental trends are changing the economics of the telecommunications business, although significant differences exist between the perspective and economics of large integrated players, alternative telecommunications companies, and other niche players.

Generally, Telecom can be described as an integrated player in its home New Zealand market, and an alternative player in the Australian market. Integrated players are generally represented in all customer and market segments, and offer a full range of products across diverse infrastructure to a large installed customer base. Alternative players typically rely on a combination of owned and leased infrastructure, and tend to focus their more limited offerings on particular product or customer segments, using a combination of traditional and non-traditional distribution channels.

Significant uncertainty still exists around two areas:

 

  the rate of industry growth – i.e. the level of acceptance and demand for new value-added services (and the resultant pricing models);

 

  the shape of the future industry profit pools – in particular, who will capture a disproportionate share of the previously independent communications, IT services, entertainment and information services value chain.

Industry participants recognise that the migration period to the new business model will take a number of years and that significant uncertainties and opportunities exist during the transition. Because of the different sets of assets and capabilities that Telecom possesses in its New Zealand and Australian businesses, coupled with the quite different market positions of the respective businesses, a different approach to the implementation of its general strategies is required for each of Telecom’s New Zealand and Australian operations. This is discussed further in the “Market Overview” section below.

 

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Industry and Sub-Sector Outlook

The outlook for the broader Australian and New Zealand telecommunications industry is mixed, with a number of positive and negative trends apparent in various product and service lines.

Sustained long-term growth rates in excess of gross domestic product are largely dependent on the market’s appetite for new value-added services, and the future competitive and regulatory environments. Growth in future operating margins will also require significant restructuring of the cost base, and efficiency gains being realised in the new IP-based service models.

A feature of the industry is the inherent level of uncertainty in each sub-industry sector, with key questions over commercial and technical issues. Given the fixed cost nature of the business, and the long lead-times involved in significant capital decisions, a proportion of the current investment programme is necessarily related to maintenance of options. Wherever possible future network and IT capability is built around open standards and non-customised architecture. A number of significant product development programmes are simply based on a set of beliefs around how customers will seek to use services in the future.

The following discussion describes Telecom’s current beliefs around each sub-industry sector. These reflect management’s most realistic expectations at the time of filing. They are subject to material change and a number of scenarios are dependent on technical, regulatory and competitive assumptions that are beyond Telecom’s control.

Communications Services

Telecom expects strong execution of sales, marketing and product development initiatives will be required to enable the industry to grow at the same pace as gross domestic product. Price-based competition is likely to continue in fixed calling and to accelerate in mobile calling, and regulatory scrutiny will remain a feature of the communications landscape. Telecom’s scale and reach should enable the business to continue to generate strong cash flows, although a changing revenue mix and competitive pressure will continue to place margins under pressure.

Under most realistic scenarios, Telecom’s cash flow from the communications sector will continue to significantly exceed the cash flow from other sectors. Telecom is currently a leader in most parts of the core communications market in New Zealand (based on revenue market share), and retaining relatively high access market share remains an important priority.

IT Services

Telecom believes growth in the IT services sector is likely to outstrip gross domestic product. Telecom expects this growth will be driven primarily by volume growth in the demand for new services. This is based on the view that customers will continue to seek efficiency improvements through technology, particularly in the enterprise market, and integrators will increasingly become an important channel for communications needs. In terms of price, Telecom expects fragmentation in the industry will continue to drive price-based competition, maintaining pressure on margins.

Telecom’s primary proposition to customers is an integrated communications and IT solution, while Telecom’s competitive advantage in this sector in New Zealand lies in the depth of its current relationships with corporate customers—combining brand with effective channels to market. Telecom believes its brand and channels to market should support its share of market revenues, while capturing the synergies of the recent acquisitions of Computerland and Gen-i should provide an opportunity to partly mitigate the industry margin pressure.

Information Services

Telecom believes the information services sector also has the potential to grow faster than gross domestic product. Growth is expected to come from substitution from print to online media.

Telecom believes industry profit pools are likely to shift from offline (print directories, print classifieds) to online (online search engines and directories, online trading platforms and classifieds), and from

 

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content provision (for example, print directories) to content distribution (for example, search engines directing users to Yellow Pages®). Telecom presently generates the large majority of its profitability in the information services sector from offline services, through its printed directory business. It, therefore, expects that a shift in business model will be required in line with trends in the sector.

Telecom considers that it has three potential sources of capital advantage in this sector:

 

  its brands (Yellow Pages®, White Pages® and Xtra);

 

  its established relationships with small and medium enterprises; and

 

  its ability to integrate information with communications, particularly in the mobile business.

The penetration of global brands in the broad area of search functionality can be seen as both a threat and an opportunity in the information sector. In order to position itself for the shift to online and the penetration of global brands, Telecom will need to identify opportunities to leverage brands and relationships in different ways and more effectively utilise its ability to integrate information content into its future communications offerings.

While Telecom has potential sources of competitive advantage in its directories business, (Yellow Pages Group) it recognises that, in light of potential new commercial partnerships with global online market participants and the significant value that some overseas telecommunications companies have realised through divestment of their directories operations, it should also consider whether other options including full or partial sale of the directories business could deliver greater value to Telecom than remaining a full owner. Accordingly, a scoping study was launched in August 2006 to evaluate Telecom’s options in this area and establish which would be most likely to maximise value to Telecom. This study is expected to be completed by the end of October 2006, at which point any further action required would be determined. In the event that Telecom decides to proceed with a sale of the directories business, Telecom would expect to negotiate a comprehensive set of ongoing commercial arrangements with the new owners in order to enhance Telecom’s ability to provide online services.

Entertainment Services

Telecom believes growth in entertainment revenues is likely to be fuelled by an increase in user spend and advertising. Advertising spend has historically followed consumer usage and is, therefore, expected to gradually move towards online media.

Telecom believes home entertainment (video, music, and gaming) is positioned to capture most of the absolute revenue growth in the entertainment services sector while mobile data has significant potential growth.

Traditional broadcast aggregation models are under threat as users become better able to self-aggregate their own content (for example, through time-shifting, personal video recorders, and the advent of consumer “media centres”). Telecom believes current aggregation models will prevail until on-demand offerings are developed and distributed broadly.

The distribution of entertainment content online is expected to drive significant increases in data traffic, both fixed and mobile, once pre-conditions necessary for successful delivery of content online are met (in particular, the availability of content in digital form, availability of ubiquitous broadband networks, advent of innovative multimedia devices, and agreement around digital rights management and copyright).

Telecom believes it has the potential to participate in future industry growth through the strength of its high-bandwidth delivery platforms and its historical relationship with the New Zealand consumer market. Given these assets Telecom does not seek to be a direct content provider, but instead intends to develop strong partnerships with third party content providers to assist in the provision of enhanced video delivery systems and interactive services over Telecom’s infrastructure.

Telecom believes there is currently a significant level of uncertainty in the future entertainment sector, and that the appropriate strategic response is to maintain a number of real options and continue to fund a sustained programme of various network and commercial trials.

 

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TELECOM STRATEGY OVERVIEW

Given the shifts occurring within the telecommunications industry, particularly intensified competition, fixed to mobile substitution, regulatory intervention and new access technologies, Telecom’s traditional communications business is subject to declining revenues and margins. In the absence of a change in Telecom’s strategic approach, this will lead to a steady reduction in Telecom’s financial performance over the next five years.

Telecom believes it has sustainable competitive advantages in core communications and print directories (though it is currently considering whether the value that print directories can generate would exceed the value that would be generated by a sale of this business), but not in other high-margin areas where it expects future revenue growth to be generated.

Telecom believes that the most likely way to improve its financial results and offset the impact of declines in the traditional communications business is through cost reductions and improved levels of competitive intensity. In order to achieve this, Telecom believes that it needs to fundamentally redesign its business model, including the way it organises itself, the products and services that it offers to its customers, the way that these products and services are delivered and the infrastructure used to provide products and services.

Telecom has developed four key strategic themes in response to these pressures.

Strategic Theme 1: Protect and enhance core revenue streams

Telecom aims to reduce the revenue decline in traditional communications services by protecting the fixed line relationship. This will entail:

 

  shifting the emphasis of Telecom’s marketing and product development initiatives from being based around the capabilities of access platform (i.e. fixed or mobile) to being focussed on specific customer needs;

 

  accelerating delivery to market of fixed/mobile converged offers and devices in order to enhance customer relationships;

 

  accelerating broadband penetration to ensure Telecom remains a key network provider in the future customer access relationship;

 

  developing a Video/TV content proposition, partly to ensure Telecom sustains a network cost advantage by creating demand for higher bandwidth applications;

 

  consolidating and integrating the ICT services business with the existing telecommunications businesses to better meet the needs of corporate and high end medium enterprise customers; and

 

  evaluating the potential of emerging fixed wireless access technologies (for example, WiMax) and making targeted investments where compelling benefits can be achieved.

Strategic Theme 2: Develop a new, lower cost business model

Telecom believes that current cost and capital expenditure initiatives will not mitigate high-margin revenue declines; and, therefore, a new and significantly lower cost business model centred around simpler, more powerful customer value propositions is required. In response, Telecom is developing the NGT programme, which aims to considerably simplify the way Telecom does business in order to provide simpler products and more transparent pricing to customers, and as a result reduce the costs that Telecom incurs in providing its products and services. To achieve this, Telecom is planning to undertake the following activities:

 

  a significant rationalisation of the products and services offered by Telecom will be carried out, to deliver a considerably smaller, more standardised set of product offerings;

 

  significantly lower cost marketing, sales, and service models (with a significant emphasis on self service) are being developed to support the new product offerings;

 

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  the replacement of Telecom’s legacy fixed line network with a IP-based NGN is continuing. The NGN will enable the delivery of the new product set and is expected to provide a considerably simpler more integrated infrastructure base than Telecom’s existing network structure of multiple networks required to deliver its existing product set; and

 

  attempt to impose tighter controls on capital expenditure, particularly where it relates to legacy systems, in order to maximise returns from Telecom’s capital expenditure programme.

The NGN programme predates the formulation of NGT, but is fully aligned to the objectives of NGT. Telecom is partway through implementing the detailed NGN plans formulated in prior years, and expects that the majority of customers will be served over the NGN by December 2015. While the remainder of the NGT initiatives have been defined at a broad level, Telecom is currently in the process of formulating the detailed planning and design work required to implement NGT at an operational level. As the NGT programme gathers momentum, the technology components that enable NGT services will be included in the scope of the NGT programme. It is currently expected that the majority of Telecom customers will be on NGT offers by December 2015.

This programme of work is discussed further in “Item 5 Operating and Financial Review and Prospects”.

Strategic Theme 3: Create options for future growth

While the most substantial future value to Telecom is expected to be provided by Strategic Themes 1 and 2 (outlined above), Telecom continues to monitor opportunities where it considers that there is potential to generate sustainable revenue and margin growth. Activities currently being undertaken or considered include:

 

  developing online search/directories and trading options;

 

  developing a robust strategy to facilitate growth in the micro-payments market;

 

  assessing the potential to become the New Zealand channel for global technology providers;

 

  formulating a strategy and approach to develop offers for potential ICT vertical markets;

 

  exploring opportunistic ICT acquisitions, but only as a secondary objective to consolidation of existing businesses; and

 

  identifying and taking positions in a variety of online vertical markets to secure a balanced portfolio of growth options.

Strategic Theme 4: Setting the organisation up for success

Telecom is putting in place the change management programmes and building the capability required to support its strategic direction and focus. This entails:

 

  ensuring that operating and technology strategies and plans are aligned to NGT objectives;

 

  adapting and developing Telecom’s research and development and third party relationship management capabilities to ensure that Telecom can continue to deliver vertically integrated offers in an IP world;

 

  defining and implementing a new wholesale approach to meet the needs of key stakeholders and ensure non-discrimination in response to changes in the regulatory environment. Further modifications to this approach may be required if additional requirements are imposed by regulation; and

 

  aligning the internal organisation to the strategic direction, including a major reorganisation of the business structure to better address customer segments (ie, consumer, business and wholesale) as opposed to technology platforms (fixed and mobile).

 

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MARKET OVERVIEW

New Zealand

Telecom Principal Products and Services

Within its integrated New Zealand operations, Telecom provides fixed line and value-added services for voice and data communications, wireless services for voice and data communications, calling and managed data network services between New Zealand, Australia and the rest of the world, internet access and online services, IT services, and directories publishing.

Telecom’s New Zealand revenues for each of the last two financial years, broken down by major products, are shown in the table below.

 

     Year ended 30 June  
    

2006

$m

  

2005

$m

  

2006/2005

% change

 

Local service

   1,049    1,063    (1.3 )

National calling

   633    671    (5.7 )

International calling

   343    323    6.2  

Interconnection

   162    163    (0.6 )

Mobile

   774    706    9.6  

Data

   438    414    5.8  

Broadband and Internet

   336    285    17.9  

IT Services

   346    308    12.3  

Directories

   248    229    8.3  

Miscellaneous other

   110    117    (6.0 )

Total revenues

   4,439    4,279    3.7  

Included within total revenues are revenues earned outside New Zealand in Telecom’s international operations of NZ$66 million for the year ended 30 June 2006 (year ended 30 June 2005: NZ$56 million). All other revenues are earned within New Zealand.

For further information on Telecom’s revenues by major products and services categories for New Zealand, see “Item 5 – Operating and Financial Review and Prospects”.

Retail Business Units - Principal Products and Services

Local Service

The local telephone service provides the customer with access to the local telephone exchange, allowing telephone communication between customers in a local calling area and access to national and international toll services.

In New Zealand, the main components of the local telephone service are fixed line services, such as business and residential line rentals, local call charges (predominantly paid by business customers) including Centrex (a product that allows conventional PSTN lines and phones to be used in such a way that they appear to be part of a private network, offering businesses an alternative to buying or leasing their own PABX) and VPN local calls and value-added services, such as call waiting, caller display, and voice messaging services.

National Calling

In New Zealand, national calls (also known as inland toll calls or, in the United States, long distance calls) include calls to a location outside the caller’s local calling area including Centrex and VPN, calls to mobile networks originating within the fixed line network, calls to toll free numbers (which in New Zealand have the prefix 0800 and are paid for by the receiver of the call) and charges for operator assisted calls.

 

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International Calling

International services provided by Telecom include:

 

  outgoing international calls made in New Zealand;

 

  collect, credit card and “New Zealand direct” calls to New Zealand;

 

  receipts from overseas telecommunications administrations and companies for calls to New Zealand that use Telecom’s facilities; and

 

  calls from international switched traffic transiting Telecom’s facilities.

Telecom makes payments to overseas administrations and companies for the use of their facilities for outward and transit calls from New Zealand to their countries.

Interconnection

Telecom exchanges calls with competing telecommunications operators which require access to Telecom’s networks in order to receive calls from or terminate calls to Telecom’s networks. Telecom’s revenues include payment for calls carried on behalf of other service providers. Prices and terms for these interconnections are determined by agreement between the parties but are subject to regulatory oversight.

Mobile

Mobile services comprise access and airtime charges for calls originating from Telecom’s mobile network (including international calls) and revenue from text and multimedia messages sent by Telecom customers, WAP services, wireless data services, paging, cellular equipment sales and other related services.

Telecom’s mobile 027 network (CDMA network) and 025 network (TDMA network) are available to approximately 97% of the New Zealand population. The networks consist of both digital (CDMA and D-AMPS) and analogue (AMPS) services. Telecom launched its CDMA network in July 2001 and is now phasing out its TDMA services and intends to close down the TDMA network on 31 March 2007. A significant proportion of Telecom’s TDMA customer base has transferred from TDMA to CDMA, and CDMA customers now make up over 95% of Telecom’s customer base, generating approximately 98% of Telecom’s mobile revenues.

At 30 June 2006, Telecom had approximately 1,703,000 mobile connections in New Zealand (approximately 45% of the New Zealand mobile market based on total connection numbers disclosed by all participants in the market) up from approximately 1,601,000 connections at 30 June 2005 (an increase of 6.4%).

Telecom’s New Zealand CDMA network provides access to a nationwide data capability by which Telecom customers can wirelessly access the internet or connect remotely to the office. In July 2002, Telecom commercially launched 1XRTT services with high quality data transmission capabilities. In November 2004, the CDMA network was further upgraded to the EV-DO version to provide high-speed wireless data capabilities in New Zealand’s metropolitan areas and holiday locations. This enabled Telecom to launch New Zealand’s first 3G mobile service, under the “T3G” brand. Telecom extended its EV-DO coverage in 2005 to cover almost all large towns and cities across New Zealand. Telecom intends to develop its mobile capabilities and recently committed to a further upgrade of its CDMA network to the new EV-DO Rev A standard which will further increase mobile data and network capabilities.

Telecom has introduced new products and services delivered over its CDMA network. These include “Push to Talk” which enables mobile phones to be used as walkie-talkies, photo and video messaging, mobile games, streaming of video clips, and a range of content (music and sport are the most popular categories) and customisation services (such as the Telecom music store, PC downloads) that provide additional value to customers.

 

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Data

Data services meet customers’ wide-area networking communications needs. There has been a shift away from traditional dedicated circuit/leased line data products towards IP-based data products, given the increased flexibility and cost efficiency that IP products offer. The majority of Telecom data business involves data transmission services, dedicated leased lines and managed data services.

LanLink and IP networking provide secure and private IP networking solutions to customers. Telecom’s Frame Relay and ATM services provide high-speed data services. The ATM service is increasingly being used to support IP services. Telecom offers a wide range of dedicated circuit services to satisfy the needs of customers requiring exclusive communications links. Telecom also provides IP network services which connect other internet service providers to their customers.

Broadband and Internet

Telecom’s internet services business generates revenues principally from providing internet access for consumer and business customers. The principal internet access products are dial-up, ADSL and fibre broadband – with dedicated and secure internet connectivity offered primarily for business customers. Telecom has made extensive use of ADSL technology to provide broadband internet access over existing copper telephone lines. Telecom has developed a range of monthly plans in the consumer market offering choices of download speeds and monthly download allowances.

Telecom also offers high speed public internet access through a nationwide network of public ‘hotspots’ which use the WiFi standard. Customers with a WiFi enabled device can access the internet from over 400 public locations around New Zealand including airports, cafés and hotels.

Telecom, through its subsidiary Xtra, has entered into a licensing agreement with Microsoft Corporation which provides Xtra with MSN services via the XtraMSN portal website. This licensing agreement was recently extended until 31 December 2006. Telecom is currently conducting a strategic review of its online value added service offerings and local search capability. The outcomes of this review have not been finalised, and are likely to affect the future operation of Telecom’s Xtra portal and directories business.

IT Services

The shift from providing PSTN and data connectivity towards becoming a fully converged integrated communication and technology services provider for business customers is a significant part of Telecom’s strategy. A priority for the 2006 financial year was to integrate traditional IT services provided by the recently acquired Gen-i and Computerland businesses, with Telecom’s network services, and to provide customers with access to the full range of integrated technology services. Initially Telecom has focussed on its largest customers in the corporate segment in its expansion into integrated communication and technology services. In the 2007, financial year this focus will be expanded to also market these services to the next tier of customers, in the medium enterprises segment.

IT services are provided under the Gen-i brand following the integration of Gen-i and Computerland with Telecom’s existing IT services business.

Converged ‘bundled’ offers

Telecom will continue to deliver new converged offers, as described in the preceding section “Telecom Strategy Overview”. Examples of recently released converged offers are that consumer customers can pay $10 a month to make unlimited calls (subject to fair use conditions) between a Telecom fixed line and a nominated Telecom mobile; also consumer customers that choose to take broadband services get a discount on the monthly access price if they also take calling and fixed access products from Telecom.

In the business segment, Telecom has launched new products for small businesses that offer price caps on calls to or from fixed lines to Telecom mobiles. For larger businesses, Telecom will continue

 

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to develop new bundled pricing packages for business customers that buy the full suite of data, voice (fixed and mobile) and IT services from Telecom.

Directories (Yellow Pages Group)

Yellow Pages Group annually publishes in New Zealand 18 regional directories listing customers’ names and telephone numbers and 22 local directories. A standard listing in the regional and local directories is free to both consumer and business customers. Special listings are available on a charged basis. Regional advertising directories classified by product or service (Yellow Pages®) are also published every year. Telecom offers single colour, four colour advertising, bold and super bold entries and logos in its directories. Telecom also provides internet White Pages® and internet Yellow Pages®. Yellow Pages Group’s revenues are principally derived from the sale of advertising in Yellow Pages® directories.

As discussed in the “Business Overview” section above, Telecom has launched a scoping study of its directories business to consider whether potential sale options for this business should be pursued.

Retail – Channels

Telecom’s marketing activities are focused on positioning Telecom as a major competitive provider of communications, IT, information and entertainment services to customers in New Zealand. Telecom maintains a number of advertising programmes, including broadcast, print and online media, to support its sales efforts. The focus of Telecom’s advertising strategy is to build preference for Telecom’s brand, increase customer awareness of products and stimulate usage.

Telecom utilises a range of indirect and direct channels to manage its different customer segments which are determined by considering both the size and complexity of those customers.

Consumer Retail Channels

The majority of consumer customer interaction is through a range of phone and online channels (primarily via Telecom’s main website). The interactions include sales, after sales service, faults, billing, credit, and 0800 issues.

Phone based contact centre operations are both provided in-house and via third parties. Telecom is increasing the information and capability available on its online channels and a growing number of customer interactions are conducted electronically.

Telecom owns and operates 29 retail stores across the country to provide face-to-face sales and service for all telecommunications device and technology needs. These stores are primarily consumer segment focused but also provide some support for smaller business customers. Telecom has exclusive relationships with approximately 120 independent Telecom dealers in New Zealand and partnerships with a number of major New Zealand retailers which adds approximately 350 additional retail PoPs throughout New Zealand.

Telecom also engages a range of third party sales specialists to provide additional channels to market, for example, door to door sales.

Business Retail Channels

Retail/Direct/Online/Other

Telecom works with a range of partners, integrators, resellers and associations to provide its business customers with a range of sales and service channels such as retail stores, direct account management and contact centres. During the year, Telecom developed and enhanced its relationships with the Computerland regional franchises in their role as Telecom’s IT sales force outside of the main centres, under the Gen-i brand.

 

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Consumer and Small Business Enterprises

A similar approach to that taken in the consumer segment is taken to servicing customers in the consumer and small business segments, with a range of phone, online, paper and face-to-face channels being utilised. They include sales, after sales service, faults, billing, credit, 0800 and via Telecom’s main website.

Corporate and Medium Enterprises

Customers in the corporate and medium enterprises segments are account managed by channel units, which provide products and customer service to Telecom’s business and public sector customers. These units principally fulfil sales and service and account management functions and also manage products specially designed for their customers.

Telecom’s business customers are expanding their use of integrated technology services on the back of the productivity and cost saving gains made from successful implementations. A key part of this is customers’ increase in uptake of mobile applications, supported by Telecom’s strong focus on the integration of mobile, fixed and ICT technologies. In 2006, overall account management responsibility for more than 50 of Telecom’s largest corporate customers was performed by the Gen-i account management teams, given the sophisticated ICT needs of these customers. In the new organisational structure that is currently being implemented, this responsibility will be expanded beyond these large corporate customers to also include medium enterprise customers.

During the year, Telecom set up the Telecom Sales Academy, with the aim of building necessary new capabilities for Telecom’s customer-facing staff in the business market.

Telecom also created a new dedicated Trans-Tasman corporate sales team in Australia, as part of the Gen-i group. This provides an integrated customer view across the two countries, as well as providing further opportunity to utilise expertise in Telecom’s New Zealand business in the Australasian market.

Retail Market Structure and Competition

Telecom’s principal competitors are affiliates of large multi-national corporations with substantial resources, including Telstra, TelstraClear, Vodafone Group Inc. through its subsidiary Vodafone, and IBM. Telecom expects competition to continue to intensify, with the prospect of existing participants extending their activities, as well as additional competitors entering the market. Smaller competitors are also actively marketing alternative access technologies to residential and business customers. Telecom believes further declines in prices for many products and services can be expected.

Telecom has extensive interconnection arrangements with other network operators and service providers, such as CallPlus Limited, Compass Communications, Worldxchange, Ihug Limited and TeamTalk Limited. These agreements cover international services, national and local voice services, data services, mobile services, internet services, and mobile trunked services.

 

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Telecom’s retail customer base

The breakdown of Telecom’s New Zealand retail customer numbers as at the end of each of the last three financial years is shown in the table below.

 

     As at 30 June  
    

2006

000s

  

2005

000s

  

2004

000s

  

2006/2005

% change

   

2005/2004

%change

 

Access lines

             

Residential

   1,346    1,360    1,425    (1.0 )   (4.6 )

Business

   253    256    271    (1.2 )   (5.5 )

Centrex

   66    68    72    (2.9 )   (5.6 )

Mobile Connections

   1,703    1,601    1,352    6.4     18.4  

Broadband connections

   335    223    90    50.2     147.8  

Dial-up internet customers

   310    374    436    (17.1 )   (14.2 )

Access and local calls

Telephone access and local calls can be provided by competitors that interconnect with Telecom.

Some of these interconnecting operators have the ability to offer local services. In most cases Telecom has call re-address agreements in place enabling competitors to provide customers the option of changing between local service providers without needing to change telephone numbers. A regulated local number portability service, which will come into force in April 2007, requires Telecom to provide a fully functional number portability service and would require Telecom’s competitors to provide reciprocal portability. Telecom has also entered into a number of wholesale service agreements for the provision of wholesale services to carriers other than TelstraClear.

Telecom expects to face growing competition for access services from wireless network providers. Vodafone has recently announced the launch of an integrated mobile, local access, calling and wireless broadband product via its mobile network that will allow customers to completely sever their relationship with Telecom. Such an offer puts at risk all Telecom’s revenue from every customer acquired by Vodafone.

TelstraClear has recently announced that it is commencing build of a 3G HSDPA mobile network in Tauranga with the intention of providing a similar service to that of Vodafone.

National long distance and international calling

Numerous competitors exist in New Zealand that compete in the national long distance and international calling markets.

In addition to those companies, with which Telecom has interconnection arrangements, numerous other organisations offer voice calling services from overseas or by re-selling services from network operators in New Zealand. Internet service providers also compete strongly in the calling market, offering internet, calling, and in some cases, access bundles.

There is increasing activity both within New Zealand and internationally around internet-based voice services which offer attractive calling offers to existing internet users through use of VoIP technology. There are predominately two types of VoIP services:

 

  software client based VoIP products that work on personal computers (for example, Skype);

 

  hardware based VoIP services that rely on an adapter to route calls over the internet (and/or the PSTN if needed).

 

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Typically these products offer free calling to other users of the same service or heavily discounted calling rates to traditional PSTN phone numbers in all national and international calling destinations. While these services typically appeal to cost-conscious and technologically capable people, they are becoming more widely adopted. These services add increased competitive pressure in the calling market.

Dial-up internet access services

Approximately 90 ISPs operate in New Zealand and many of these have customer access through the Telecom network using 0867 and 0873 dial-up numbers provided by Telecom Wholesale. Currently competitors are aggressively targeting the dial-up customer base with low priced dial-up offers with either very high or unlimited usage caps.

Broadband services

Telecom faces increasing competition in the broadband services market. TelstraClear now offers fibre, cable and DSL broadband services to businesses in the metropolitan and some regional centres. These services are offered through TelstraClear’s xDSL, fibre and hybrid fibre infrastructure. TelstraClear also has the ability to sell ADSL services through a wholesale arrangement with Telecom.

Recent regulatory decisions on competitor access to Telecom’s copper local loop means that in the near future Telecom’s broadband competitors will have:

 

  wholesale access to the same broadband access products as those offered by Telecom retail units;

 

  access to Telecom’s local telecommunications exchanges to install their own DSL equipment (for example, Digital Subscriber Line Access Multiplexers (“DSLAMs”)) – allowing competitors to avoid using Telecom Wholesale products; and

 

  a standalone wholesale internet DSL product that does not require a customer to have a local service voice access line (also known as ‘naked DSL’).

Telecom expects that competitive activity in the broadband market will increase significantly as operators seek to quickly capture market share. As with dial-up activity, Telecom expects that competitors will seek to capture calling revenues with attractively priced broadband offers.

There is also growing competitive activity in the broadband market from high speed wireless services offered by providers such as Woosh Wireless Limited and Vodafone. Vodafone’s mobile network upgrade will give it the ability to offer full broadband services to its customers – primarily in metropolitan areas. Vodafone is already aggressively targeting new and existing broadband customers with mobile broadband products that are priced at a small premium to equivalent Telecom ADSL products. Vodafone has also recently stated that it is changing its global strategy away from a mobile-only strategy, meaning that if it wished, it could choose to integrate fixed line internet services with its mobile-only offers.

In addition, the Government established the PROBE project. This enabled the rollout of broadband to all schools that do not currently have access to broadband and promotes competition in broadband outside metropolitan areas. There are 15 regions, one of which is a satellite region. The confirmed suppliers in the satellite region following tenders are Telecom, Woosh Wireless, Counties Power Limited, The Pacific.Net Limited and Internet Company of New Zealand Limited.

Mobile telecommunications services

There are currently two mobile network operators in New Zealand – Telecom and Vodafone. Telecom operates a CDMA service. Vodafone operates a UMTS/GPRS/GSM mobile network which competes with Telecom’s CDMA EV-DO offering.

TelstraClear currently resells mobile services via the Vodafone GSM network, but is investing in building a new 3G mobile network in Tauranga and is expected to seek regulated roaming on Vodafone’s network to provide nationwide 3G services.

 

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Econet Wireless is also deploying a 3G network in Auckland city in partnership with Huawei Technologies Co., Ltd.

Given this increased level of infrastructure build Telecom will face increasing competition in the mobile market and may have to consider accelerating its plans to invest in mobile networks, alternative technologies and compelling bundled services.

Telecom also faces competition in leased-line services, paging, directories publishing and supply, and installation and maintenance of Customer Provisioning Equipment.

Data services

There is significant competition in the data market, particularly in those products and services that are currently experiencing growth (for example, DSL and IP services). TelstraClear is Telecom’s main competitor owing to its network reach to the majority of metropolitan and urban locations. There are also niche operators which provide competition in specific locations, segments and products.

Payphones

Competition in the payphone market arises in the form of substitutes, principally calling cards and mobile phones. This competition will intensify with the increased market penetration of mobile phones, and greater activity and lower entry barriers for calling card operators.

Advertising, directories and information services

Yellow Pages Group’s White Pages®, Yellow Pages®, Local DirectoriesTM and related products (both print and online) are key advertising and contact information channels for local and central New Zealand Government and businesses, in particular small and medium enterprises across New Zealand. As such, Yellow Pages Group operates within the highly competitive advertising market competing with a range of other domestic and international advertising businesses, local newspapers, television, radio and direct marketing companies, which also target a similar customer base.

Yellow Pages Group has a range of specialty databases and services derived from the Yellow Pages® and White Pages® databases. These products and services are used by businesses for direct marketing and updating databases and as such it competes in the provision of lists and value-added services within this industry.

Telecom Principal Products and Services - Wholesale

Telecom Wholesale focuses on providing interconnect, wholesale, and retail-based services in terms of products, provisioning, and customer service to Telecom’s wholesale customers who include carriers, ISPs, resellers and broadcasters. Telecom Wholesale also actively seeks growth opportunities with its customers for unregulated services. Within Telecom Wholesale specialist fault management and provisioning teams have been established to handle service fulfilment and faults resolution for wholesale customers.

Wholesale Business Unit – Channels

Most wholesale customer contact by Telecom Wholesale happens electronically. This reduces costs for both Telecom Wholesale and its customers. Wholesale also provides Business-to-Business (“B2B”) interfaces into its faults and provisioning systems. These provide connections for Telecom Wholesale customers into Telecom’s systems, reducing double-handling and the potential for errors. These B2B interfaces are replacing previous methods such as the use of email.

Wholesale Market Structure and Competition

Competition in the wholesale market has also increased with the entry of energy companies into the communications market. Vector Communications Limited has high-capacity fibre optic networks in

 

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central Auckland and Wellington and an extensive network in south Auckland. Vector currently only operates in the wholesale market. Wired Country Limited, a subsidiary of Compass Communications, is offering wholesale broadband services in the Auckland metropolitan and south Auckland areas. A number of retailers have taken up these services and are now providing access and calling to a small part of that market. Another participant in the wholesale market is Broadcast Communications Limited, which operates a wireless network for the provision of wholesale access services. Telecom is acquiring wireless services from Broadcast Communications Limited to increase its rural broadband product portfolio.

TelstraClear is a significant wholesale competitor particularly in relation to services utilising its national backbone network. This includes services such as national calling and wholesale data services.

Wholesale customer base

The breakdown of Telecom’s New Zealand customer numbers as at the end of each of the last three financial years is shown in the table below.

 

     As at 30 June
    

2006

000s

  

2005

000s

  

2004

000s

  

2006/2005

% change

  

2005/2004

%change

Access lines

              

Residential

   68    57    —      19.3    NM1

Business

   50    49    33    2.0    48.5

Broadband connections

   100    35    —      185.7    NM1

 

1 Not meaningful

New Zealand

Regulation

Overview

The core telecommunications regulatory framework in New Zealand is made up of the following key elements:

 

  industry-specific competition legislation in the form of the Telecommunications Act 2001;

 

  the Commerce Act 1986 (antitrust law);

 

  the “Kiwi Share”: one preference share held by the Government in Telecom that attaches special rights;

 

  The Telecommunications Service Obligation (“TSO”) Deed, an agreement between the Crown and Telecom governing the supply of the universal service obligation pursuant to the Kiwi Share;

 

  consumer protection laws (for example, Fair Trading Act 1986, Consumer Guarantees Act 1993);

 

  the Telecommunications Carriers’ Forum, a statutory self-regulatory body that promulgates industry codes;

 

  Radiocommunications Act 1989; and

 

  Overseas Investment Regulations 1995.

The Telecommunications Act and other aspects of the regime will be subject to significant change over the next year, as set out further below.

 

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Principal regulators

The principal regulator is the Telecommunications Commissioner (“the Commissioner”), who oversees the regulatory regime provided for by the Telecommunications Act (see below) and sits as an industry-specific branch of the Commerce Commission, New Zealand’s competition regulator. The Commerce Commission oversees the Commerce Act antitrust law and consumer protection law, such as the Fair Trading Act.

There are also two industry self-regulatory bodies, being the Telecommunications Carriers’ Forum, which was set up under the regulatory regime to promulgate industry codes, and the Number Administration Deed, a self-regulatory body set up to administer the phone numbering scheme.

Industry-specific competition regulation – Telecommunications Act

The introduction of the Telecommunications Act in 2001 created a telecommunications industry-specific regulatory regime in place of a comparatively deregulated environment governed by general antitrust law. The design of the 2001 regulatory regime under the Act was relatively light-handed, providing limited powers for the Commissioner to make determinations on access disputes between individual parties, in addition to:

 

  determining the net cost and allocation of the cost of Telecom’s universal service obligation under the TSO Deed;

 

  monitoring compliance with the service obligations recorded in the TSO Deed;

 

  investigating whether services that are currently unregulated should be regulated and added into legislation in addition to services that are already regulated; and

 

  approving telecommunications access codes drafted by the Telecommunications Carriers’ Forum.

Government review of the state of competition in telecommunications

In February 2006, the Prime Minister announced the Government would be advancing policies to ensure the telecommunications sector becomes more competitive in order to enhance economy-wide economic transformation objectives, particularly broadband services in the top half of OECD rankings by 2010. Pursuant to this announcement, Government conducted a broad ‘stock take’ review of the telecommunications sector.

The conclusions of the stock take review were released in a Cabinet paper on 3 May 2006. The paper proposes significant amendments to the Telecommunications Act and a series of further specific policy reviews to achieve the goals sought by the Government. The proposed changes to the Telecommunications Act are likely to be significantly more intrusive than the existing regime.

Legislative Amendments to the Telecommunications Act 2001

The Telecommunications Bill was introduced into New Zealand’s Parliament on 26 June 2006. It has now been referred to Parliament’s Finance and Expenditure Select Committee to hear public submissions and report back to the executive branch of Government on the recommended final shape of the pending legislative review. Legislative change is expected to be implemented by the end of this year or early 2007.

Key amendments proposed in the Telecommunications Bill are:

 

  the introduction of an accounting separation regime;

 

  regulation of copper LLU;

 

  regulation of naked DSL (broadband bitstream access without the associated voice stream);

 

  the introduction of enforcement and penalty clauses (potentially including fines of up to $300,000, or in the case of breach of the accounting separation information provisions, $1 million and further penalties for continuing breach), and the power for the Commission to include consequences for breach in determinations (such as liquidated damages) that may be enforced by parties in the High Court in its civil jurisdiction;

 

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  a “government policy statement” provision, meaning that the Commissioner must take into account the Government’s relevant economic policy statement when making decisions on whether to regulate new services, thus constraining the Commissioner’s independence from Government to some extent;

 

  broad information seeking powers for the Commissioner, including a mandatory role to monitor competition and performance of telecommunications’ markets and to make information about these issues publicly available;

 

  introduction of “standard terms determinations”, intended to apply to the whole industry rather than just the applicant, and intended to be issued by the regulator without the pre-condition of an application by an access seeker;

 

  the ability for the Commission to accept an “undertaking” from Telecom in lieu of a change in regulation;

 

  access seekers will be able to apply for a determination of a regulated service even if there is a commercial agreement in place for supply of that service, or an agreement not to seek a determination. Currently, these would prevent an access seeker applying for a regulatory determination; and

 

  the removal of automatic expiry of service designations after a 5 year period.

Local Loop Unbundling

The proposed designation of local loop unbundling as a regulated service would require Telecom to lease copper loops (meaning the copper going from Telecom’s exchange or street-side cabinet to an end-user’s building) to access seekers. Access seekers would then be able to connect the end-user’s local loop to their own equipment co-located in Telecom’s exchange and use their own network to provide services, such as broadband, to their customers.

Pricing is proposed on a two-stage basis – an initial and a final price. The proposed initial access price for lease of the local loop is to be calculated by benchmarking against prices for similar services in comparable countries that use a forward-looking cost-based pricing method. If dissatisfied with the benchmarked price, either party may then seek a final price. The final price is likely to be backdated and is proposed to be calculated in accordance with a TSLRIC price methodology.

The proposed pricing principle is similar to cost-based pricing principles in the existing Telecommunications Act for interconnection services. However, the Government has also proposed that the regulator must consider ‘relativity’ between the price of LLU and the price of UBS. Previously, pricing principles were considered on a service by service basis without reference to how they fit together.

The insertion of the “relativity” requirement is based on the economic theory of the “ladder of investment”, which provides that regulators should price access services in such a way as to actively move access seekers up through a “ladder” of regulatory access services towards infrastructure investment. This means a new entrant may purchase simple retail resale services (priced on a “retail-minus” basis under the Telecommunications Act) with little investment other than sales and marketing costs. This lowers entry barriers. However, the retail-minus pricing principle provides lower margins for the entrant than cost-based services. The entrant should then move to purchasing UBS, including naked DSL. UBS services are intermediate services providing a bridge for the access seeker between resale (retail-minus) and unbundled loops (cost-based). Like resale services, UBS services are priced on a retail-minus basis. Once the entrant has built up a customer base using resale and UBS, they should then progress to purchasing unbundled loops. These are cost-based, providing higher margins for access seekers but requiring a higher level of investment and network build – possible once the scale and customer base has been built up using resale and UBS services.

The Telecommunications Bill does not prescribe how the inclusion of pricing relativities would be interpreted by the regulator. Accordingly, the regulatory implementation of the pricing principles of both LLU and UBS (including naked DSL), the maintenance of relativities between them (including the recovery of foregone access line revenues), and the economic theory underpinning the inclusion of the relativity criterion in the legislation is uncertain and as currently proposed gives the regulator broad discretion to determine this.

 

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Unbundled Bitstream Services

UBS has been regulated since 2004. It connects access seekers to Telecom’s fixed Public Data Network (“PDN”) from the end-user’s building to Telecom’s first data switch (other than a DSLAM). The Telecommunications Bill proposes UBS may be applied for without a voice service attached. In other words, it is proposed to be made available as a ‘naked DSL’ service. This allows substitution of the fixed voice access service by mobile services and VoIP services.

Again, there is a two-stage pricing process. The initial price for UBS (with or without voice service) is retail-minus. It is proposed to be calculated by taking retail prices, less a discount benchmarked against discounts in comparable countries that apply retail prices minus avoided costs saved pricing in respect of the service. If either party is dissatisfied with the benchmarked price, they may apply for a final price, proposed to be calculated by taking the retail price, minus a discount comprising avoided costs saved where Telecom faces limited or lessened competition in a market, or minus a discount comprising actual costs saved in a case where Telecom does not face limited or lessened competition in a market.

As with LLU, the regulator must have regard to the relativity of pricing between this service and Telecom’s unbundled copper local loop network service. Similar risks and uncertainties apply to UBS pricing as to LLU pricing in this respect. A further uncertainty is the precise retail-minus calculation the regulator uses and in particular how the regulator will factor in access line recovery into naked DSL pricing.

Accounting separation

The Telecommunications Bill proposes the Commerce Commission should require Telecom to prepare and disclose information about the operation and conduct of its wholesale and retail business activities as if those activities were operated as independent or unrelated companies. Other than this, it does not prescribe the framework or methodologies to be used, leaving this to the regulator to determine. The Telecommunications Bill specifically allows the Commerce Commission to adopt any methodology it chooses for fulfilling this requirement, including any allocation methodology. Under the Telecommunications Bill, the Commerce Commission may also allocate any of Telecom’s business activities or any part of Telecom’s business activities to either the retail or the wholesale part of Telecom’s business, as it sees fit.

Because Telecom is offering to voluntarily separate its retail and wholesale operations (details below), it has submitted to Parliament’s Select Committee that accounting separation is not necessary and should be made discretionary rather than mandatory. It is noted, however, that the United Kingdom and Australian jurisdictions require accounting separation in addition to operational separation. Telecom expects to be subject to some form of accounting separation or additional regulatory reporting. In the alternative, Telecom has submitted accounting separation should be related to the actual operation of its business under its proposed operational separation model and related to Targeted Access Services only. If accepted, this would limit the cost of accounting separation to Telecom.

Telecom has submitted to Parliament’s Select Committee that the $1 million fine per breach for breaching the accounting separation provisions is disproportionate (the comparable provision in Australia is $AUD 250,000). As the Telecommunications Bill is currently drafted, the accounting separation provisions are unclear and Telecom believes there is a risk it could inadvertently breach the requirements.

 

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Operational Separation Model

In addition to seeking submissions on proposed legislative change as outlined above, Parliament’s Select Committee has also been asked to seek submissions on various separation options for Telecom, including operational separation and structural (or ownership) separation. It has been asked to report back to the executive branch of Government on this issue recommending any changes to the Telecommunications Bill before it is passed, although there is no provision for imposing operational or structural separation of Telecom in the Telecommunications Bill at the present time.

Telecom has filed submissions on the Telecommunications Bill with the Select Committee in which it is proposing to enter into a set of permanent, binding undertakings with the Government based on a voluntary operational separation of its retail and wholesale operations, which maintains Telecom New Zealand Limited as a single entity but with separate retail and wholesale operations for the delivery of Targeted Access Services. The separation model Telecom has proposed is based on the United Kingdom British Telecommunications plc (“BT”) undertakings with the Office of Communications (or Ofcom), the United Kingdom communications regulator.

The key proposed features are:

 

  public binding undertakings

 

  separation of Telecom’s retail and wholesale operations for the delivery of Targeted Access Services;

 

  an independent oversight group (“IOG”) to monitor compliance with the undertakings; and

 

  non-discrimination by Telecom’s wholesale operations in the supply of Targeted Access Services between Telecom retail and wholesale customers.

Telecom expects the Government to seek to negotiate aspects of the undertakings if the Select Committee recommends operational separation. Accordingly, both the form of the separation model and its timing remain uncertain.

Parliament’s Select Committee will report back to the Government on which, if any, separation models are recommended. Telecom expects to begin discussions with the Government at that stage (targeted for late 2006) if operational separation is recommended.

The key proposed features of the proposed operational separation of Telecom are as follows:

 

  Separation of Telecom’s Retail and Wholesale operations

Telecom’s proposal to separate wholesale and retail operations includes separate (controlled access) premises for wholesale and retail and separate incentives for wholesale staff that relate only to wholesale targets (rather than overall -Telecom targets). Separation of Telecom’s wholesale operation also includes the proposal that wholesale commercial policy will not be influenced by Telecom retail unless the same opportunity for influence is available to all wholesale customers. It also includes restricted information flows.

 

  Independent Oversight Group

The independent oversight group (“IOG”) is proposed to consist of 5 members, 3 of whom are independent of Telecom. The key role of the IOG is to monitor and report on Telecom’s compliance with the undertakings both to the regulator and directly to Telecom’s board. The IOG’s brief does not go wider than the undertakings, for example, into any other governance issues.

 

  Non-Discrimination

As stated above, Telecom is proposing to commit to two levels of non-discrimination. First, in relation to Targeted Access Services provided over the planned NGN, Telecom proposes to provide services to its wholesale customers in accordance with a commitment to “equivalence of inputs”. This means that those services will be provided on the same

 

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timeframes, terms and conditions (including price) and using the same systems and having been provided the same commercial information. This is the same as the BT equivalence commitment.

Second, in the transition period leading up to the NGN, Telecom has proposed to provide services on the basis of “equivalence of outcomes”. This means Telecom retail and wholesale customers obtain substantially the same outcome notwithstanding that the systems used to deliver those outcomes to service providers other than Telecom retail may differ from the systems used to deliver those outcomes to Telecom retail. This will largely relate to Targeted Access Services delivered over its legacy PSTN network.

 

  Other key elements of Telecom’s submissions

Other key elements of Telecom’s submissions are the recommendation the Telecommunications Bill be amended to require the regulator to review regulated services from time to time to assess whether regulation is still necessary. Telecom also submitted that a competition test should be included in the service descriptions for the proposed new regulated services. This would align with existing service designations which contain a competition test requiring the regulator to make a finding of limited or lessened competition in the relevant market before intervening. Telecom also submitted to the Select Committee that a merit review be included in the Act.

Further Policy Reviews

In addition to the proposed legislative change, the Government has also undertaken to conduct a number of policy reviews including;

 

  Retail-minus pricing

As set out above, retail-minus pricing principles are intended to apply to all resale services and to UBS services (including naked DSL) (other than UBS backhaul). A review of the retail-minus pricing principle to measure whether that regime is consistent with the overall intentions of Government’s legislative change, has been proposed and poses a key risk to Telecom that retail-minus pricing is replaced by cost-based prices across all regulated services;

 

  A review of the TSO

This is likely to encompass some commitment on Telecom’s part to rural broadband coverage and is also anticipated to herald some increase in rural public spending on communications;

 

  A review of geographic price discrimination

This review is focused on Telecom’s ability to reduce prices in geographic areas targeted by new entrants as a competitive response;

 

  A review of the cellular market by the Commission

This commenced on 26 May and focuses on the promotion of new entry and the absence of virtual operators in the New Zealand market. This is likely to open up the mobile market to resellers. Currently, the outcome of this review is uncertain due to Vodafone subsequently entering commercial agreements for resale and TelstraClear entering the cellular market in Tauranga. The Government is considering whether, in light of these competitive initiatives, intervention is in fact warranted. In either case, Telecom expects that resale competition is likely to increase in the provision of cellular services; and

 

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  A review of next generation technology, including network interoperability and convergence of retail services, with a view to ensuring competitive markets are not foreclosed by Telecom’s NGN

Telecom has offered to voluntarily commit to industry consultation and interoperability of its NGN as part of its operational separation commitments. If accepted, this review is unlikely to go ahead, and instead, Telecom would be obliged to consult with industry participants on interoperability of network and retail services in accordance with any undertakings it enters into with the Government.

Recent determinations on access to regulated services

In the first five years of the legislation, the Commissioner’s key determinations were:

 

  interconnection by TelstraClear with Telecom’s PSTN (with respect to price and non-price terms);

 

  resale of Telecom’s business retail services;

 

  resale of consumer access and other consumer services in non-networked metropolitan areas and non-metropolitan areas;

 

  local and cellular number portability;

 

  resale of business VPN services and four other business services;

 

  access to interconnection with Telecom’s PDN or UBS; and

 

  draft determination on interconnection with Vodafone’s proposed “homezone” local mobile service.

Further details of number portability, UBS and Vodafone local service are set out below.

Access to interconnection with Telecom’s UBS

UBS (a best efforts ADSL based internet service) was regulated in 2004. TelstraClear have agreed commercial terms with Telecom for access to the UBS service. Smaller internet service providers ihug and CallPlus have been granted access to the service by the regulator in June 2006. ihug and CallPlus are currently appealing the UBS price ($28.04) in the High Court, seeking a price of approximately $20.00. Regardless of the outcome of the litigation, significantly increased competition in broadband in the consumer and small and medium enterprise markets is anticipated as a result of UBS access by Telecom’s competitors.

Application by Vodafone for interconnection with Telecom’s PSTN (“local” mobile service)

Vodafone has indicated that it is likely to launch a “Homezone” service of some sort assisted by the likely regulation of interconnection between Telecom’s PSTN and Vodafone’s “local” mobile service (distinguished from its ordinary mobile service by the use of local numbers) network. The regulator has issued a draft determination stating that interconnection is likely at bill and keep rates (meaning charges are netted off to zero) and prohibiting Telecom from recovering cost at retail, in order to maintain parity with Telecom’s local free calling obligation under the TSO (described above). Telecom and Vodafone are currently in discussions over commercial terms for Telecom’s interconnection service. If commercial terms are reached, the regulator will not issue a final determination. Regardless of whether interconnection with Vodafone’s local service is on regulated or commercial terms, as Telecom’s main competitor in New Zealand, Vodafone’s local mobile service is likely to increase competition for converged fixed and mobile services in the short term.

Determination on Local and Cellular Number Portability

On 31 August 2005, the Commerce Commission issued a determination on the delivery of number portability by the telecommunications industry. The determination set out the formula for allocating the cost of delivering portability services between access seekers and access providers of the service, the functions that must be performed by a system for delivering the services and standards to which those functions must be performed. The terms of the determination must be complied with by April 2007. Number portability is expected to increase churn between providers to some extent.

 

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Determinations on whether to regulate further services

As set out above, under Schedule 3 of the Telecommunications Act the Commerce Commission is empowered to investigate whether services that are currently unregulated should be regulated and added into the governing legislation. The Commerce Commission has conducted the following investigations into whether further services should be regulated;

 

  Local loop unbundling

In 2004, the Minister accepted the Commerce Commission’s recommendation that Telecom should provide a commercial unbundled partial circuits service (a dedicated symmetrical private circuit) to business customers and the regulation of UBS in place of regulating LLU. This is being revisited currently as outlined above.

 

  Mobile termination rates

The Commerce Commission recommended to the Minister mobile termination rates should be regulated. The Commission has recommended indicative prices of 15 cents, trending down to 12 cents in 2010. Termination revenues are likely to decline as will retail rates as a result. Telecom and Vodafone have both put commercial proposals to the Minister for a gradual reduction in price over a 5 year period. The Minister will consider the commercial proposals and reach a final decision.

 

  Service designations

The Commerce Commission has issued a determination regulating 10 of the 13 currently regulated services in the Telecommunications Act for a further two years. The remaining services were national toll free number portability, Telecom fixed PSTN to mobile carrier pre-selection and co-location for fixed telecommunications at Broadcast Communications Limited (a Government owned broadcaster) sites.

 

  Mobile Services review

The Commerce Commission has indicated it may investigate whether changes should be made to current mobile services specifications covering roaming and mobile co-location to make it easier for a third mobile service provider, particularly a mobile virtual network operator to enter the market.

Kiwi Share/TSO Deed

The TSO Deed records the following obligations:

 

  the obligation to charge no more than the standard rental for local consumer telephone service (increased consistently with the Consumer Price Index (“CPI”)) as it was at 1 November 1989 unless overall profitability of Telecom’s fixed business is unreasonably impaired;

 

  a local free calling option for local consumer telephone service (including voice and dial-up data services) to be maintained for all Telecom consumer customers;

 

  the obligation that line rental for local consumer telephone service in rural areas will be no higher than the standard rental and Telecom will continue to make local consumer telephone service as widely available as it was at 19 December 2001; and

 

  in addition, under the TSO Deed, Telecom is required to meet certain minimum standards for dial-up connection to the internet from consumer phones. These include, from December 2003, that 95% of all existing consumer lines meet the 14.4 kbps connect speed and 99% of all existing consumer lines meet the 9.6kps connect speed.

The “TSO loss” that arises from providing these services to loss-making customers is assessed annually by the Commerce Commission. The loss is then shared between industry participants in accordance with their share of liable revenue.

 

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As part of the Government stock take announcements in May 2006, the Government announced that it intends to review the TSO. However, it is not clear at this stage what changes the Government is seeking to the TSO. However, there is also the possibility that the Government could simply legislate for an increased TSO commitment.

Telecommunications Carriers’ Forum

The Telecommunications Act also provides for an industry forum to be developed for the purpose of preparing industry Codes for approval by the Commerce Commission. The Telecommunications Carriers’ Forum was formed as an incorporated society on 23 August 2002. The Telecommunications Carriers’ Forum prepares Codes for regulated services in accordance with the Telecommunications Act (among other things). These Codes for designated access services and specified services are intended to be confined to implementation of the access principles in the Telecommunications Act. These principles are: timeliness, non-discrimination and international best practice.

The Codes for designated multi-network services only provide for the functions that must be performed by a system for determining the service and the standard to which those functions must be performed. To date the following codes have been completed or are pending:

 

  co-location of Radiocommunications facilities regulated under the Telecommunications Act;

 

  Code for the transfer of telecommunications services;

 

  mobile content Code;

 

  consumer complaints Code; and

 

  SMS (or Short Message Service) anti-spam Code.

The Forum also prepared two draft Codes governing number portability, which were submitted to the Commissioner and incorporated (with some amendments) into the number portability determination (described below).

Number Administration Deed

On 29 August 2005, TelstraClear alleged that Telecom and Vodafone had breached the Number Administration Deed (“NAD”), which governs the way that numbers are allocated. The complaint relates to the allocation of short codes for SMS messages. The complaint was referred to the Independent Chair of the NAD. The Independent Chair’s interim decision was Telecom and Vodafone are in breach of the NAD but he has adjourned his decision to allow the parties to work to find a solution to the SMS issue. If a breach is upheld Telecom could be required to change the way that it allocates numbers, which would have some impact on the mobile business. The Independent Chair could also impose an insignificant fine on Telecom and Vodafone. This is the first allegation of a breach in the history of the NAD, so there is no precedent as to the likely outcome.

Interconnection Termination Rates

Interconnection termination rates for toll bypass, standard, toll-free payphone calls and calls to premium rate services were reduced by the Commerce Commission in November 2002 from 2.7 to 1.13 cents per minute. The 1.13 cents per minute rate is a benchmarked rate, which is subject to review in accordance with the forward-looking TSLRIC cost methodology model. This materially decreased Telecom’s interconnection revenues from fixed line calling but at the same time, revenues increased from mobile termination revenue, largely driven by increased volumes of texting traffic.

Both Telecom and TelstraClear applied to the Commerce Commission for a final pricing review of the interconnection termination rate. Those applications were withdrawn after a termination rate of 1 cent per minute was commercially agreed.

Regulated resale

Since May 2003, the Commerce Commission has required that Telecom resell fixed line business services on a retail-minus basis. Since June 2004, the Commerce Commission has also required that Telecom resell consumer services on a retail-minus basis. This introduced competition for

 

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consumer and business access across largely all of New Zealand by allowing Telecom’s competitors access to its nationwide products and services. Telecom expects to continue to lose market share in access, calling and data products and services as a result. These determinations have both expired but the services continue to be supplied on a commercial basis.

Both Telecom and TelstraClear have applied to the Commerce Commission for final pricing reviews in relation to business and consumer services. However, these were subsequently withdrawn after commercial agreement was reached.

In November 2004, TelstraClear applied to the Commerce Commission for the wholesale regulation of six further fixed line business services. Five of those six services (which included a managed data product) were regulated by the Commerce Commission.

Radiocommunications Act

Telecom currently holds the following spectrum rights:

 

  management rights until 2012 in respect of both the AMPS A and B bands (20 MHz in total) that its mobile network currently utilises. The Government is in the process of determining renewal of these rights;

 

  management rights until 2010 in respect of eight MMDS channels (64 MHz in total). Telecom’s future use of these channels is currently under review. These rights are in the 2.3 GHz band, which is potentially capable of being used for WiMax;

 

  management rights until 2021 in respect of 25 MHz of DCS1800 spectrum;

 

  management rights until 2021 in respect of 15 MHz of 3G UMTS spectrum;

 

  management rights until 2022 in respect of 7 MHz of 3.5 GHz spectrum; and

 

  licence rights (spectrum licences) for periods from 5-20 years in respect of approximately 150 point-to-point systems operating in the DCS1800 bands.

Such management rights and licence rights are deemed to be assets of a business for the purposes of the Commerce Act.

The Government’s current policy is to offer the opportunity to renew rights approximately five years before existing rights expire. The offer to incumbents will be based on a price-setting formula that is intended to estimate the market value of the spectrum. Where the formula cannot be applied, the Government intends to hold an auction.

As part of its stock take announcement, the Government announced it would begin work to review the way spectrum is managed and allocated. That work is being conducted at present and the Government recently released a discussion paper to gain views on management and allocation of spectrum that is capable of being used for broadband wireless access. That includes how the 2.3 GHz rights will be re-packaged and re-allocated. There is a key risk that Telecom will not acquire the entire spectrum it needs for future wireless services. There is also a risk Telecom will not be able to renew the entire spectrum it requires for its CDMA cellular service.

Telecom also holds approximately 7,000 radio apparatus licences, relating to frequencies that have not yet been brought under the new regime. These licences are usually issued annually, and renewed automatically, although there is no statutory right to renewal.

Commerce Act

The Commerce Act remains the general antitrust statute regulating market behaviour. It is now accompanied by the regulatory regime in the Telecommunications Act.

The Commerce Act prohibits various forms of restrictive trade practices in New Zealand. These include entry into contracts, arrangements or understandings that have the purpose, effect or likely effect of substantially lessening competition in a market. Price fixing and resale price maintenance are deemed to have the effect of substantially lessening competition and are, therefore, prohibited by the Commerce Act. Any person who has a substantial degree of market power is also prohibited from taking advantage of that market power for an anti-competitive purpose. The Commerce Act

 

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further prohibits the acquisition of the assets or shares of a business that will substantially lessen competition in a market.

The Commerce Commission may authorise a restrictive trade price or business acquisition if the public benefits of the practice or acquisition outweigh the substantial lessening of competition. Clearance can also be sought from the Commerce Commission for a business acquisition if the acquisition does not substantially lessen competition.

The Commerce Act contains penalties for business acquisitions which proceed without Commerce Commission clearance or authorisation and which have anti-competitive effects.

The Commerce Act gives the Commerce Commission the power to issue cease and desist orders for any anti-competitive activity that is likely to do irreparable harm to a competitor. The High Court also has the power to grant injunctions to restrain conduct and to award damages and impose pecuniary penalties. The maximum penalty for companies is the greater of NZ$10 million, three times the value of the commercial gain (where this can be readily ascertained), or up to 10% of turnover (where the commercial gain cannot be readily ascertained). Individuals involved in a prohibited practice are liable for a penalty of up to NZ$500,000. There is a statutory presumption that a penalty will be sought from the individual(s) who engaged in the anti-competitive conduct. Companies are prevented from indemnifying staff and directors in respect of liability for price fixing.

The Commerce Commission investigates complaints about alleged breaches of the Commerce Act. Private persons can also bring actions under the Commerce Act.

Recent proceedings brought by the Commerce Commission against Telecom are detailed in “Item 8 – Legal Proceedings”.

Fair Trading Act

Telecom is also subject to the Fair Trading Act, like all trading enterprises in New Zealand. The Fair Trading Act prohibits misleading and deceptive conduct, false representations and unfair trade practices. It also establishes a mechanism for the prescription of consumer information and product safety standards.

Consumer Guarantees Act

The Consumer Guarantees Act provides rights of redress to consumers against suppliers and manufacturers of goods and services, in respect of any failure to comply with guarantees given, or deemed to be given by the Consumer Guarantees Act. In July 2003, the Consumer Guarantees Act was amended to ensure that it applied to the supply of utilities (including telecommunications).

Telecommunications (Interception Capability) Act 2004

The Telecommunications (Interception Capability) Act 2004 aims to ensure that government surveillance agencies can effectively carry out interceptions of telecommunications under lawful interception warrants and authorities. The Telecommunications (Interception Capability) Act also aims to ensure that interception requirements do not create barriers to the introduction of new or innovative telecommunications technologies, and that telecommunications Network Operators and Service Providers (as those terms are defined in that Act) have the freedom to choose system design features and specifications that are appropriate for their own purposes.

The Telecommunications (Interception Capability) Act achieves its purpose by requiring telecommunications Network Operators, such as Telecom, to have interception capable public telecommunications networks and telecommunications services. PSTNs and telecommunications services must be interception capable by October 2005, and PDNs by April 2009. However, the Minister of Justice may grant exemptions from these requirements. Where a Network Operator needs to make changes to its PSTN to comply with the Act, Government funding is available in some situations.

 

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The Telecommunications (Interception Capability) Act also requires Network Operators and Service Providers to assist Surveillance Agencies with the execution of interception warrants and interception authorities by making available personnel who can provide reasonable technical assistance, and taking all other reasonable steps necessary for giving effect to the interception. The Surveillance Agencies are required to reimburse Network Operators and Service Providers for the costs they incur in providing this assistance.

Persons exercising powers and carrying out duties under the Telecommunications (Interception Capability) Act must also ensure that the privacy of telecommunications that are not subject to an interception warrant are maintained, and that interceptions must be undertaken without unduly interfering with any telecommunications.

If a Network Operator or Service Provider does not comply with their obligations under the Telecommunications (Interception Capability) Act, the High Court may make a Compliance Order requiring that person to do a specified thing or cease a specified activity. Contravention of a Compliance Order can result in a financial penalty of up to $500,000, and in the event of a continuing contravention, $50,000 for each day that the contravention continues.

Overseas Investment Regulations

Under the Overseas Investment Regulations, Telecom is deemed to be an “overseas person” because of its foreign shareholders. Overseas persons are required to obtain consent for certain business activities. Telecom must obtain consent from the Overseas Investment Commission for business acquisitions where the value exceeds NZ$50 million, or for certain acquisitions involving land.

Australia

Australian Business Unit strategy

Telecom’s subsidiaries in Australia can generally be thought of as alternative telecommunications service providers, with limited access infrastructure and focused product and channel strategies. Telecom’s goal in the Australian market is to deliver growth through the execution of service-layer strategies. A service orientation requires a proportionately higher investment in information systems and people capability and requires a detailed understanding of niche market segments, and differentiated pricing, service and delivery models.

Telecom has reorganised the management of its business so that larger business customers in Australia will be serviced through a single Trans-Tasman business unit. The largest customers will be managed in a Trans-Tasman approach under the premium customers sub-unit, including the telecommunications outsourcing arrangement with the Commonwealth Bank of Australia, which was recently extended for a further three year period. In addition, an agreement to supply other key services to the bank, including voice and call centre services, has been entered into for a three year period. Other customers attracting direct account management are managed under AAPT Business Solutions that sells both telecommunications and IT services through the Gen-i and AAPT brands.

AAPT otherwise intends to also target the consumer and small enterprise market and non-account managed customer base (particularly the small to medium-sized business market). The three principal strategic themes to implement the strategy and achieve market differentiation include:

 

  innovative pricing, promotion and packaging for the consumer and small enterprise, non-account managed market;

 

  building a portfolio of channels relevant to the consumer and small enterprise market (including a shift to indirect channels); and

 

  building self-service and internal IT and support capability for the consumer and small enterprise market.

Successful execution of the above strategies is designed to differentiate Telecom’s business from the traditional players, by creating value in offerings that extend beyond pure connectivity.

 

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Telecom has pursued a primarily “infrastructure-light” strategy in Australia, acquiring access and core transmission from other vendors and differentiating itself through the switching and routing capabilities, through value added network elements such as Intelligent Network platforms and in the operation of customer service platforms. In the latter category and as part of its third strategic theme, AAPT is one year into a replacement of its customer IT systems, with improvements already implemented to improve billing capability. Further developments due to be delivered in 2006/07 are likely to reduce the operating costs of servicing customers.

Telecom’s principal products and services

Through AAPT and Gen-i Australia, Telecom provides a range of fixed line, voice and data, internet, pay TV and mobile telecommunications services to consumer, business, corporate, Government and wholesale customers.

Telecom’s Australian revenues for each of the last two financial years, broken down by major products, are shown in the table below.

 

     Year ended 30 June  
    

2006

$m

  

2005

$m

  

2006/2005

% change

 

Local service

   32    38    (15.8 )

National calling

   318    357    (10.9 )

International calling

   99    92    7.6  

Interconnection

   42    43    (2.3 )

Mobile

   95    129    (26.4 )

Data

   164    188    (12.8 )

Broadband and internet

   112    91    23.1  

Resale

   363    336    8.0  

Miscellaneous other

   80    80    —    

Total revenues

   1,305    1,354    (3.6 )

For further information on Telecom’s revenues by major products and services categories for Australia, see “Item 5 – Operating and Financial Review and Prospects”.

Local service

Telecom only generates a limited amount of local service revenue in Australia owing to the limited number of customers who are directly connected to AAPT’s infrastructure. AAPT resells Telstra’s local service products to a large number of its consumer customers (this is included in resale revenue).

National calling

Across Australia, AAPT provides a range of voice services to all consumer segments, to all Australian destinations and to international destinations. AAPT owns or leases a high-speed inter-capital fibre network between major cities to carry both data and voice.

In addition, AAPT’s existing long distance customers who have pre-selected AAPT are automatically provided with fixed to mobile services by AAPT, as long distance and fixed to mobile services are not unbundled in Australia. Calls made from a fixed wire phone to mobiles are carried over AAPT’s network, and terminated on a mobile network. AAPT pays an interconnect fee to mobile operators to terminate calls on their networks.

International calling

Australian international calling revenue is primarily derived from long distance traffic carried by undersea cable or by satellite to and from Australia, both for AAPT and Gen-i Australia retail customers and for wholesale customers, such as calling card providers.

 

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Interconnection

Interconnection revenue arises where AAPT terminates calls originating on other carriers’ networks, be they fixed line or mobile.

Mobile

AAPT retails mobile services as a reseller of Vodafone Australia mobile products. In November 2001, AAPT and Vodafone Australia signed a network services agreement. Under this agreement AAPT purchases capacity at wholesale prices and connects to Vodafone Australia’s network while continuing to market its mobile services to customers through the AAPT brand. AAPT no longer actively markets mobile as a stand-alone product, now selling mobile predominantly in combination with fixed line products.

Data

AAPT owns and operates a large, secure, MPLS IP network that is used to provide nationwide internet and VPN services. Gen-i Australia uses this network to support key accounts such as the Commonwealth Bank of Australia. This network also supports AAPTs VoIP services, and forms a central part of AAPT’s strategy of moving towards an all-IP network that will consolidate all internet, VPN, ATM, Frame Relay and voice services onto a single transport infrastructure.

Broadband and Internet

AAPT derives revenue in the consumer and small enterprise market part of its business by providing dial-up internet access as well as reselling Telstra’s broadband service. These services are primarily marketed as part of a bundle with voice services. The managed part of the business derives revenue from providing internet access and e-commerce services to business customers and also generates revenue by wholesaling services to other ISPs, who in turn resell their services to retail customers.

Resale services

AAPT resells Telstra’s local call services to customers not directly connected to AAPT’s network. This service is principally marketed to customers as part of a bundle with AAPT’s other services, particularly calling services.

Targeting full service customers continues to be an important strategy for AAPT’s consumer business, given the positive effects on churn that this generates.

VoIP

AAPT currently has two VoIP offers. The first is “Hosted Voice” a VoIP solution targeted at the medium enterprise and corporate markets. The solution utilizes the BroadSoft platform to offer the customer the functionality of a hosted PBX and is distributed primarily through it’s direct channels. The second offering has just been launched and is called “Business Connect”. It integrates DSL tails and AAPT’s BroadSoft platform to displace traditional PSTN voice connections. This service also offers fast broadband access, VPN and remote working functionality. Business Connect is being sold through both direct and indirect channels.

Broadband

AAPT currently resell Telstra ADSL for its internet broadband offerings in the consumer and small enterprise market. In the managed market, AAPT resell both Telstra and Optus for internet access as well as direct connections for its IP-VPN and data services. The onset of ADSL2 in the next 12 months will result in the roll out of higher speed access to the customer base.

Channels

Marketing communications programmes including advertising, face-to-face, direct mail and telemarketing are used to support Australian customer acquisition and retention goals. Cross-selling

 

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and up-selling of services to customers is achieved through a combination of in-house and outsourced call centres. In the year ended 30 June 2006, AAPT has continued to enhance its outbound telesales capability by augmenting the new sales teams within its in-house call centres. This required AAPT to hire a significant number of additional call centre staff.

Also during the year ended 30 June 2006, further steps were taken to extend AAPT’s portfolio of channels to market, with emphasis on consolidating the position of IProvide in the business market. IProvide is dedicated to helping small and medium enterprises take advantage of IP services, including VoIP, VPNs and other value-added IP applications.

This growth in channels is consistent with the second element of AAPTs strategic initiatives.

Different marketing strategies are applied to each of the Australian customer segments.

Consumer

AAPT Consumer is targeting customers with bundled offers that build scale around Telecom’s voice and IP infrastructure. AAPT has continued to grow the number of customers who have acquired a bundle of services in the year to June 2006. New customers are acquired through a combination of inbound and outbound channels. Targeting existing customers for bundles is done using both outbound and inbound campaigns, primarily from AAPT’s own call centres.

Business

AAPT Business’s marketing strategy is to take advantage of AAPT’s integrated IP network to provide a range of business applications such as VoIP and “best-in-class” reporting tools that offer a transparent view of communications costs and solutions for mobilising a workforce.

Industry Structure and Competition

Competition for the provision of telecommunications services was deregulated in Australia from 1 July 1997 with the introduction of a package of legislation. This legislation introduced a number of changes to the existing regime, including:

 

  the removal of barriers to entry into the telecommunications infrastructure market;

 

  an industry-specific access regime that allows third parties access to certain telecommunications services;

 

  an industry-specific rule to regulate anti-competitive conduct; and

 

  increased emphasis on industry self-regulation.

Since the introduction of these legislative changes there has been a significant increase in competition in telecommunications markets, particularly in the provision of long distance national and international voice and mobile telecommunications services, and long distance national and international data services to businesses.

Demand for telecommunications services is forecast to continue to grow in the foreseeable future. In particular, there is a demand for more bandwidth intensive products with lower growth for basic voice services. Price reductions, which have already been seen in the market for long distance and local fixed wire services, are expected to continue.

While voice is expected to continue as the most significant revenue contributor to the Australian industry, demand for data carriage and managed services is expected to grow over the medium-term approaching voice in volume and revenue. In anticipation of this growth in data traffic, substantial investment in high capacity networks has taken place in recent years, leading to an over-supply of bandwidth capacity. This imbalance has resulted in downward pressure on prices, particularly over metropolitan and long-haul routes accessible by commercial users.

The consumer and small enterprise market in Australia is on the cusp of change driven by the emergence of technologies enabling faster and better existing services and new services for the end customer as the benefits of integration driven by convergence are realised. These types of

 

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technologies include VoIP, 3G and high speed broadband (DSL2+ or wireless technologies). It is AAPT’s intent to offer these services in the future once it has secured access to the relevant third party infrastructure at suitable commercial rates.

While still in its infancy for the consumer and small enterprise market customer, VoIP will exert further downward price pressure on the margin rich voice calling part of AAPTs business. AAPTs pricing principles around voice are taking into account the impact VoIP will have on its business.

The pricing pressure in both voice and data segments of the market have recently impacted the performance of all market participants. This has resulted in the exit of some smaller participants and consolidation among other participants. Many expect that further consolidation of the second and third tier markets will occur in due course.

There are approximately 140 carriers licensed to maintain their own telecommunications infrastructure and to provide services to the public in Australia. The Australian Communications and Media Authority currently has responsibility for administering the carrier licensing regime and there is no limit on the number of carrier licences that it may grant. Of the existing licensed carriers, there are currently three main facilities-based competitors to AAPT—Telstra, SingTel Optus and Vodafone Australia – as well as other competitors such as Hutchison Telecommunications (Australia) Limited. The local call market remains dominated by Telstra, as it owns most of the domestic local loop network, duplication of the Telstra fixed network is not economically feasible in many parts of Australia. Interconnection with Telstra’s local loop is necessary for competitive carriers, including AAPT, to offer many telecommunications services.

There is vigorous competition in the national and international long distance market, and there is a necessity to interconnect with other carriers for both national and international originating and terminating traffic.

The Australian regulatory system is complex and access to interconnection services can be subject to protracted disputes. AAPT is currently engaged in five access disputes under the telecommunications access regime. AAPT has notified two access disputes against Vodafone Network Pty Limited in respect of the MTAS for 2005 and 2006 and one access dispute with Optus in respect of the MTAS for 2005. If AAPT is successful, the per minute amount paid for the MTAS will be reduced. AAPT will seek to have the final determinations backdated to 1 January 2005 or 1 January 2006 as appropriate.

Regulation

Overview of legislation

The current regulatory regime for telecommunications is contained in a number of Australian Commonwealth Acts, the most significant of which are:

 

  the Telecommunications Act 1997 (the “Telecoms Act”);

 

  the Telecommunications (Consumer Protection and Service Standards) Act 1999 (the “Telecom Standards Act”) (which mainly contains consumer protection provisions previously contained in and transferred from the Telecoms Act);

 

  parts XIB and XIC of the Trade Practices Act 1974 as well as the non-industry specific provisions in the Trade Practices Act;

 

  the Radiocommunications Act 1992; and

 

  the Australian Communications and Media Authority Act 2005.

The main object of the Telecoms Act is to provide a regulatory framework that promotes the long-term interests of end users and the efficiency and international competitiveness of the Australian telecommunications industry. Industry self-regulation is encouraged. The key self-regulatory body is the Australian Communications Industry Forum which develops industry codes of practice. Codes may be registered with the Australian Communications and Media Authority. The Australian Communications and Media Authority may enforce registered industry codes, and may impose industry standards if self-regulation fails.

 

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Among a number of changes recommended by the Dawson Committee’s review of the Trade Practices Act, the Australian Government is considering whether to criminalise hard-core cartel conduct. A Bill to introduce these and other changes was introduced in 2005 but failed to pass the Senate. It is anticipated the Bill will be reintroduced in the in the Spring 2006 sitting of Parliament.

In late 2005, the Government amended legislation to permit sale of its remaining (controlling) shares in Telstra Corporation Limited. This legislation included a number of further amendments to the telecommunications regulations, including for the operational separation of Telstra. While these changes should assist the Australian Competition and Consumer Commission (“ACCC”) in exercising its powers under Parts XIB and XIC of the Trade Practices Act, it is not expected that these will create fundamental differences in regulatory outcomes.

Regulatory bodies

On 1 July 2005, the Australian Broadcasting Authority and the Australian Communications and Media Authority merged to become the Australian Communications and Media Authority. The Australian Communications and Media Authority oversees technical and consumer aspects of the industry. It is the primary regulator responsible for radiocommunications and telecommunications standards. The Australian Communications and Media Authority is responsible for managing radio frequency spectrum (under the Radiocommunications Act), managing carrier licensing, consumer and technical issues relating to telecommunications and for enforcing the Telecoms Act.

The ACCC is responsible under the Trade Practices Act for administering the:

 

  general competition law regime;

 

  consumer protection regime;

 

  industry-specific access regime under Part XIC of the Trade Practices Act; and

 

  anti-competitive conduct and record keeping rule regimes in Part XIB.

The Telecommunications Industry Ombudsman is an industry body established to provide a dispute resolution forum for complaints from consumer and small business users. All carriers are required to be members of the Telecommunications Industry Ombudsman which is funded through charges levied on its members.

Broadcasting matters are regulated principally by the newly formed Australian Communications and Media Authority under the Broadcasting Services Act 1992. The ACCC has responsibilities in this area in relation to mergers and acquisitions. The Government has announced proposals to remove existing statutory restrictions on certain cross-media holdings and as a consequence the ACCC may be asked to determine the competitive impacts of mergers that might be proposed following these changes.

The Minister for Communications IT and the Arts has significant powers under various statutory instruments to give directions to various statutory authorities and carriers to bring about particular outcomes within the compass of their office.

Declared services

Part XIC of the Trade Practices Act contains an industry-specific regime for access to “declared” telecommunications services. Services can be “declared” by the ACCC following a public inquiry. Certain services (notably domestic PSTN, PSTN OTA, GSM originating and terminating services (which have subsequently been varied) were deemed to be declared as at 1 July 1997. The ACCC has subsequently declared a number of additional services including:

 

  the unconditioned local loop service, local PSTN originating and terminating service and local carriage service;

 

  the ISDN originating and terminating services; and

 

  the analogue subscription television broadcast carriage service.

 

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Mobile services review

In March 2003, the ACCC announced that it would conduct a review of the regulation of mobile services. In June 2004, the ACCC determined that it would no longer regulate the mobile originating access service.

The ACCC determined in June 2004 that the MTAS will remain regulated until 30 June 2009. This decision was a “technologically neutral” declaration, as the terminating access service is declared irrespective of the form of mobile technology employed. Vodafone Network and Optus Networks Pty/Optus Mobile Pty Limited (together “Optus”) have lodged access undertakings with the ACCC in relation to the MTAS. The ACCC has rejected the undertakings and both Vodafone Network and Optus have appealed the ACCC’s decisions to the Australian Competition Tribunal. AAPT has applied to intervene in both proceedings. An outcome on both matters is expected later in 2006. AAPT, along with a number of other Australian telecommunications carriers, has notified disputes with Vodafone Network and Optus about the price of the MTAS. If the Competition Tribunal upholds the ACCC’s decision, AAPT can expect lower termination prices.

The ACCC’s mobile services review also considered the domestic originating access service and the mobile domestic inter-carrier roaming service. Neither service is to be regulated at this time, although the ACCC has decided to monitor the mobile domestic inter-carrier roaming service, through a Record Keeping Rule. It has released a draft Record Keeping Rule for consultation. AAPT will be subject to the rule.

Internet interconnection services

Internet interconnection is the manner in which ISPs connect to each other’s backbone networks and transfer internet traffic between each other. The ACCC conducted an inquiry into whether or not an internet interconnection service should be declared. In January 2005, the ACCC confirmed its draft decision not to declare internet interconnection services at this time, but it outlined a range of measures to monitor the industry for behaviour that might indicate the use and effect of market power through a Record Keeping Rule and disclosure direction under Part XIB of the Trade Practices Act. AAPT is one of the four largest ISPs in Australia to provide internet interconnection services. The Record Keeping Rule and direction apply to AAPT.

ISDN and Digital Data Access Services

In September 2004, the ACCC announced it would conduct a public inquiry to determine whether the declaration of the ISDN and Digital Data Access services should be maintained, varied or revoked. The ACCC issued its final report in June 2005. The ACCC has varied the declarations – they will only continue to apply to rural areas, after a transition period of 12 months in relation to central business district and metropolitan areas of the capital cities, to allow for a smoother transition to alternative technologies. At this stage, AAPT does not anticipate this decision will result in any reduction in its ability to competitively supply services in the data market.

Local Carriage Service

In 2005, the ACCC undertook a review of the Local Carriage Service declaration. It has decided to continue the declaration of the service for a further two years. It has also added an explicit amendment of the declaration to include wholesale line rental services and the consideration of a cost-based price rather than the existing retail-minus avoidable cost methodology.

Fixed Services Review

In 2006, the ACCC undertook a strategic review of fixed network services declarations. The ACCC’s final report was released in July 2006. The ACCC has determined that it will continue the declaration of the PSTN interconnect service and the unbundled local loop for a further three years.

 

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Regulation of industry participants

There is no limit on the number of carrier licences that may be issued by the Australian Communications and Media Authority. As a general rule, there is no time limit on a licence. Subject to the payment of an annual charge, a licence will continue in force until it is surrendered or cancelled.

As an alternative to obtaining a licence, a carriage service provider may operate network units by obtaining a “nominated carrier declaration” from the Australian Communications and Media Authority, which involves the nominated carrier assuming the licence responsibilities in relation to specified network unit(s) owned by a non-carrier.

Carriage service providers are not required to be licensed or registered but they must comply with the service provider rules contained in the telecommunications legislation, including compliance with minimum standards and, where they supply the “standard telephone service”, to provide un-timed local calls and directory assistance and to be members of the Telecommunications Industry Ombudsman scheme.

Content service providers are subject to only minimal regulation, under the Telecoms Act, but are subject to a wide variety of restrictions in relation to ownership and local content, among other things, under the Broadcasting Services Act.

AAPT has held a carrier licence since 1 July 1997 and is also a carriage service provider.

A number of other regulations apply specifically to Telstra, but have an impact on the remainder of the industry. Under the Telecom Standards Act, Telstra can be subject to price controls which are made by the Minister. On 27 February 2006, the Minister made a new price control determination covering the period 1 January 2006 to 30 June 2009. Under the new controls, a basket of line rental and calls has been limited to an absolute freeze in nominal terms, while residential line rental is limited to increase by CPI (which is also an absolute freeze in real terms). While these price controls still encourage Telstra to rebalance by reducing calling charges and increasing the line rental, the size of the changes will be relatively small and, of themselves, are likely to have minimal impact on AAPT’s competitiveness.

Competition

Anti-competitive practices in the telecommunications industry are subject to a general anti-competitive regime contained in Part IV of the Trade Practices Act and also to a telecommunications specific regime in Part XIB of the same Act. Under the “competition rule” in Part XIB, a carrier or carriage service provider will be held to have engaged in anti-competitive conduct if it has a substantial degree of power in a telecommunications market and takes advantage of that power with the effect, or likely effect, of substantially lessening competition in that or any other telecommunications market, or breaches certain other of the general competition law prohibitions in Part IV of the Trade Practices Act. A competition notice may be issued by the ACCC stating that a particular carrier or carriage service provider has contravened or is contravening the competition rule. Substantial financial penalties apply to a breach of the competition rule when a competition notice is in force.

Number portability

In Australia, local number portability has been available to all carriers since November 1999. Customers can now keep their local numbers when taking AAPT’s bundled consumer telephony service. Mobile number portability has been available since 25 September 2001. Portability of Freephone (1800) and National Rate (13) numbers has been available since November 2000.

In June 2005, the ACCC decided not to mandate portability for data network access service numbers.

 

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United States

Telecom is subject to the rules and policies of the United States’ Federal Communication Commission (“FCC”) related to its international telecommunications services. Pursuant to its authority under Section 214 of the Communications Act of 1934, as amended, the FCC originally granted Telecom authority to operate in the United States as a global reseller and facilities-based international carrier in December of 1996. In January 2003, Telecom consolidated its authorisations to provide international common carrier services in its wholly-owned subsidiary, Telecom New Zealand (USA) Limited.

Presently, the FCC regulates Telecom as a “dominant” carrier on the international routes between the United States and New Zealand and between the United States and the Cook Islands, and as a non-dominant carrier on all other international routes. As a dominant carrier between the United States, New Zealand and the Cook Islands, Telecom is required to provide services in the United States via its wholly-owned subsidiary, Telecom New Zealand (USA) Limited, which must maintain separate books and accounts from Telecom. Telecom’s United States subsidiary is also required to comply with certain reporting requirements in relation to its dominant carrier status, including the filing of quarterly traffic and revenue reports, circuit status reports and reports summarising the provisioning and maintenance of all basic network facilities and services procured from any foreign affiliated companies.

TELECOM’S PRINCIPAL ACTIVITIES AND APPROACH TO THE MARKET

Organisational Structure

Telecom is currently reorganising its organisational structure. The new structure is organised around customer groupings. This structure is described below. For financial reporting purposes, this structure was effective from 1 July 2006.

Telecom’s organisation comprises two primary retail operations – the Consumer and Business operations, as well as its stand alone Yellow Pages Group and international operations. These operations are supported by a centralised Technology and Enterprise operation and three corporate support units which provide advisory support to those operational units.

Consumer Operations

Consumer operations comprises two divisions:

New Zealand Consumer Division

The New Zealand Consumer division provides both fixed and wireless services to New Zealand consumer and home business customers. Services include voice, data and internet services. Services provided include fixed line and value-added services. The division provides New Zealand customers with national and international fixed calling services (including calls to mobile networks). Mobile calling, messaging and Wireless Application Protocol (“WAP”) data services are provided via the 027 (CDMA) and 025 (TDMA) mobile networks. Dial up and broadband internet services, value-added online services and advertising for New Zealand customers are provided within this division under the Xtra brand. Xtra is the largest ISP in New Zealand and operates the Xtra website in alliance with Microsoft Corporation.

Australia Consumer Division

In Australia, AAPT operates an integrated business providing a range of fixed line calling services including national, international, and calls to mobile; mobile calling and data services, and internet access products and services to consumers.

Business Operations

Business operations provides both fixed and wireless services to New Zealand and Australian business customers ranging from small enterprise up to large corporate.

 

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In New Zealand, services provided include fixed line, wireless and ICT services. Business Operations provides New Zealand customers with national and international fixed calling services (including calls to mobile networks). Mobile calling, messaging and WAP data services are provided via the 027 (CDMA) and 025 (TDMA) mobile networks. This division also provides 3G mobile broadband connectivity via PC data cards, private network management and IT services, including Telecom’s ICT services business operating under the Gen-i brand. Telecom’s online trading business, Ferrit, is managed within this operation.

Business operations also provides services to Australian and Trans-Tasman customers through the AAPT and Gen-i Australia brands. The largest customers are managed in a Trans-Tasman approach under the Gen-i Key Clients sub-unit.

Technology and Enterprises

The Technology and Enterprises operation provides technology and wholesale services to both New Zealand and Australian markets, including the provision and management of fixed and mobile network connectivity and IT applications. The technology sub-units are responsible for Telecom Group technology strategy, architecture and investment, operation of technology platforms and asset lifecycle management, shared capability and share services such as billing, provisioning and programme delivery. The wholesale sub-units (one each in New Zealand and Australia) are responsible for supply of wholesale network services (both regulated and commercial) to retailers.

Yellow Pages Group

Yellow Pages Group provides hard copy White Pages® telephone listings and Yellow Pages® advertising to New Zealand customers. Telecom also provides internet White Pages® and internet Yellow Pages®.

Telecom International

The International division operation provides calling and managed data services between New Zealand, Australia and other countries worldwide to New Zealand and Australian customers. This unit operates through switches in Sydney, Los Angeles, Tokyo, New York, Miami, Frankfurt and London supporting international traffic including “transit” traffic where Telecom is an intermediary carrier of international calls.

Corporate Support Units

Corporate Finance

Telecom’s Corporate Finance unit is responsible for investment and performance management, financial reporting, taxation and treasury compliance, credit management, investor relations, and other corporate finance-related activities. Telecom’s Video Services sub-unit is also managed within this division.

General Counsel and Public Affairs

Telecom’s General Counsel unit comprises the legal services, secretariat, internal audit, risk management, media, regulatory and public affairs areas.

Human Resources

Telecom’s Human Resources unit is responsible for recruitment, performance management, remuneration, employment relations, retention and development.

 

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PROPERTY, PLANT AND EQUIPMENT

Estate Assets

New Zealand

Telecom’s network-related property portfolio in New Zealand consists mainly of telephone exchanges, microwave radio stations, mobile phone sites, and multi access and other minor radio sites. Approximately 1,015 of these sites, the majority of which comprise telephone exchanges and radio stations, are owned freehold. In addition, Telecom occupies (primarily via leases, licences and easements) a further approximately 2,500 operational sites. A significant proportion of these are mobile phone sites.

The current net book values (as at 30 June 2006) for Telecom’s network related properties in New Zealand is approximately NZ$417 million, which includes land, buildings, building and engineering services and security infrastructure.

Telecom’s rights to access and maintain a significant proportion of its network plant linking these properties is dependent on statutory rights included in the Telecommunications Act.

The number of Telecom’s mobile phone sites occupied by Telecom is growing as Telecom expands mobile coverage and builds more capacity into the network.

Telecom’s New Zealand network property portfolio is mainly held by Telecom New Zealand, with some properties held by Telecom Mobile and other Telecom Group subsidiaries. However, the portfolio is managed by Telecom New Zealand’s Network Estate unit.

In recent years, Telecom has divested the majority of its obsolete depot sites and surplus telephone exchange land and buildings. In addition, Telecom continues to divest other surplus properties contained in its portfolio. When divesting properties Telecom is required to comply, among other things, with the offer-back provisions of the Public Works Act 1981. In most cases, however, such compliance has not had a material impact on the realisation value from the divestments.

For office accommodation, Telecom leases floors in 32 commercial office buildings in the main centres of New Zealand. In addition, Telecom occupies floors or part floors in 18 Telecom Exchange Buildings, in both the main cities and regional centres.

Australia

AAPT leases commercial premises in all major cities of Australia and certain regional centres for office accommodation, major network switch sites, call centre operations and signage.

Network Assets

New Zealand

In New Zealand Telecom operates an advanced telecommunications network supported by IS providing billing, customer service and operational support capability.

Transmission infrastructure

Telecom’s transmission infrastructure connects over 400 exchanges nationwide. Fibre optic transmission systems deliver 95% of Telecom’s transmission capacity. Over 900 radio systems, however, still serve remote rural areas, provide partial diversity, and have a significant role in Telecom’s disaster recovery plans. The transmission systems are primarily SDH based although some PDH remains in the low capacity parts of the network. Telecom’s core transmission routes use extensively DWDM.

Telecom has completed the deployment of a 10Gbps DWDM system to all the major urban and provincial centres in the country to support IP growth including broadband and managed data.

 

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During the past year Telecom has continued to migrate the inner core transmission network to a semi-meshed architecture to improve resiliency and survivability. In particular, Telecom has deployed 230km of optical fibre cable to close the lower South Island transmission ring (which includes Christchurch, Dunedin, Invercargill and Queenstown) enabling self-healing 2.5 Gbps SDH and 10 Gbps DWDM transmission systems will be deployed on the ring. Telecom is currently undertaking similar work in the North Island Bay of Plenty region (which includes Tauranga, Whakatane and Rotorua) and the central North Island region (which includes Taupo, Turangi and Waiouru). The latter will create a third long-haul network route through the centre of the North Island between Hamilton and Palmerston North.

Telecom also recently approved the introduction of multi-protocol transport that provides the capability to carry Ethernet and ATM on the SDH network. This new technology will dramatically increase nationwide Ethernet coverage to support IP-based products and services and to resolve the scalability issues Telecom faced on its ATM network. During the 2007 financial year, Telecom will deploy this technology in most major centres.

The Trans-Pacific Southern Cross submarine cable provides the majority of Telecom’s international transmission capacity. The international gateways are located in Auckland. Telecom still uses some geostationary satellite capacity to reach locations where undersea cables are not feasible.

Public Switched Telephone Network

Telecom provides fixed line and value-added fixed line voice services. The PSTN carrier grade network consists of various models of NEC New Zealand Limited’s NEAX circuit switches, which provide capability for trunk switches, local exchanges and remote switching sites. The PSTN services analogue lines, ISDN lines and Centrex lines. Smartphone services (or value-added fixed line voice services), which include call waiting and calling line identification, are available in most areas.

Telecom is planning the replacement of the PSTN network with an IP-based solution, via the NGN project which is discussed under “Item 4 – Telecom Strategy Overview” above.

ISDN

Telecom’s ISDN is a digital switched service and is capable of transmitting voice, video and data from one location to another. Telecom ISDN lines have the flexibility of the standard telephone network with additional high-quality, fast and reliable digital transmission. Telecom ISDN services are available in most areas.

Intelligent Network and messaging platforms

The Telecom Advanced Intelligent Network provides national and international 0800 and 0900 calling services. A Telecom 0800 number allows businesses to provide customers with a number they can call free of charge. Additional features available provide businesses with enhanced call management features. Telecom’s 0900 service enables businesses to provide information or a service over the phone in return for payment, using an 0900 number.

Telecom has a Sun Microsystems Unix-based server infrastructure that hosts Openwave MX Version 5 email application software and message stores. The platform supports approximately 600,000 Xtra email customers. It is expected to be upgraded in the next financial year with a new Sun Unix-based server infrastructure and deployment of Openwave MX Version 6 email application software.

Advanced voice-mail and fax-mail messaging services are provided by a Unisys Voice Services Platform. Telecom will, over the 2006 financial year, be implementing a replacement messaging platform to upgrade its voice messaging capability.

 

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Broadband access

Telecom operates a high-speed internet access service based on ADSL technology. In January 2003, Telecom commissioned Broadcast Communications Limited to build an open access network to enable it to provide a range of broadband and wireless services to rural customers who were beyond the reach of Telecom’s ADSL Xtra services. The network was completed in November 2003.

The Telecom broadband network is designed to provide two-way transmission for interactive services and high-speed data transfer in excess of 6Mbps using ADSL and in excess of 20Mbps when ADSL2+ technology is employed. ADSL is a broadband access technology that uses existing PSTN access infrastructure with products offering speeds of up to 8Mbps (download) and up to 1Mbps (upload).

Currently broadband is available to approximately 95% of Telecom’s customers. A symmetrical variant is also available at a majority of exchange sites to provide business services. The symmetrical variant SHDSL has products that offer up to 2Mbps both ways.

Telecom has extended its core and carrier grade IP networks to customer sites in metropolitan and some regional areas using fibre optic cables. Telecom delivers a number of IP and wide band ATM-based services on these fibre optic cables.

Telecom has completed construction of a pilot, Fibre to the Premise (“FTTP”), to serve around 400 customers in a Greenfield residential area in Manukau City, Auckland using a Broadband Passive Optical Network (“BPON”). The network is due to connect its first customer in late 2006. This network is capable of offering products with expected speeds of up to 30Mbps (download) and up to 5Mbps (upload). Larger Greenfield FTTP pilots are planned in the coming year.

Telecom is currently working on the introduction of an IP DSLAM (“ISAM”) to deliver its next generation of DSL services. It is planned to have these units installed in major metropolitan areas by December 2006. The introduction of the ISAM will result in the capping of deployment of the ATM based DSLAMs and the capping of growth on the ATM core network.

Data and IP Networks

Telecom operates a number of data networks including:

 

  public fixed data networks such as the ATM and DDN;

 

  Transaction Switching Networks (“TTS and ATS”);

 

  Switched Data network (“Pacnet”);

 

  Dial IP Platform (“IPNet”); and

 

  IP/MPLS Network.

Asynchronous Transmission Mode

Telecom’s public ATM network is comprised of switches located at 34 locations nationally, which support national coverage for site-to-site and multi-site WAN connectivity. The ATM network is the access aggregation for a number of IP-based services and DSL-based broadband services. It provides HS DDS, Frame Relay and ATM access connections from 64kbps to 2 Mbps (subject to available transmission capacity); and ATM access rates to 155Mbps (subject to available transmission capacity).

Digital Data Network

The DDN has 14 national switch sites and provides dedicated secure site-to-site transmission at speeds from 1200bps up to 2Mbps using the DDS. This network has extensive coverage with more than 700 PoPs for both retail and wholesale products. It also acts as a backbone to support the Pacnet and Transaction networks described below.

Telecom’s retail customers use ATM, Frame Relay and DDS to build wide-area corporate data networks. Wholesale customers use these networks as a key element of their own retail offerings.

 

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Pacnet

Telecom’s Pacnet is a public packet switching data network which has switches at three locations and access equipment at six sites. The network supports a wide range of X.25 and serial databased applications, and acts as the backbone for the two National Transaction Switching Networks.

Telecom Transaction Service

The TTS is a specialist network that provides dedicated and dial-up access in a secure environment suitable for electronic funds transfer between merchants and their chosen service provider.

Alarm Transport Service

The ATS is a specialist network for transmitting fire alarms from commercial buildings to the New Zealand Fire Service. The network has PoPs at 125 sites within New Zealand.

Dial IP

Telecom’s Dial IP platform provides dial-up access from the PSTN to ISPs for internet access and acts as a dial-up access for VPN access.

IP/MPLS

Telecom has embarked on an investment programme to build a large scale IP/MPLS-based network that, over time, will provide the connectivity backbone for virtually all of Telecom’s future services. The first stage of development has involved expansion of the network footprint, with Juniper IP Edge router coverage being provided in the main metro and provincial centres. Telecom has also invested in a dedicated IP Core and corresponding investment has been made in underlying transport and IS systems.

This network provides the capability to deliver Telecom’s flagship “One Office” IP data services for corporate customers and has been used for backhaul of core data traffic for other services such as broadband and dial IP. Further investment is being made to deliver end-to-end quality of service and support Multi-Service Single Access delivery models, whereby multiple services will be delivered over a single physical access, including voice, data, internet and other services.

Telecom also has a number of dedicated Juniper IP routing platforms for:

 

  point-to-point protocol authentication and rate limiting;

 

  termination of Layer 2 Tunnel protocol; and

 

  termination and routing of traffic using the IPsec protocol.

Legacy data network services will migrate to this new network and the older networks (such as DDN) will be retired in their existing format. With that in mind, objective closure dates have been established for the older of these networks.

Mobile networks

Telecom offers pre-paid and post-paid mobile phone services with a TDMA (AMPS/D-AMPS) mobile network and a CDMA mobile network. Telecom operates a CDMA 1xRTT mobile network in New Zealand offering both voice and packet data services. It is expected that the existing TDMA cellular network will continue to operate until March 2007.

In 2003 Telecom outsourced the development and maintenance of the CDMA network to Lucent. The TDMA network is managed by Ericsson Communications Limited.

The CDMA network was upgraded during the financial year ended 30 June 2005 to support CDMA EV-DO to provide high-speed wireless packet data service in New Zealand metropolitan areas and holiday locations, and an expansion of EV-DO coverage to all major towns and cities in New Zealand

 

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was completed in the year ended 30 June 2006. Telecom has announced that it will commence further upgrading the data capabilities of the CDMA network to the Rev-A standard in the year ended 30 June 2007.

Cross border leases

Telecom has entered into several cross border leases in respect of telecommunications assets including certain parts of digital telephone exchanges, digital transmission systems, the Intelligent Network, IP & ATM Data equipment and CDMA equipment. These cross border leases are treated as finance leases, and limit Telecom’s ability to sell or sub-lease the equipment, but do not affect the day-to-day running and management of the network or services Telecom provides to its customers.

Billing systems

Telecom is continuing the upgrade of its billing systems having implemented Intec’s Intermediate and Singl.eView systems for mediation and rating. The first stage of this implementation also involving an eServ Global UAS prepaid mobile solution was completed in early 2005. Further products will continue to be migrated to the new systems in 2006 and 2007. New online bill presentation and analysis systems are also being introduced in 2006. The CallVision product from VeriSign has been implemented in mid 2006 as an online bill analysis tool for businesses. Work is in progress to move invoice printing to the Autograph print platform with EDS in mid 2007. The ICMS billing system is expected to remain in operation as the new billing environment is progressively rolled out.

Fulfil systems

The fulfil capability is based on a number of systems interlinked to provide provisioning capability for customers of PSTN data and IP services. Main systems used are ICMS and AxiOSS from Axiom.

Assurance systems

The service assurance capability is based on a number of systems that provide both network and customer monitoring capability. The main systems used are Proviso and Netcool from Micromuse Inc.

Network management

Telecom’s network is managed through a number of management systems which monitor the network, record network traffic flows and rearrange network capacity, as necessary. This has been advanced by the addition of management systems for the Multi Service Core network and IP-VPN services based on Netcool’s policy-based network management system. Existing deployed network systems include the Alcatel 5620 for ATM and DSL network management and Dorado Redcell for element management of the core IP network nodes.

Customer Relationship Management systems

The CRM system Telecom uses is based on ICMS and other systems (for example, Vantive and Oracle for data warehousing). This has been enhanced to allow for improved access to customer information for customer services representatives using Graham Technology’s GTx workflow system. Telecom is currently replacing its Vantive applications with new solutions, owing to Vantive now being an end-of-life product, and enhancing the capability of its core enterprise data.

Online environment

Telecom operates several online environments, including those operated by:

 

  Telecom, which is the main sales and service portal for all wireline and mobile services;

 

  Xtra (in partnership with Microsoft pursuant to an agreement that is due to expire on 31 December 2006), which is a consumer portal of the Xtra ISP and incorporates a large email infrastructure;

 

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  Yellow Pages Group (White Pages® and Yellow Pages®), which is Telecom’s online directory listing and service portal;

 

  Gen-i, which is Telecom’s sales and service portals for its ICT consultancy, hosting and contact centre arm; and

 

  AAPT, which is the main sales and service portal for all wireline and mobile services in the Australian market.

In addition, Telecom operates the WAP Portal, which is a news and information portal, with mobile content download facilities, for WAP-enabled devices. Telecom also has an intranet which provides support services to Telecom staff. Vignette Content Management is used for managing content for a significant (and increasing) number of these online environments.

Desktop environment

Gen-i supports Telecom’s desktop infrastructure. Telecom retains control over its desktop assets and finances its desktop requirements through leasing arrangements with Alltech Finance NZ Limited and RentWorks Limited.

General IS infrastructure

Telecom’s main technology suppliers are Oracle for database management systems, Microsoft Corporation for desktop tools, IBM for hardware and middleware, Sun Microsystems for hardware and online systems, SAP for financial and ERP (or Enterprise Resource Planning) systems and HP/Compaq for file and print platforms.

Supplier relationships

In 1999, Telecom outsourced the operation of its information services systems to EDS. In addition, in 2002 outsourcing arrangements were established with Ericsson for the operational management of the TDMA network.

Telecom has long-term supply relationships with various equipment suppliers for equipment installed in its network. These suppliers include NEC New Zealand Limited, Nokia NZ Limited, Cisco Systems Inc., Lucent, Ericsson, Alcatel and Marconi Pty Limited.

To jointly manage the development and integration of the NGN, in June 2002 Telecom and Alcatel entered into a strategic partnering relationship. Telecom and Alcatel have agreed to work together to migrate Telecom’s current voice and data networks to an IP network in New Zealand and to integrate that network with Telecom’s core network in Australia. Alcatel is the primary supplier to Telecom of Alcatel and third party sourced network equipment to provide new services in New Zealand. In July 2003, Alcatel took increased responsibility for the management of Telecom’s network planning, development and operations services in New Zealand and Australia.

In 2003, Lucent signed a five-year agreement with Telecom in which it agreed to manage Telecom’s network planning, design, implementation and operational services for Telecom’s CDMA network in New Zealand including all support and maintenance.

Australia

AAPT operates a large national voice and data telecommunications network, supported by IS for internal and external customers, billing and operational service and management.

Transmission Infrastructure

AAPT has acquired high bandwidth transmission capacity on SingTel Optus’ National Backbone Network (“NBN”) linking Cairns, Brisbane, Sydney, Canberra, Melbourne, Adelaide and Perth. SingTel Optus has also provided 42 regional drop-off points and these are linked with AAPT’s regional PoPs.

 

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The NBN consists of two pairs of dark fibre with full geographic diversity along coastal and inland routes between Brisbane and Melbourne. The fibre pairs are lit with STM64 SDH equipment terminating in dual AAPT Central Offices, except in Perth where a single Central Office exists. AAPT has the option under the NBN contract to upgrade the STM64 capacity to DWDM using the existing fibre pairs. The remaining term of the NBN contract is 19 years. The AAPT regional drop-off points are supported with STM16 capacity using SDH add/drop multiplexers.

NBN capacity between Brisbane and Cairns is covered under a 10 year agreement of which 5 years remain and is made up of 2xSTM1 between Brisbane and Cairns.

In 2003 to achieve geographic diversity between Melbourne, Adelaide and Perth, AAPT acquired additional lease capacity of 2xSTM64 from Telstra for the NBN along the west coast, of which one is currently in use. The NBN covers a geographic route distance of approximately 5,900 km along the coastal route and approximately 6,500 km along the inland route.

In 2005 AAPT acquired additional high bandwidth capacity of 2.5 Gbps on Telstra’s DWDM network to support traffic growth on the MPLS platform on the Sydney to Melbourne coastal route. In Tasmania, 155Mbps of capacity was acquired in 2003 linking Hobart, Launceston and Melbourne.

A new Telstra inland Sydney-Melbourne NBN STM16 service was activated in January 2006 and a new Optus coastal Sydney-Melbourne STM16 for diversity was activated in March 2006.

Public Switched Telephone Network

AAPT’s voice network consists of nine major switching sites and a site located in Sydney for technical development and testing purposes. These switches have full Class Five switching functionality but act mainly as Class Four functions for national and international connectivity. The voice switches also provide local number portability functionality using an internal Intelligent Network function.

In addition, AAPT has a presence in all 66 call collection areas in regional cities and towns throughout Australia. These PoPs are interconnected with a number of Australia’s national and international carriers.

Intelligent network

AAPT’s Intelligent Network uses Alcatel Service Control Points in Sydney and Melbourne. The Intelligent Network provides toll-free numbers (i.e. 1800, 13 and 1300), presence and VPN end-user services, as well as Mobile Number Portability and Inbound Number Portability services.

AAPT uses Alcatel’s Signal Transfer Point system for signalling within AAPT’s PSTN, Intelligent Network and for signalling to other carriers’ networks.

Broadband access

AAPT operates various broadband accesses using optical fibre, DSL, point-to-point microwave, LMDS and Gigabit Ethernet. These services are available in Australian states’ metropolitan capital city areas.

In 2002, AAPT commercially launched a high bit-rate ADSL service from 22 Australian PoPs. The service provides high-speed internet access to the central business districts in Australia’s capital cities. In 2003 the platform was upgraded to provide 2 Mbps PRA capability over SHDSL technology. Additionally, AAPT has 19 LMDS hubs providing broadband wireless services and 345 fibred buildings providing broadband connectivity to business customers. SDH, Fast Ethernet and GB Ethernet technologies are available at these sites.

AAPT has 106 network fibred sites nationally consisting of central offices, PoPs and PoIs.

In addition to its national inter-capital backbone, AAPT has central business district and metropolitan fibre networks in all of Australia’s capital cities, consisting of approximately 1,205 km of its own and leased fibre cables. Additionally, AAPT has a total of 820 SDH nodes and 19 Metropolitan Ethernet aggregation switches.

 

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Data and IP network

AAPT’s nationwide data and IP network consists of an MPLS Core, MPLS Edge, ATM/Frame Relay and Regional Frame Relay infrastructure for its data network in addition to the Router infrastructure deployed to provide internet services. The MPLS Core is used for transport of both internet services and the newer IP-VPN services. The ATM/Frame Relay network provides Frame Relay services and aggregation of LMDS, DSL and third party provided.

AAPT is classified as a tier one ISP with peering agreements in place with all major tier one carriers in Australia.

AAPT recently upgraded the access distribution IP network providing higher bandwidth and increased network redundancy to the MPLS Core. This upgrade was in line with Telecom’s NGN investment plan, which will implement an IP-based multi-service network. AAPT expects to be able to offer multiple services over a single access including voice, data, internet and other services in the NGN, when it becomes available.

Hosted VoIP

AAPT completed its investment in the BroadSoft platform, which is a hosted VoIP platform, in 2002. The BroadSoft platform enables AAPT to host and manage customers’ telephony services using IP. This will allow AAPT to further leverage off the capabilities of the former “Connect Internet Solutions” ISP network (Tier 1 ISP capability), now fully integrated into the AAPT network.

Information Systems infrastructure

AAPT’s IS consists of billing, provisioning and CRM.

AAPT’s key billing platform, namely “MEGA”, is an IBM-based mainframe with “DB2” database (other billing platforms include but are not limited to Revchain, Singl.eView, ASM, JBill, InBill). The Business Integrated Operation Support Systems (“BIOSS”) manage network and customer provisioning. The system is based on Sun with an Oracle database, which supports AAPT’s customer care, service, development and operations, and network and systems management processes.

AAPT uses a number of CRM modules to support its customer relationships, these are SalesForce.com, SmartCafe, Self Service Web, SmartChat, E3 and FORTE.

An extensive set of applications support customer calls into the call centres, namely WITNESS, Launcher, Genesys, Softphone and TCP Dialer.

General IS infrastructure

AAPT’s main technology suppliers are Oracle for database management systems, Microsoft Corporation for desktop tools, IBM for hardware and middleware, Sun Microsystems for hardware and online systems, SAP for financial and ERP systems and HP/Compaq for file and print platforms.

Network Management

InfoVista is used to measure and report on end-to-end service performance for IP-VPN traffic on a customer-by-customer basis. It reports on the core, edge and customer premises equipment.

Online Assets Register or Neptune

Network Enhanced Prequalification Tool Using Next Generation Environment, or Neptune, is AAPT’s online asset recording and qualifying tool based on “Map Info” systems. The system records AAPT’s

 

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geographical network assets. The system is also used internally by sales force and communication consultants in qualifying AAPT’s presences, service availability and capacity.

International

Telecom’s international network has been designed to maximise the performance and delivery of telecommunications services from its customers in New Zealand and Australia to the rest of the world. Telecom is connected to approximately 510 international telecommunications companies via international submarine cable systems and satellite links. The international network is 100% digital.

Telecom has entered into a conditional agreement, dated 17 August 2006, to dispose of its 90% shareholding in Telecom Samoa Cellular Limited. The disposal is scheduled to complete on or about 21 September 2006.

Cable systems

Telecom is a cable owner, or a purchaser of capacity, in most Pacific and Asian cable systems including:

 

  TASMAN 2, linking Australia and New Zealand;

 

  SEAMEWE 3, linking Japan through South East Asia, via the Middle East to Western Europe, with a link from Singapore to Australia;

 

  PacRimEast, from New Zealand to Hawaii;

 

  APNG-2, from Sydney to Papua New Guinea;

 

  Trans Northern Pacific via TPC 5 China-US and Japan-US;

 

  Around Asia on APCN and JASURAUS;

 

  Trans Northern Atlantic on Atlantic Crossing cables AC-1 and AC-2; and

 

  Trans Pacific on the Southern Cross Cable Network.

In 1998, Telecom joined with SingTel Optus and WorldCom (now Verizon) in an investment to build and operate the Southern Cross Trans-Pacific submarine optical fibre cable, linking Australia, New Zealand, Fiji, Hawaii and the West Coast of the United States. Southern Cross provides international capacity for growth of traffic generated by data services, including internet traffic, and commenced operations in November 2000. Telecom has a 50% equity investment in Southern Cross Cables Limited.

Satellite services

Telecom owns satellite earth stations at Warkworth, Waitangi, in the Chatham Islands and Scott Base in Antarctica, which are operated by Broadcast Communications Limited. These satellite earth stations provide telecommunications services via Intelsat and PANAMSAT to destinations not generally served by international submarine cable systems.

Global Gateway Internet Service

Global-Gateway-Internet-Service is Telecom’s managed IP Internet access service enabling access for New Zealand and Australian wholesale and retail customers (business and consumer) to global Internet services via its international links (primarily cable systems).

Points of Presence

Telecom operates PoPs in Australia, the United States, the United Kingdom and Japan to obtain better options for its Australian and New Zealand retail customers, while generating new business with carriers seeking competitive wholesale pricing into Australia and New Zealand and the rest of the world.

Telecom’s PoP in Los Angeles switches international wholesale telephony minutes. Trans-America links also enable Telecom to meet wholesale carriers in New York, Miami and San Jose. Other value-added services such as international leased services and private network offerings can be supported from these facilities.

 

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Telecom’s PoP in Sydney supports international leased services and private network offerings into Australia. These value-added services are supplied Trans-Tasman in support of Australian and New Zealand corporate customers.

Telecom’s PoP in London has voice and data service capabilities. Access from London to the Frankfurt market further extends Telecom’s reach into the emerging Central and Eastern European wholesale voice markets.

Telecom’s PoP in Tokyo enables it to service the northern Asia area. This PoP has only wholesale voice service capability at this time.

Spectrum Assets

Telecom currently holds spectrum rights as detailed under the heading “New Zealand Regulation - Radiocommunications Act” above.

In addition AAPT holds the following spectrum property rights:

 

  spectrum licences until 2013 in the 800 MHz AMPS A band. AAPT holds 5-10 MHz of spectrum across most of Australia (except Sydney, Melbourne and remote central Australia); and

 

  spectrum licences until 2014 in respect of 1150 MHz of LMDS spectrum in the bands 27.5 -28.35 GHz and 31.0-31.3 GHz across all of Australia.

Further detail regarding Telecom’s spectrum assets is contained under the headings “New Zealand Regulation” and “Australia Regulation” above.

Environmental issues

Telecom is subject to certain environmental requirements which can impact on the installation, maintenance, operation and upgrade of its fixed assets. Environmental issues arise in respect of:

 

  the storage and transportation of dangerous goods;

 

  noise levels from equipment cabinet cooling fans;

 

  the visual impact of network structures;

 

  emissions to air from engine alternators;

 

  radio frequency emissions from mobile phone sites; and

 

  the disposal of redundant equipment.

Telecom seeks to minimise the potential adverse environmental impacts associated with its New Zealand operations through a Networks Environmental Compliance System, which is overseen by its Environmental Manager. Audit processes and compliance action tracking are in place to mitigate the potential for significant environmental impacts.

In Australia, Telecom does not operate the main telecommunications network nor operate a mobile network. Redundant equipment is disposed of through appropriate recycling agencies, including the possibility of reuse for some computer equipment.

There are currently no significant environmental issues that prevent Telecom’s utilisation of its network or network integrity. Managing the environment is important to Telecom’s long-term success and Telecom strives for high standards in technology, operations efficiency and relationships with communities.

PARTNERING ARRANGEMENTS

Alcatel New Zealand Limited

Telecom and Alcatel entered into a strategic partnering relationship in June 2002 to manage the development and integration of the Trans-Tasman IP-based multi-service NGN. Telecom and Alcatel

 

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have agreed to work together to migrate Telecom’s current voice and data networks to an IP network in New Zealand and to integrate that network with Telecom’s core network in Australia. Alcatel will be the primary supplier to Telecom of network equipment to provide new services in New Zealand. Since July 2003, Alcatel has taken increased responsibility for the management of Telecom’s network planning, development and operations services in New Zealand and Australia.

Broadcast Communications Limited

In January 2003, Telecom signed an agreement with Broadcast Communications Limited by which Broadcast Communications Limited agreed to build an open access network to enable Telecom to provide a range of broadband and wireless services to rural customers who were beyond the reach of Telecom’s ADSL Xtra services. The network was completed in November 2003.

Lucent Technologies (NZ) Limited

In June 2003, Lucent signed a five-year agreement with Telecom in which Lucent agreed to supply Telecom with CDMA network products and services and to manage Telecom’s network planning, design, implementation and operational services, including all support and maintenance in relation to Telecom’s CDMA network in New Zealand.

Sky Network Television Limited

In July 2003, Telecom entered into a reseller agreement and a retransmission agreement with Sky Network. Under the retransmission agreement Telecom is able to retransmit Sky Network programming over Telecom’s network. Under the reseller agreement Telecom can resell Sky Network services to domestic customers and to commercial customers with Sky Network’s consent. Sky Network and Telecom have agreed that in 2007, they will consider a renewal of the agreements, however, there is no obligation on either party to renew.

EDS (New Zealand) Limited

In 1999, Telecom outsourced the operation of its information services systems to EDS as part of a 10-year IT services agreement. In 2002, the term of the original agreement was extended by a further three-years and Telecom relinquished its 10% shareholding in EDS. Additionally, Telecom and EDS agreed changes to align the outsourcing agreement with Telecom’s business requirements including, in June 2004, the implementation of fully contestable application development and maintenance services, and in January 2005 the introduction of a similar construct for facilities management services. The EDS outsourcing agreement for Australia replicates that for New Zealand, except that EDS does not provide application development and maintenance services in Australia.

Microsoft Corporation

Telecom, through its subsidiary Xtra, has entered into a licensing agreement to provide certain Microsoft services via the Xtra website. This agreement was recently extended until 31 December 2006 pending a full review of Telecom’s partnering agreements for its Xtra portal website. Gen-i is also a vendor of Microsoft products.

Sprint Nextel Corporation

In 2003, Telecom and Sprint entered into a Master Services Agreement (“MSA”) where they agreed to collaborate on procurement, marketing and service development initiatives for products and services relating to their respective CDMA wireless networks. In August 2006, Telecom and Sprint entered into a new Contract Order (pursuant to the 2003 MSA) agreeing to expand the scope of collaboration beyond wireless networks to include WiMax technology. The level of collaboration has also been expanded to include joint planning, development and procurement across 4 key areas as they relate to CDMA and WiMax. These 4 key areas are terminals, infrastructure (network and IT), content and products. The term of the Contract Order is for a minimum of 3 years and the objective is to align (as much as possible) product planning, development and deployment in order to improve Telecom’s time to market and to secure more advantageous terms from vendors (including price).

 

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These arrangements with Sprint have enabled Telecom to be more competitive than it would otherwise have been.

Hutchison Whampoa Limited

In June 2006, Telecom and Hutchison Whampoa agreed to terminate their existing partnering arrangements and enter into a new five year services agreement. Under the new agreement the parties agree to share information in relation to UMTS business operations and Telecom can participate in Hutchison group brand and strategy forums.

 

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Item 4A. Unresolved Staff Comments

Not applicable.

 

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Item 5. Operating and Financial Review and Prospects

This “Item 5 - Operating and Financial Review and Prospects” section should be read in conjunction with the consolidated financial statements and related notes included in Item 18.

The following discussion of Telecom’s performance information uses financial data prepared in accordance with NZ IFRS, which differ in certain respects from US GAAP. Information relating to the nature and effect of such differences is presented in Note 37. Critical accounting policies and other material matters impacting Telecom’s reconciliation of certain financial measures to US GAAP are discussed in this section.

All monetary amounts in this “Item 5 - Operating and Financial Review and Prospects” are presented in NZ dollars unless otherwise indicated. In this Item 5 reference is made to the financial years ended 30 June 2006 and 30 June 2005 as 2006 and 2005 respectively. The period encompassing both the 2005 and 2006 financial years is referred to as “the two year period”. The financial year ending 30 June 2007 is referred to as 2007.

This “Item 5 - Operating and Financial Review and Prospects” is organised as follows:

 

  Executive Summary – a high level overview of the key trends and developments highlighted in this Item 5.

 

  Principal Factors Impacting Telecom’s Results and Key Trends – a description of the principal factors and key trends impacting Telecom’s operations and financial results during the two year period.

 

  Critical Accounting Policies – a discussion of the accounting policies that require critical judgments and estimates in the course of preparing Telecom’s financial statements.

 

  Consolidated Results of operations – an analysis of Telecom’s consolidated results of operations during the two-year period.

 

  Segmental Results of operations – an analysis of results for each of Telecom’s business segments.

 

  Liquidity and Capital Resources – an analysis of cash flows, sources and uses of cash, contractual obligations and matters affecting Telecom’s debt.

EXECUTIVE SUMMARY

Telecom’s operating results for 2006 largely reflected the evolution of significant trends evident in 2005 performance as a result of important changes occurring in its business. Operating margins continue to contract, as revenue from Telecom’s high margin traditional calling business declines and is replaced by growth in broadband, mobile and IT services revenue, which are generally lower margin. Earnings from Telecom’s Australian operations have fallen substantially as a result of negative industry factors which have led to substantial write-downs in the carrying value of Telecom’s Australian operations.

Recent financial performance and operating trends will, however, prove a less reliable guide to future performance, once proposed regulatory changes in New Zealand begin to take effect. In May 2006, the New Zealand Government announced a comprehensive set of proposed changes to telecommunications regulation. These changes include proposals to extend the range of regulated wholesale broadband services and introduce LLU to the New Zealand marketplace. In addition, the Government has recently scheduled reviews of mobile market regulation, and signalled an intention to conduct a review as to whether some form of operational or structural separation model for Telecom is warranted. Telecom has voluntarily proposed a form of operational separation and is beginning to implement this, however, it is possible that the Government may require a stronger form of operational separation, or even structural separation once it has completed its review.

The Telecommunications Bill was introduced to the New Zealand Parliament on 29 June 2006, and at this stage it is too early to predict final outcomes regarding key pricing and service requirements. Telecom expects the process of finalising the legislation and implementing the detailed recommendations to take the majority of the 2007 financial year. While the legislative and regulatory timetable suggest that many of the direct effects of the new regulatory regime may not be felt until the

 

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2008 financial year, Telecom will seek to proactively reset its strategies to reposition itself for the new environment. These strategies will directly impact capital and operating plans in 2007.

The ultimate financial impact of the new package of regulation proposed by the New Zealand Government is uncertain, as a significant portion of the impact is dependent on the pricing decisions and terms of access to regulated services that are yet to be clarified. Once regulatory settings are clarified, Telecom expects further pressure on revenues and margins as a result of increased competition. The requirement for LLU and naked DSL is likely to lead to some loss of market share in access, calling and broadband, which would negatively impact these revenue lines. Proposals for mobile regulation may also result in intensified competition in the mobile market, negatively impacting mobile revenues and margins.

In light of the various market and industry pressures that Telecom is facing, particularly regulation, competition and technology, Telecom’s operating earnings would be expected to decline steadily over the next five years without a change in strategies. In response to this, Telecom is in the process of developing the NGT programme, which aims to reduce costs and increase capital efficiency through simplification of Telecom’s product set; its approach to marketing, sales and customer service; its network infrastructure, and its internal organisational structure. Telecom currently expects to have the majority of customers on NGT offers by December 2015.

Financial results for Telecom’s New Zealand operations in 2006 reflected the ongoing change in revenue mix being experienced by Telecom, with decreasing revenues from higher margin traditional fixed line telephony services, offset by increasing revenues from other products and services, particularly mobile, broadband and IT services. These newer revenues generally yield lower margins than traditional fixed line services.

Traditional fixed line revenues are being eroded as a result of pressure on both prices and volumes owing to increased competition and regulatory activity coupled with product substitution, as mobile, email and internet are increasingly being used by customers as substitutes for fixed line calling.

Telecom’s drive into areas of growth is leading to increased operating costs as Telecom invests in retaining, migrating and acquiring customers for new services, particularly mobile and broadband.

Telecom has also recently launched a scoping study of its New Zealand directories business (Yellow Pages Group), which will consider options for this business including the possibility of full or partial sale. If a sale of this business were to eventuate, this would impact Telecom’s future financial results through the removal of a high margin revenue stream (in 2006 directories revenue was $248 million), although any sale would therefore be expected to generate significant sale proceeds.

Within Telecom’s Australian operations, several significant negative trends have emerged that have resulted in a substantial downturn in reported financial results. Retail prices continue to decline across all products, while wholesale prices have risen sharply following revisions to key supplier arrangements. This has resulted in a substantial decline in margins. These negative trends have been exacerbated by a deferral of project expenditure by Telecom’s enterprise customers. As a result of the revisions to key supplier arrangements, AAPT is currently managing a number of disputes with Telstra, its competitor and principal supplier of wholesale services. Final resolution of the disputes could have a further adverse impact on ongoing earnings. These factors have resulted in a substantial decline in the fair value of Telecom’s Australian operations and, accordingly, impairment charges totalling $1,301 million were recognised in 2006. Following these impairment charges, Telecom’s Australian operations had a remaining carrying value of A$270 million at 30 June 2006.

Pressure on the earnings of Australian operations is expected to continue in 2007. Wholesale arrangements with Telstra remain unresolved and retail price erosion is expected to continue due to competitive pressures. Telecom is continuing to invest significant capital expenditure in Australia as part of a programme to redesign the business model aimed at restoring the profitability of Telecom’s Australian operations (forecast capital expenditure for Australian operations for 2007 is NZ$145 million, an increase on capital expenditure of NZ$131 million in 2006). If this programme is unsuccessful it is possible that further impairment write-downs in respect of Telecom’s Australian operations will occur.

 

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Despite this, operating cash flows have remained robust through the two year period and following a sustained period of debt reduction, Telecom was able to increase its dividend distributions in 2006 while still maintaining a stable level of debt.

In the short term, Telecom expects:

 

  the shift in revenue mix from traditional fixed line products to products such as mobile, broadband and solutions will continue, potentially exacerbated by changes in the regulatory environment, with resulting continued contraction in margins;

 

  operating costs will continue to be negatively impacted by growth in marketing, acquisition and service provisioning costs resulting from targeted growth in the broadband customer base;

 

  the rate of growth in the mobile subscriber base will slow as mobile penetration approaches 100%. Mobile revenues are also likely to be impacted by pending regulatory reviews;

 

  as a result of the above factors, operating earnings for Telecom’s New Zealand operations are expected to moderately decline in 2007;

 

  competitive conditions in Australian operations are expected to remain challenging and, accordingly, Telecom does not expect an improvement in operating results for Australian operations in 2007 (excluding the impact of depreciation and amortisation);

 

  depreciation and amortisation expense for 2007 will decrease significantly as a result of the write-down of Australian operations in 2006;

 

  increased capital expenditure reflecting upward pressure as a result of the multi-year transition to the NGN and other growth initiatives in both New Zealand and Australia; and

 

  the decline in interest expense that previously resulted from declining debt levels during a period of debt reduction will cease in light of debt levels that are now stable, and are expected to remain so.

PRINCIPAL FACTORS IMPACTING TELECOM’S RESULTS AND KEY TRENDS

The principal external factors that have impacted Telecom’s result of operations in the two-year period are set out below. In response to these factors, Telecom is in the process of developing the NGT programme to enable the organisation to better service its customers and continue to generate satisfactory financial results in the new environment in which it operates. NGT and its potential impact on Telecom’s future financial results are discussed at the end of this section.

Increasing Regulation

The regulatory environment has had a significant bearing on Telecom’s results, particularly within its New Zealand operations. The impact of regulation on Telecom’s results will increase substantially with the comprehensive set of changes to industry regulation embodied in the Telecommunications Bill, which is currently before Parliament. Much of the extent of the impact will depend upon key pricing and service requirements, which are not yet known, though the overall impact on Telecom’s future financial results is expected to be negative. In the interim, however, Telecom will seek to proactively revise its strategies to prepare for the new environment. Specifically, Telecom intends to:

 

  increase the level of investment and service offerings designed to attract high value customers to integrated service packages;

 

  further address the efficiency of current business processes; and

 

  accelerate the introduction of the NGT business model. This model is a longer-term programme designed to fundamentally reduce the operating cost structure of the future business by greatly simplifying consumer and business offers and the construction of a next generation access network with related enhancements in service, provisioning, and product development capability. This is discussed further at the end of this section.

Telecom also proposes to implement a form of operational separation as a response to the new regulatory environment. The proposed model would operationally separate Telecom Wholesale from the retail business units, and reinforce the separation with legally binding undertakings, independent and auditable oversight, and other structural changes designed to support non-discriminatory treatment of competitors. As part of its package of regulatory change, the New Zealand Government

 

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is currently considering operational separation options. It is possible that the Government could determine that a more onerous form of separation than that proposed voluntarily by Telecom, even structural separation, should be mandated. This could impose additional costs on Telecom’s operations and impair its competitive position. For further information on this see “Item 3 - Risk Factors” and “Item 4 - Market Overview - New Zealand Regulation”.

Competitive Environment

Within its New Zealand operations, Telecom is subject to competition from subsidiaries of large foreign corporations (principally TelstraClear in the fixed line market and Vodafone in the mobile market) as well as a number of smaller local competitors. As the incumbent in the market, Telecom has traditionally had a large share of the markets in which it operates. Since deregulation of the telecommunications industry in New Zealand, competition has intensified, eroding Telecom’s market share. Competition has remained strong throughout the two-year period, putting downward pressure on service pricing across all sectors of the market and increasing the cost of acquiring and retaining customers.

As a result of the package of regulatory changes currently being developed by the New Zealand Government, competition in the New Zealand market is expected to increase. Competitors will have increased access to Telecom’s fixed line network and will be able to offer products such as naked DSL that will potentially sever or significantly curtail Telecom’s fixed line access relationship with existing customers. Increased competition in mobile services may also result from governmental reviews of this market.

Within its Australian operations, Telecom has a very small share of the overall telecommunications market. Competition from larger competitors has restricted Telecom’s ability to acquire new customers, particularly in the corporate and large business sector, and has also put significant downwards pressure on prices.

Technological Change and Product Substitution

The evolution of communications technology is an ongoing trend. This is resulting in changing customer behaviour and giving rise to new competitive challenges. Traditional fixed line telecommunications services are increasingly being replaced by new IP-based technologies, which provide cost advantages and the ability to offer new value-added services. The level of acceptance and demand for new value-added services (and the resulting pricing models) are, however, still subject to uncertainty. There is also an increasing substitution from fixed line to mobile services, given the greater flexibility that mobile communications offers users.

These trends are significantly impacting revenue growth rates for different products, and the capital expenditure decisions that operators must make to address the shifts in the market. These capital expenditure decisions are long-term in nature and uncertainties and opportunities exist during the transition to this new business model. Operators must balance the pursuit of new technologies and operating models with the need to maximise returns from existing infrastructure.

Industry Convergence

There is increasing convergence between the telecommunications and IT sectors as technological changes see telecommunications and IT services become enmeshed, particularly in the corporate and business segments of the market. This is resulting in telecommunications companies competing with entities that they have not previously competed against, both as telecommunications companies expand their businesses into the IT sector and vice versa. There is also increasing convergence between the telecommunications and entertainment and information services sectors. Uncertainty exists as to which entities will obtain significant market shares in these previously independent industries.

Economic Conditions

Economic conditions globally, and in the telecommunications sector in particular, impact Telecom’s operations. The New Zealand and Australian economies have both recently been experiencing

 

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periods of economic growth in excess of long run average growth rates. Within the New Zealand economy in particular there are a number of signs indicating that the economy is slowing, which may impact future growth rates for the overall telecommunications market.

Movements in the NZ dollar/Australian dollar exchange rate also affect NZ dollar results reported by Telecom’s Australian operations.

These factors have driven the key trends discussed below in Telecom’s results of operations, liquidity and capital resources during the two-year period.

Changing Mix of Operating Revenues

As a result of the factors outlined above, Telecom continues to experience a shift in its business from traditional fixed line calling products to wireless and broadband products, and IT services. As newer revenue streams are generally lower margin than the traditional fixed line revenue streams they are replacing, overall gross margin percentages are contracting.

Traditional fixed line services still remain the core of Telecom’s operations, however, the proportion of Telecom’s total revenues represented by these services is falling owing to the impact that competition, product substitution and regulation is having on these revenue lines. In 2001, local service, calling and resale revenues made up 57.6% of Telecom’s total revenues. In 2006, this had reduced to 48.8%. Local service revenues have limited potential for significant further growth given Telecom’s already leading market share and the impact Telecom expects that competitive pressure and regulatory activity will have on prices and market share. Calling revenues have declined in 2006 as competition has impacted prices and market share, and substitution for products such as email, broadband and mobile has impacted volumes. Telecom expects these trends to continue for the foreseeable future.

Given the constraints on growth in Telecom’s traditional calling business, Telecom has sought to grow its revenues in other areas, particularly mobile and broadband, as well as expanding its operations into the IT services sector.

Telecom has grown its New Zealand mobile revenues in 2006 (up 9.6% in 2006), much of which was attributable to growth in its customer base (with total connections growing 6.4% in 2006 despite a substantial decline in the TDMA base as this network approaches its close down date). Market penetration of mobile connections is trending towards 100% and the rate of penetration growth is expected to slow in the near to medium term. Future mobile data revenue growth is expected to be driven more by applications and content than by text messaging (which is currently the most significant driver). Future mobile voice revenues will be driven by share of connections and rate of substitution from fixed line services. As an integrated operator, Telecom also has a focus on the convergence of fixed and mobile services, which is expected to gain momentum in future periods. New converged product offerings were released into the market in the current financial year.

Telecom has also increased its New Zealand broadband and internet revenues in 2006 (up 17.9%), principally as a result of growth in broadband revenues from Telecom’s ADSL services. At 30 June 2006, Telecom had 435,000 broadband connections, of which 279,000 were consumer connections. Telecom views consumer broadband as a significant growth opportunity as well as being key to maintaining Telecom’s position in fixed line access and calling markets, as there is a propensity for customers to use the same carrier for local and national calling as the provider of their broadband connection. The introduction of LLU and naked DSL could threaten Telecom’s fixed line access relationship with customers and could accelerate the rate of decline in traditional telephony services such as calling, see “Item 3 – Risk Factors” and “Item 4 – Market Overview - New Zealand Regulation”.

Accordingly, Telecom is targeting substantial growth in its retail consumer broadband customer base and has set itself the new target of achieving 500,000 retail broadband connections by 30 June 2007. To achieve this target, marketing, customer acquisition and provisioning activities will be required that are likely to increase operating costs in the year ended 30 June 2007.

 

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Partly offsetting the growth in broadband revenue, New Zealand internet revenue (which is primarily sourced from dial-up internet access) is declining at an increasingly rapid rate (falling by 23.1% in 2006). This is the result of migration of the dial-up customer base to broadband. Telecom expects this decline in internet revenue to continue.

Telecom’s IT services business continues to grow following the successful integration of the acquired Gen-i and Computerland businesses with Telecom’s existing IT services business under the Gen-i brand. In 2006, Telecom has seen an improved contribution from the merged Gen-i business as a result of the benefits of integration. Telecom currently believes that the IT services market has the potential to grow faster than the traditional telecommunications market and accordingly sees this segment as a potential source of future growth for the Telecom Group.

Deterioration in operating performance of Telecom’s Australian operations, resulting in substantial write-downs

Telecom first acquired a controlling stake in AAPT in November 1999. During the initial period of ownership, AAPT pursued a full service model principally based on price-differentiation, and its revenues grew rapidly. Much of this revenue was, however, at very low margins. In 2002, Telecom wrote-down the carrying value of AAPT by $850 million, an impairment reflecting negative industry and economic trends impacting AAPT’s operations and a reduction in expected future growth rates compared to those expected when the investment was first undertaken.

Following the 2002 write-down, Telecom sought to refocus AAPT’s business model, moving away from a full-service model to concentrate on those market segments where AAPT believed it could provide compelling customer offers while achieving satisfactory margin. At the same time Telecom focused on improving AAPT’s cost structure, particularly intercarrier costs, which make up the majority of AAPT’s total operating expenses.

However, the competitive position of Telecom’s Australian operations substantially worsened in 2006, principally as a result of the following three factors:

 

  a significant tightening of wholesale prices and terms with Telstra (the principal supplier to Telecom’s Australian operations);

 

  continued downward pressure on retail prices as a result of further competition in this market; and

 

  the deferral of major project expenditure by key corporate customers.

Several substantial contracts with large corporate and Government customers were also lost to competitors during 2005 and 2006. The combined impact of these factors was a rapid deterioration in AAPT’s financial performance. Telecom’s Australian operations recorded a loss from operations of NZ$85 million in 2006, compared to a profit of NZ$3 million in 2005. As well as negatively impacting current year performance, these trends lowered near and medium term expectations for the future prospects of this business. As a result, further impairment charges totalling NZ$1,301 million were recognised in 2006 to reflect the decline in value of Telecom’s Australian operations. This resulted in all goodwill resulting from the purchase of AAPT being written off, as well as a substantial reduction in the value of other non-current assets.

As the negative trends outlined above show no sign of dissipating, Telecom does not expect an improvement in the operating results of its Australian operations in 2007 (excluding the impact of reduced depreciation and amortisation expense following the write-downs in 2006).

In order to attempt to improve the financial results of its Australian operations in the longer term, Telecom is redesigning the Australian business and investing in new sales, customer service and operating support capabilities. This has resulted in an increase in the amount of capital expenditure allocated to Australian operations. Forecast capital expenditure for Telecom’s Australian operations for 2007 is NZ$145 million, an increase over 2006 capital expenditure of NZ$131 million (which was in turn higher than 2005). In the event that this organisational redesign process is not successfully implemented, the potential for further impairment write-downs exists, see “Item 3 – Risk Factors”.

 

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Technological Developments

Technology also has a fundamental impact on Telecom’s business and the results that it generates. The core of Telecom’s revenues has traditionally been generated by its fixed line PSTN network.

Implementation of an IP-based NGN over several years should enable Telecom to introduce new IP-based products and services to its customers more quickly than was previously possible. Telecom anticipates that the NGN will help manage operating costs by reducing the costs of provisioning, delivery and network support. If, however, existing legacy systems cannot be decommissioned when the new NGN platform is completed, these operating cost savings may not be achieved as Telecom would bear the additional cost of supporting multiple platforms, see “Item 3 – Risk Factors”.

Technological developments are also having a significant impact in Telecom’s New Zealand mobile operations. Telecom currently operates both CDMA and TDMA mobile networks in New Zealand. The TDMA network has been superseded by the more advanced CDMA technology and the carrying value of the network has been written down to zero in prior years. The TDMA network is scheduled for closure in March 2007.

Telecom continues to develop its CDMA network and during 2006 expanded the coverage of the EV-DO upgrade beyond metropolitan areas to cover main towns and cities outside the major metropolitan centres. The EV-DO upgrade enables Telecom to deliver 3G mobile data services. In 2007, Telecom plans to further upgrade its CDMA network to the EV-DO Rev A standard, which enables even greater data transmission speeds to be achieved. This will create the potential for delivering higher bandwidth mobile applications creating further growth in mobile data revenues. In operating a CDMA mobile network, however, Telecom is dependent on Telstra to provide roaming services for its customers in Australia. Telstra has announced that it intends to close its CDMA network. If this network is closed down in accordance with Telstra’s stated intentions, this will necessitate the consideration of alternative options which could impose additional capital and operating expenditure costs on Telecom, see “Item 3 – Risk Factors”.

Implementation of NGT

In the absence of a major strategic change to its business model, Telecom expects that its operating earnings will decline over the next five years as a result of regulatory, competitive and technology pressures and the impact that this is having on Telecom’s traditional high-margin telecommunications business. While Telecom is pursuing strategies to mitigate the decline in the core tele-communications business (principally through aggressive promotion of products and bundled offers that deepen Telecom’s relationship with its customers and hence reduce the threat of loss of the fixed-line access relationship), it believes that the most likely way to deliver improved financial results is for it to implement a lower cost, more efficient business model.

As a result, Telecom is developing the NGT programme, which aims to create a significantly simpler, and therefore lower cost, operating model. The key components of this programme are:

 

  A substantial reduction in the number of products offered by Telecom

Telecom has historically operated a highly customised approach to product development. Within the business market, products have been extensively tailored to individual customer needs resulting in a proliferation of discrete products. Within the consumer and business markets, a large number of plans and options have been created to address particular niches or for individual promotion or managed customer requirements. The complexity created by delivering such a large product set drives costs in provisioning, billing and supporting this wide range of products, and significantly increases the time required for Telecom to take new services to market and to build and implement new information systems.

As part of NGT, Telecom is aiming to develop a much narrower, more standardised set of products for its consumer and small and medium enterprise business customers. If successfully implemented, this will result in a substantial reduction in the number of

 

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products offered by Telecom and, therefore, has the potential to lead to meaningful reductions in the costs of provisioning and supporting these products.

 

  Simpler pricing structures

In line with the reduced product set, Telecom also aims to move to a simpler pricing model. Greater use of subscription based billing (where customers pay a fixed monthly fee to receive a set bundle of services, regardless of the level of usage) is likely to be made. Setting the price level for these bundles will involve a trade-off between driving uptake of bundled services and the impact on existing usage-based revenues. A simplified pricing structure will have the potential to reduce complexity and, therefore, costs associated with billing operations.

 

  Developing lower cost marketing, sales and service approaches to support the new products

NGT aims to make increasing use of online channels for marketing, sales and customer service. The objective is to enable customers to order products online, with automated fulfilment of orders and customer self-provisioning. Billing and bill analysis will also be provided online. Given the lack of human intervention required for each of these activities, successful implementation of this aspect of NGT has the potential to result in substantial savings in personnel and related costs associated with each of these activities. Realisation of these cost savings will be dependent on transitioning a substantial proportion of Telecom’s customer base onto these services.

 

  Replace legacy network platforms with the NGN to deliver NGT services across an IP network

Telecom currently employs multiple discrete network platforms to deliver its existing products. It is currently part way through a multi-year programme to deliver the NGN. The goal of the NGN project is to create a single integrated IP based network to replace Telecom’s multiple legacy platforms.

Implementation of the NGN has the potential to reduce operating costs through simplification. By reducing the number of platforms that Telecom needs to support, network maintenance and development costs will potentially reduce. Achieving cost reductions will be dependent on Telecom’s ability to successfully shift customers off legacy platforms and close these down. Implementing the NGN will also potentially enable Telecom to expand its revenue base through the delivery of new IP based services.

 

  Optimising capital expenditure

A significant focus of NGT will be on attempting to ensure that Telecom obtains the maximum benefit from each dollar of capital expenditure. This will involve making trade-offs between competing capital projects in order to ensure that capital funds are applied to the highest return projects and seeking to keep expenditure on legacy systems to the minimum.

 

  Redesigning the internal organisational structure

In line with the changes being made to Telecom’s business model as part of NGT, the internal organisational structure is being redesigned in order to make it easier for Telecom to deliver NGT. Currently Telecom’s management structure is being redesigned to create a flatter hierarchy. This will result in a reduction in the number of management positions within the group, which will lead to savings in personnel costs in future years. Once the management restructure in complete, the remainder of the organisation will be redesigned to align with NGT. Further reductions in total staff numbers are currently expected as a result of this process.

 

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Other than the NGN implementation, which predates NGT and hence for which detailed plans are already in existence, the NGT initiatives have currently only been defined at a broad level. Telecom is currently in the process of formulating the detailed planning and decision work required to implement NGT at an operational level. It is currently expected that the majority of Telecom’s customers will be on NGT offers by December 2015.

CRITICAL ACCOUNTING POLICIES

Adoption of IFRS

Telecom commenced reporting under NZ IFRS in the financial year ended 30 June 2006. In complying with NZ IFRS, Telecom is also in compliance with IFRS as issued by the International Accounting Standards Board.

The transition of Telecom’s financial statements to NZ IFRS has been carried out in accordance with NZ IFRS 1 “First Time Adoption of New Zealand Equivalents to International Financial Reporting Standards”. The transition date was deemed to be 1 July 2004, being the start of the comparative period for the year ended 30 June 2006.

Normally accounting changes of this nature would require full retrospective application, however, NZ IFRS 1 provides certain optional and mandatory exemptions to full retrospective application. Telecom has applied the following key exemptions in accordance with NZ IFRS 1:

 

  business combinations – business combinations occurring prior to the transition date have not been restated on an NZ IFRS basis;

 

  share based payments – no expense has been recognised in respect of share based compensation instruments that had vested prior to 1 July 2004;

 

  financial instruments – NZ IAS 32 “Financial Instruments: Disclosure and Presentation” and NZ IAS 39 “Financial Instruments: Recognition and Measurement” have been applied from 1 July 2005. Prior year comparatives are presented in accordance with previous NZ GAAP.

 

  translation differences – The balance of the foreign currency translation reserve, representing all cumulative translation differences that have arisen on the translation of foreign entities, was reset to zero on 1 July 2004; and

 

  compound financial instruments – the equity and liability elements of compound financial instruments have not been restated separately where the liability element was extinguished prior to 1 July 2005.

The impact of restatement under NZ IFRS on Telecom’s opening balance sheet and 2005 results is disclosed in Note 38.

Other Critical Accounting Policies

As set out above, Telecom’s consolidated financial statements are prepared in accordance with NZ IFRS. Telecom’s significant accounting policies are set out in Note 1. Preparing these financial statements requires management to make estimates and judgments that affect reported amounts and disclosures in the financial statements. These estimates and judgments are based on historical experience and other factors that management considers relevant in the circumstances. Of the significant accounting estimates and judgments made by Telecom, management considers that the following are the most critical. Where the accounting policy is significantly different under US GAAP, the US GAAP policy is also described.

Valuation of goodwill

Goodwill arising from the acquisition of a business or shares in subsidiaries is not amortised for either NZ IFRS or US GAAP purposes, but instead is subject to an impairment test at least annually (or more frequently if circumstances indicate that an impairment may have occurred). The initial determination of goodwill is dependent on the allocation of the purchase price to the assets and liabilities acquired. This allocation is based on management’s judgment of the fair value of those assets and liabilities acquired.

 

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The balance of goodwill is reviewed periodically and to the extent that it is no longer probable of being recovered from the future economic benefits of the investment (based on discounted expected cash flows), it is recognised immediately as an expense. Performing this assessment requires management to estimate the future economic benefits that it expects to derive from the investment. This generally requires management to estimate future cash flows to be generated by the investment, which entails making judgments including the expected rate of growth of revenues, expected margins to be achieved, the level of future capital expenditure required to support these outcomes and the appropriate discount rate to apply when valuing future cash flows. The resulting valuation of goodwill is sensitive to changes in any of these assumptions. Under US GAAP, goodwill is reviewed at least annually for impairment. An indication of impairment exists when the carrying value of the reporting unit in which the goodwill resides exceeds its estimated fair value. An impairment charge is recognised to the extent the carrying value of the goodwill exceeds its implied fair value.

During 2006, a goodwill impairment charge totalling NZ$834 million pertaining to AAPT was recognised as a result of a significant downwards revision in the assessment of the value of Telecom’s Australian operations. Under US GAAP this goodwill impairment charge was NZ$952 million. As a result of this impairment charge, all goodwill relating to AAPT has now been written off. Remaining goodwill of $105 million at 30 June 2006 largely arose on the purchase of Gen-i and Computerland in 2005. Management considers the carrying value of the remaining goodwill to be recoverable.

Valuation of investments

Telecom holds long-term investments that comprise minority shareholdings in unlisted companies. Equity investments where Telecom does not have significant influence are required by NZ IFRS to be recognised at fair value unless it is not possible to determine fair value with sufficient reliability.

Telecom’s long-term investments of $520 million at 30 June 2006 consist entirely of investments in privately held entities. The main item within this balance is Telecom’s A$400 million investment in Hutchison 3G Australia. The stake in Hutchison 3G Australia is particularly difficult to value given the fact that this business is still in a relatively early stage in its life cycle and is embarking on a period of rapid growth as the business attempts to achieve the scale required to generate a satisfactory return on its equity in the long run. The value of this entity arises from future cash flows that are highly uncertain.

Given that there is no objective measure of fair value for this privately held investment and that a wide range of estimates of fair value exist due to the level of uncertainty surrounding Hutchison 3G Australia’s future cash flows, management considers that it is not possible to obtain a reliable measure of fair value and hence carries this investment at cost in the balance sheet. Notwithstanding this, Telecom is still required to periodically assess whether there has been any impairment in Telecom’s investments.

In assessing whether there has been an impairment, consideration is given to the financial performance of the investee and other factors that impact on management’s expectation of recovering the value of the investment. This assessment also requires management to make judgments about the expected future performance and cash flows of the investee, and an appropriate discount rate, in order to determine the fair value of investments based on discounted expected cash flows of investees. This is a difficult exercise to perform in relation to Hutchison 3G Australia for the precise reasons set out above as to why the investment is carried at cost. Nonetheless, taking into account the evidence available at 30 June 2006, management currently consider the carrying value of Telecom’s investment in Hutchison 3G Australia to be recoverable.

Accounting for property, plant and equipment and finite-lived intangible assets

Telecom has a significant investment in long-lived property, plant and equipment assets, principally telecommunications plant and equipment and other IT assets. Telecom also has substantial investments in finite-lived intangible assets, principally software and international cable capacity. At 30 June 2006, the net book value of Telecom’s property, plant and equipment and finite-lived intangible assets was $4,025 million, representing 64.9% of Telecom’s total assets.

 

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These assets are initially recorded at cost, which comprises costs directly attributable to bringing the item to working condition for its intended use, including capitalised interest. Judgments must therefore be made about whether costs incurred relate to bringing an item of property, plant and equipment or an intangible asset to working condition for its intended use and therefore are appropriate for capitalisation as part of the cost of the asset or whether they should be expensed as incurred. Where assets are internally constructed, this will also entail assigning an appropriate amount of overhead costs to construction activities. As there is no direct causal link between construction activities and overheads, allocation models are necessary to apply overheads to capital projects. These models are based on analysis of costs incurred in prior years, updated to reflect changes in work patterns where necessary.

For internally constructed assets capitalisation only occurs where it is considered there is sufficient probability that the project will successfully generate an asset to be used in future operations. In capitalising costs, judgments must, therefore, be made about the likelihood of project success. Such judgments can be difficult where the project involves the application of unproven technology.

Once cost of the asset has been determined, this value, less any expected salvage value, is then depreciated or amortised over the asset’s expected useful life. The determination of the appropriate useful life for a particular asset requires management to make judgments about, among other factors, the expected period of service potential of the asset, the likelihood of the asset becoming obsolete as a result of technological advances, and the likelihood of Telecom ceasing to use the asset in its business operations.

Telecom periodically reviews the useful lives and salvage values of its property, plant and equipment and finite-lived intangible assets to ensure that these remain appropriate. Remaining asset lives and salvage values are adjusted where necessary to reflect changes in conditions since the asset was brought into service. Adjustments to asset useful lives and salvage values could have a material impact on depreciation and amortisation expense given the significant carrying value of property, plant and equipment and finite-lived intangible assets.

The carrying values of Telecom’s property, plant and equipment and finite-lived intangibles are also periodically reviewed to ensure they do not exceed their recoverable amounts (the economic benefits Telecom expects to derive through the use and ultimate disposal of the relevant asset). Where the carrying value exceeds the recoverable amount, the difference is recognised immediately in earnings as an impairment charge.

Assessing whether an asset is impaired may involve estimating the future cash flows that the asset is expected to generate. This will in turn involve a number of assumptions, including rates of expected revenue growth or decline, expected future margins and the selection of an appropriate discount rate for valuing future cash flows.

Under US GAAP, long-lived assets to be held and used are evaluated when there is an indication that impairment exists. An asset is considered impaired if its carrying value exceeds the future (undiscounted) cash flows expected to be generated by the asset. In such cases, the asset is then written-down to its fair value.

In 2006, impairment write-downs totalling NZ$373 million were made in respect of property, plant and equipment of Telecom’s Australian operations. This reflected the fact that it was determined that the cash flows expected to be generated by the asset grouping as a whole were not sufficient to support their carrying value.

Provision for doubtful debts

Telecom maintains a provision for estimated losses expected to arise from customers being unable to make required payments. This provision takes into account known commercial factors impacting specific customer accounts, as well as the overall profile of Telecom’s debtors’ portfolio. In assessing the provision, factors such as past collection history, the age of receivable balances, the level of activity in customer accounts, as well as general macro-economic trends, are taken into account. Significant changes in these factors would likely necessitate changes in the doubtful debts provision. At present, however, Telecom considers the current level of its provision for doubtful debts to be

 

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adequate to cover expected credit losses in its accounts receivable balances. Bad debt expenses are reported as other operating expenses in the consolidated income statements.

Telecom’s doubtful debt provision for the years ended 30 June 2006 and 30 June 2005 is included in the table below:

 

     Telecom Group

(Dollars in millions)

   Balance at
beginning
of period
$
  

Charged to
costs and
expenses

$

   Balance
written off
against
provision
$
    Release
from
provision
$
   Balance
at end
of
period
$

30 June 2006

             

Provision for doubtful debts

   42    34    (37 )   —      39

30 June 2005

             

Provision for doubtful debts

   61    40    (59 )   —      42

Accounting for interconnection revenues and expenses

In the course of its normal business operations, Telecom interconnects its networks with other telecommunications operators. Telecom both supplies and receives network services under interconnection arrangements. In some instances management may be required to estimate levels of traffic flows between networks in order to determine amounts receivable or payable for interconnection.

The terms of interconnection, including pricing, are subject to regulation in some instances. Pricing may be subject to retrospective adjustment, in which case estimates of the likely effect of these adjustments are required in order to determine revenues and expenses. Likewise, where interconnection rates are in dispute with another carrier, estimates of the likely outcome of disputes are required to determine financial results. Telecom bases these estimates on management’s interpretation of material facts, as well as independent advice. Telecom considers its estimates reasonable in the circumstances, however, in the event that the outcomes of regulation or disputes differ from management’s estimates, adjustments could be required.

There are currently a number of disputes and uncertainties between AAPT and the carriers it uses. The accounting treatment adopted reflects management’s assessment of the most likely outcome for all of the key disputes. These include:

 

  AAPT’s previous contract with Telstra expired on 31 December 2005. Following this date, Telstra tabled revised contractual arrangements with adverse terms and conditions to the previous contract. AAPT and Telstra continue to discuss the basis of future supply arrangements and have been unable to reach agreement to date. The latest contractual offer from Telstra has subsequently been withdrawn by Telstra;

 

  in addition to the change in contractual arrangements, wholesale residential line rental prices were increased by Telstra in December 2005. This increase was the basis of a dispute lodged with the ACCC, and in April 2006 the ACCC issued a competition notice against Telstra alleging anti-competitive conduct. AAPT has accounted for the consumer line rental costs at the historic rates; and

 

  there are a number of other substantive disputes with Telstra related to 1-900 charges and interconnect.

There is uncertainty around the timing and nature of the resolution of these disputes. As at 30 June 2006, approximately $28m was subject to dispute and being withheld. Management has separately estimated possible outcomes and accounted for intercarrier costs accordingly. Local call prices and local call override penalties have been accrued for based on the current Telstra agreement.

 

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In addition, Telecom recognised a charge of $18 million within its New Zealand operations in 2006 to settle a number of long-standing commercial issues between Telecom and TelstraClear (principally involving back-dating of pricing).

Accounting for income taxes

Telecom is required to determine its income taxes in each jurisdiction in which it operates. This entails a jurisdiction-by-jurisdiction estimation of current tax exposure, as well as an assessment of the impact of temporary differences, which result from different valuation of items for accounting and tax purposes. Telecom’s principal temporary differences relate to fixed assets, provisions and accruals, and tax losses in subsidiaries.

Preparation of the annual financial statements requires management to make estimates as to, among other things, the amount of tax that will ultimately be payable, the availability of losses to be carried forward and the amount of foreign tax credits that it will receive. Actual results may differ from these estimates as a result of reassessment by management and/or taxation authorities. This may significantly impact Telecom’s financial position and results of operations.

Under US GAAP, deferred tax assets are generally recognised for all deductible temporary differences and a valuation allowance is established when management consider the likelihood of not realising the benefit of deferred tax assets is more likely than not. Further details on Telecom’s deferred tax assets, valuation allowances and deferred tax liabilities under US GAAP are disclosed in Note 37.

Additional Critical Accounting Policy Under US GAAP

In Note 37, Telecom presents a reconciliation of a number of its NZ IFRS measures to those that would be reported under US GAAP. In addition to the critical accounting policies applicable in determining certain of the NZ GAAP financial measures, the following critical accounting policy is solely applicable to the determination of certain financial measures under US GAAP.

Consolidation of Variable Interest Entities (“VIE”)

As a result of the issue of FIN 46R “Consolidation of Variable Interest Entities”, under US GAAP companies are required to determine whether they hold any interests in VIEs. If they do hold such interests, companies must assess whether these interests could be expected to absorb a majority of the expected losses of the VIE or receive a majority of the VIE’s residual returns, in which case FIN 46R would deem the company to be the primary beneficiary and require it to consolidate the VIE.

Determining what the expected losses of a VIE are and which party (if any) holds interests that would be expected to absorb a majority of these expected losses can be a complex process requiring results for the VIE to be forecast and probabilities assigned to scenarios under which results vary from this forecast. This exercise, particularly the assignment of probabilities, in most cases involves highly subjective judgments.

As a result of the application of FIN 46R for US GAAP purposes in 2004, Telecom determined that Southern Cross was a VIE subject to the rules of FIN 46R and that Telecom was also the primary beneficiary of Southern Cross as a result of providing contingent credit support to Southern Cross in addition to holding 50% of Southern Cross’ equity and subordinated debt. This required the consolidation of Southern Cross by Telecom for the purposes of presenting certain financial measures under US GAAP, resulting in a substantial reduction in shareholders’ equity in accordance with US GAAP.

At 31 March 2006, Telecom determined that it was no longer the primary beneficiary of Southern Cross as a result of the elimination of certain variable interests previously held by Telecom consisting of contingent credit support obligations (which ceased upon the repayment by Southern Cross of all its senior bank debt). Accordingly, Telecom ceased to consolidate Southern Cross for US GAAP purposes from this date, resulting in an increase in 2006 net earnings and shareholders’ equity in accordance with US GAAP of $526 million.

 

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Impact of Recently Issued Accounting Standards

United States

In June 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS 154 “Accounting Changes and Error Corrections - a Replacement of APB 20 and SFAS 3”. This statement changes the requirements for the accounting for and reporting of a change in accounting principle. APB 20 previously required that most voluntary changes in accounting principle be recognised by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle. This standard will be effective for Telecom for the year ending 30 June 2007. The impact of this standard on Telecom’s financial statements will depend on the extent to which Telecom effects changes in accounting principle in the future.

In June 2006, the FASB issued FIN 48 “Accounting for Uncertainty in Income Taxes - an interpretation of SFAS 109”. This Interpretation clarifies the accounting for uncertainty in income taxes recognised in an enterprise’s financial statements in accordance with SFAS 109, “Accounting for Income Taxes”. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation will be effective for Telecom for the year ending 30 June 2008, although early adoption of the provisions of the standard is allowable. Management is currently evaluating the impact FIN 48 will have on Telecom.

NZ IFRS

In August 2005, the International Accounting Standards Board (“IASB”) issued IAS 7 “Financial Instruments: Disclosures”. The New Zealand equivalent to this standard, NZ IFRS 7, was issued by the New Zealand Financial Reporting Standards Board in November 2005. It replaces NZ IAS 30 “Disclosures in the Financial Statements of Banks and Similar Financial Institutions” and some of the requirements of NZ IAS 32 “Financial Instruments: Disclosure and Presentation”. NZ IFRS 7 requires companies to disclose information about the significance of financial instruments and the nature and extent of risks arising from financial instruments. It will be effective for Telecom for the year ending 30 June 2008. As this standard solely addresses disclosure and most of its requirements relevant to Telecom are embodied in existing standards, management do not believe that application of NZ IFRS 7 will have a significant impact on Telecom.

In April, June and August 2005 the IASB issued three amendments to IAS 39 “Financial Instruments: Recognition and Measurement”. These amendments address cash flow hedges of forecast intragroup transactions, the fair value option and financial guarantee contracts. These amendments will be effective for Telecom for the financial year ending 30 June 2007. Management is currently evaluating the impact that these amendments will have on Telecom.

US GAAP reconciliation

The consolidated financial statements are prepared in accordance with NZ IFRS, which differ in certain significant respects from US GAAP. These differences, and the effect of the adjustments necessary to present certain financial measures in accordance with US GAAP, are detailed in Note 37.

Impact of differences between NZ IFRS and US GAAP

As a result of the differences between NZ IFRS and US GAAP, Telecom’s US GAAP net losses for the year ended 30 June 2006 were smaller than its NZ IFRS net loss by $374 million (86.0%). For the year ended 30 June 2005, US GAAP net earnings were greater than its NZ IFRS net earnings by NZ$11 million (1.1%).

US GAAP net losses for the year ended 30 June 2006 were smaller than NZ IFRS net losses principally owing to a gain of $526 million arising on the deconsolidation of Southern Cross. As

 

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explained in the heading “Other Critical Accounting Policies” above, Southern Cross ceased to be consolidated for US GAAP purposes at 31 March 2006. Southern Cross had a substantial deficit in equity, which reduced Telecom’s reported equity in accordance with US GAAP upon consolidation. Following deconsolidation, Southern Cross is accounted for using the equity method with the investment recorded at a carrying value of zero. The investment is not recorded at an amount below zero because Telecom has not guaranteed the obligations of Southern Cross or otherwise committed to provide future financial support. Accordingly, a gain of $526 million arose on deconsolidation of Southern Cross reflecting the deficit in Southern Cross’ equity at 31 March 2006.

Partly offsetting this were charges of $128 million on the revaluation of derivative financial instruments and $118 million in relation to the impairment write-down of Telecom’s Australian operations. Hedge accounting is applied to derivative financial instruments for NZ IFRS purposes, with changes in valuation being recorded in equity. Hedge accounting is not applied for US GAAP purposes and accordingly changes in valuation are recorded in earnings. This resulted in a charge to US GAAP earnings in respect of derivative financial instruments. The charge in relation to the impairment writedown resulted from the fact that the carrying value of Telecom’s Australian operations under US GAAP was higher than the carrying value under NZ IFRS due to the earlier cessation of amortisation of goodwill.

US GAAP net earnings for the year ended 30 June 2005 were greater than NZ IFRS net earnings principally owing to an unrealised gain of $38 million of the revaluation of derivative financial instruments. This gain was partly offset by losses of $21 million recorded by Southern cross that were consolidated by Telecom for US GAAP purposes in accordance with FIN 46R.

CONSOLIDATED RESULTS OF OPERATIONS

Reported results under NZ IFRS are summarised in the table below.

 

     Year ended 30 June  
     2006
$m
    2005
$m
    2006/2005
% change
 

Operating revenues

   5,755     5,650     1.9  

Other gains

   60     154     (61.0 )
              

Total operating revenues and gains

   5,815     5,804     0.2  

Operating expenses

   (3,558 )   (3,402 )   4.6  

Asset impairments and other expenses

   (1,335 )   (59 )   NM1  

Depreciation and amortisation

   (705 )   (698 )   1.0  
              

Total expenses

   (5,598 )   (4,159 )   34.6  
              

Earnings before interest and tax

   217     1,645     (86.8 )

Net interest expense

   (254 )   (289 )   (12.1 )
              

(Loss)/earnings before tax

   (37 )   1,356     (102.7 )

Tax expense

   (394 )   (386 )   2.1  

Minority interest

   (4 )   (3 )   33.3  
              

Net (loss)/earnings

   (435 )   967     (145.0 )

 

1 Not meaningful

 

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Components of earnings are analysed in further detail below.

Reported NZ dollar results from Telecom’s Australian operations have been impacted by movements in exchange rates. The average NZD:AUD exchange rates for 2006 and 2005 are shown in the table below.

 

     Year ended 30 June  
     2006    2005   

2006/2005

% change

 

Average NZD:AUD exchange rate

   0.8949    0.9247    (3.2 )

The average exchange rate for 2006 was 3.2% lower than the average exchange rate for 2005, resulting in an equivalent increase in reported NZD revenues, expenses and earnings for Australian operations. In order to remove the impact of exchange rates from the following analysis, both NZ dollar reported results and underlying Australian dollar results are included in the tables below, with discussion and analysis based on the underlying Australian dollar results.

Telecom Group Revenues

The following discussion analyses revenues for the major categories of products and services. Factors impacting Telecom’s New Zealand operations differ from those impacting Telecom’s Australian operations as a result of the different stages of maturity, competitive positions and scope of operations of the respective businesses and the differing characteristics of the markets in which they operate. Accordingly, revenues from New Zealand and Australian operations are generally analysed separately in the discussion below.

Revenues from Telecom’s traditional calling business have declined during the two year period owing to competitive pressures and the impact of product substitution. This continues a trend evident in recent financial years. Telecom has sought to offset this by expanding its revenues from newer communications technologies (particularly mobile and broadband) and expanding its scope of operations into areas such as IT solutions. These growth areas generally offer lower margins than the traditional fixed line telephony business. Telecom expects competition and substitution to continue to impact its calling revenues, which may be exacerbated by proposed changes to the regulatory environment.

 

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A breakdown of reported Telecom Group revenues is provided in the table below.

 

      Year ended 30 June  

Group Revenues

  

2006

$m

  

2005

$m

  

2006/2005

% change

 

Local service

   1,081    1,101    (1.8 )

Calling

        

National

   905    980    (7.7 )

International

   442    415    6.5  

Other

   46    48    (4.2 )
            

Total calling

   1,393    1,443    (3.5 )

Interconnection

   204    206    (1.0 )

Mobile

   869    835    4.1  

Data

   602    602    —    

Broadband and internet

   448    376    19.1  

IT Services

   346    308    12.3  

Other operating revenues

        

Resale

   363    337    7.7  

Directories

   248    230    7.8  

Equipment

   55    69    (20.3 )

Miscellaneous other

   146    136    7.4  

Dividends from investments

   —      7    (100.0 )
            

Total other operating revenues

   812    779    4.2  
            

Total operating revenues

   5,755    5,650    1.9  

Other gains

   60    154    (61.0 )

Total revenues and gains

   5,815    5,804    0.2  

Significant line items are analysed in further detail below.

Local service

Local service revenue is principally generated in New Zealand. It primarily represents fixed monthly access charges. Under the terms of the TSO, Telecom is required to provide free local calling to consumer customers while maintaining the cost (on an inflation adjusted basis) of standard consumer line rental at or below the amount charged when Telecom was privatised in 1993. Telecom also derives a lesser amount of local service revenue from business local calls, Centrex and VPN local calls and local calls by those consumer customers who elect the low rental, charged calling option instead of flat rate access.

Since November 2004, Telecom has been required to provide local service products on a wholesale basis to other carriers for resale to their consumer customers (business wholesale access has been available for several years). This has so far led to a very small reduction in Telecom’s retail market share for local service. The introduction of LLU and naked DSL may result in a more significant loss of market share in local service as a result of customers shifting their local service connection to other providers (LLU) or ceasing to have a fixed line connection and instead using mobile or VoIP services for voice calling (naked DSL). Similarly, the likely introduction of such service by Vodafone using its existing mobile network may result in a loss of market share in local service. If Telecom does lose market share in local service, this may also negatively impact calling revenues, as customers will generally choose the same service provider for national and international calling as they do for local service.

Telecom only generates a limited amount of local service revenue in Australia, owing to the limited number of customers who are directly connected to AAPT’s infrastructure. AAPT resells Telstra’s local service products to a large number of its consumer customers. Revenues from this activity are included as Resale revenue within Other Operating Revenues.

 

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      Year ended 30 June  

Local Service

   2006    2005   

2005/2006

% change

 

New Zealand (NZ$m)

   1,049    1,063    (1.3 )

Australia (NZ$m)

   32    38    (15.8 )
            

Local service revenue (NZ$m)

   1,081    1,101    (1.8 )

Australian revenues in local currency

        

Australia (A$m)

   29    36    (19.4 )

New Zealand access lines at year end

        

Residential (000s)

   1,414    1,417    (0.2 )

Business (000s)

   303    305    (0.7 )

Centrex (000s)

   66    68    (2.9 )

In New Zealand, local service revenue decreased by NZ$14 million (1.3%) in 2006. The decrease is primarily the result of a decline in local call revenues of NZ$12 million, due largely to businesses migrating from dial-up internet access to broadband (with a corresponding shift in revenue from local service to broadband and internet) and declining call volumes as a result of competitive pressure. Access revenues decreased by NZ$2 million, with the effect of a minor decrease in total access lines and a small shift from retail to wholesale partly offset by a small increase in service pricing in March 2006.

The increase in service pricing in New Zealand was owing to adjustments in Telecom’s service pricing reflecting inflation (as measured by the CPI). Telecom is entitled to increase consumer access prices in line with growth in the CPI under the terms of the TSO, however, increasing competitive pressure may restrict Telecom’s ability to further raise access prices in the future.

At 30 June 2006, 68,000 of Telecom’s consumer access lines and 50,000 of Telecom’s business access lines were wholesale connections. As noted above, an increase in the number of wholesale connections has the potential to negatively impact calling revenue, as well as local service revenue (as wholesale connections have lower margin than retail connections).

In Australia, local service revenue declined with a loss of volumes in the business and corporate sector, reflecting the loss of a small number of substantial customers.

National calling

National calling revenue is derived from calls from one fixed line to another fixed line outside the local free calling area, calls from a fixed line terminating on a mobile network, calls to toll free numbers (which in New Zealand have the dialling prefix 0800 and are paid for by the receiver) and operator assisted calls.

 

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     Year ended 30 June  

National Calling

   2006    2005   

2006/2005

% change

 

New Zealand (NZ$m)

        

National calls

   193    217    (11.1 )

Calls to mobile networks

   294    298    (1.3 )

National 0800

   90    98    (8.2 )

Operator services

   9    10    (10.0 )
            
   586    623    (5.9 )

Australia (NZ$m)

        

National calls

   118    140    (15.7 )

Calls to mobile networks

   201    217    (7.4 )
            
   319    357    (10.6 )
            

Total national calling revenue

   905    980    (7.7 )

Australian revenues in local currency

        

Australia (A$m)

        

National calls

   103    136    (24.3 )

Calls to mobile networks

   184    193    (4.7 )
            
   287    329    (12.8 )

National calling minutes (m)

        

New Zealand

   3,238    3,304    (2.0 )

Australia

   2,601    2,671    (2.6 )

In New Zealand, Telecom’s calling revenue continues to decline due to lower call minutes and average prices resulting from the impacts of competition and product substitution. Competition has resulted in decreased prices with increased use of capped rates and other forms of discounting to attract and retain customers in a competitive market. Some reduction in market share has also occurred.

Product substitution has also had an impact on national calling revenue. Other communication alternatives, particularly email, internet and mobile phones, are increasingly being used by customers instead of fixed line calling. This has been a factor in declining national calling minutes in New Zealand.

Revenue from calls to mobile networks comprises a substantial portion of calling revenue. The Commerce Commission has proposed regulating the cost of terminating fixed line calls on mobile networks. This regulation has been proposed in order to lower the cost of calls to mobile networks, hence there is an expectation that lower termination rates will flow directly through into lower retail prices for calls to mobile networks. As a result, it is expected that revenues from calls to mobile networks will decline in future (with an offsetting decrease in interconnection costs for those calls terminating on competitors networks).

In Australia, the decline in revenue from both national calls and calls to mobile networks was largely the result of lower prices reflecting competitive activity in the market. Promotional activities and the use of price caps as well as growth in lower margin wholesale traffic in the business sector resulted in a decline in average price per minute. There was also some loss of volumes in national calling as a result of fixed to mobile substitution in the consumer sector and the loss of a high volume, low margin customer in the business segment.

 

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International calling

International calling revenue for New Zealand operations comprises:

 

  outward calling revenue, where New Zealand customers make calls originating in New Zealand and terminating overseas;

 

  inwards calling revenue, where calls originate on other carriers’ networks and terminate in New Zealand; and

 

  transit calling revenue, where Telecom acts as an intermediary carrier of international calls originating and terminating on other carriers’ networks.

Outward revenues are principally derived from Telecom’s consumer and business customers. They are influenced by domestic demand and competition. Inwards revenues and transit revenues are derived from other international carriers. Inwards and transit revenues are principally denominated in US dollars and are significantly influenced by movements in the wholesale international telecommunications market.

Following adoption of IFRS, transit revenues are now reported gross, that is with gross payments received from originating carriers shown as revenue and payments by Telecom to terminating carriers shown as an expense (within intercarrier costs). Previously, the net of these two amounts was included within international calling revenue as transit margin. The grossing-up of transit revenues has introduced volatility into Telecom’s reported revenues and expenses, as the gross receipts and payments under transit arrangements can vary substantially based on the mix of traffic carried, while the net of transit revenue and transit intercarrier costs tends to be considerably more stable.

Australian international calling revenues are derived from outward calls originated by AAPT and TCNZA’s business and consumer customers.

 

      Year ended 30 June  

International Calling

   2006    2005   

2006/2005

% change

 

New Zealand (NZ$m)

        

International outward

   128    137    (6.6 )

International inward

   33    44    (25.0 )

International transit

   182    142    28.2  
            
   343    323    6.2  

Australia (NZ$m)

   99    92    7.6  
            

Total international calling revenue

   442    415    6.5  

Australian revenues in local currency

        

Australia (A$m)

   89    85    4.7  

International calling minutes (m)

        

New Zealand

   4,133    3,141    31.6  

Australia

   877    776    13.0  

Total New Zealand international calling revenue increased by NZ$20 million (6.2%) as a result of growth in transit revenues. As noted above, gross transit revenues exhibit significant volatility. In 2006, there was a shift in revenue mix from higher margin destinations to lower margin destinations. This resulted in substantial growth in volumes (reflected in the growth in total calling minutes for New Zealand of 31.6%), but was offset by a significant decrease in the average price per minute. As a result, the increase in transit revenue was exactly matched by the increased in intercarrier costs for transits.

Outward revenues declined, despite growth in outward calling minutes, due to lower average prices. The reduction in prices was largely a reflection of competitive pressures in the New Zealand market. Inward revenues declined as a result of both lower volumes and lower average prices. The reduction

 

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in average price was a result of a change in mix of calling minutes, with a reduced percentage of higher rate mobile terminating minutes.

In Australia, international calling revenues increased due to growth in wholesale volumes. This growth in wholesale was the reason for the growth in calling minutes in Australia. However, as wholesale is lower margin than retail, this resulted in lower average price per minute and hence a lesser increase in revenue.

Interconnection

Interconnection revenue arises where Telecom terminates calls originating on other carriers’ networks, be they fixed line or mobile.

 

      Year ended 30 June  

Interconnection

   2006    2005   

2006/2005

% change

 

New Zealand (NZ$m)

   162    163    (0.6 )

Australia (NZ$m)

   42    43    (2.3 )
            

Interconnection revenue

   204    206    (1.0 )

Australian revenues in local currency

        

Australia (A$m)

   37    40    (7.5 )

New Zealand interconnection revenue was stable, reflecting an increase in the volume of text messaging offset by lower average prices.

As noted in the discussion of “National Calling” revenue above, the Commerce Commission has recommended regulating the mobile termination price for voice calls on mobile networks. If this proposed regulation is implemented the revenue that Telecom generates from interconnecting with other mobile operators would be expected to fall significantly (as would interconnection costs). Telecom is currently a net payer of mobile interconnection (i.e. mobile interconnection costs exceed mobile interconnection revenue, as Telecom sends more traffic to other carriers than it receives in return).

Australian interconnection revenues recorded a moderate decrease, consistent with the overall reduction in the revenue base of Australian operations.

Mobile

Mobile revenues are derived from access, airtime, other network services (such as mobile data) the sale of mobile equipment (such as mobile handsets and wireless laptop cards) and other mobile services such as paging. Excluding equipment sales and other miscellaneous revenue, mobile revenue is a function of the number of connections and the Average Revenue Per User (“ARPU”) that each connection generates.

In New Zealand, there has been a significant migration of the customer base from the legacy TDMA network to the more modern CDMA network. As a result, the TDMA network is scheduled for closure in March 2007.

With an increasing proportion of its customer base on the CDMA network, Telecom’s mobile data revenue (from text messaging and data services provided across mobile devices) continued to increase substantially, with an increase of NZ$60 million (54.1%) recorded in 2006. Growth was also stimulated by the continuation of monthly caps on billings for text messaging, which led to increased connection numbers and usage. Customers are currently billed no more than NZ$10 per month for up to 500 text messages (some plans offer a greater number of text messages to other Telecom subscribers also for $10 per month).

Market penetration of mobile connections is trending towards 100% and the rate of penetration growth is expected to slow in the near to medium term. Future mobile data revenue growth is expected to be driven more by applications and content than by text messaging (which is currently

 

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the most significant driver). Future mobile voice revenues will be driven by share of connections and rate of substitution from fixed line services. As an integrated operator, Telecom also has a focus on the convergence of fixed and mobile services, which is expected to gain momentum in future periods. New converged product offerings were released into the market in 2006.

In Australia, AAPT resells other carriers’ mobile services. In November 2001 AAPT signed a network services agreement with Vodafone that saw it move towards a single carrier resale relationship. In 2004 AAPT ceased marketing mobile as a standalone product. AAPT now offers mobile services solely to customers as part of a bundle of telecommunications services. In 2006 AAPT sold its prepaid customer base to CommidiTel. As a result, AAPT now only has post-paid mobile customers.

 

      Year ended 30 June  

Mobile

   2006    2005   

2006/2005

% change

 

New Zealand (NZ$m)

   774    706    9.6  

Australia (NZ$m)

   95    129    (26.4 )
            

Mobile revenue (NZ$m)

   869    835    4.1  

Australian revenues in local currency

        

Australia (A$m)

   86    123    (30.1 )

Mobile connections at year end

        

New Zealand (000s)

   1,703    1,601    6.4  

Australia (000s)

   162    158    2.5  

Growth in New Zealand mobile was driven by growth in mobile data revenue, reflecting increased volume of text messaging, greater penetration of high speed mobile data services and growth in the customer base. The CDMA customer base has continued to grow strongly. CDMA customers increased from 1,123,000 at 30 June 2005 to 1,618,000 at 30 June 2006. This has, however, been partly offset by a significant decline in the TDMA customer base (down from 478,000 at 30 June 2005 to 83,000 at 30 June 2006) as a large proportion of the TDMA customer base has upgraded to CDMA or become inactive.

Customer acquisition has been pursued aggressively for much of 2006, which has seen growth in the CDMA customer base accelerate. While increasing revenues, this has had a negative impact on cost of sales owing to the commissions, subsidies and other promotional offers required to achieve connection growth.

In Australia, mobile revenues declined as a result of lower average customer numbers during the period, reduced revenue from handset sales and a shift in customer mix from stand-alone mobile customers to bundled customers. Bundled customers have displayed lower usage than stand-alone customers (hence generating lower revenues), however, they have also displayed lower churn rates.

ARPU

Telecom uses ARPU within its New Zealand operations to measure the average monthly service revenue on a per-customer basis. Management believes that this measure provides useful information about the usage of Telecom’s products and the company’s ability to attract and retain high value customers. Telecom calculates ARPU as mobile voice and data revenue for the year divided by the average number of customers for the year. This is then divided by 12 to express the result as a monthly figure. The revenues that Telecom uses in calculating ARPU exclude revenues from handset and accessory sales, as these are not ongoing customer revenue streams, and paging revenue, inwards roaming and other miscellaneous mobile revenues, as these are not generated by Telecom’s mobile customers. As calculated by Telecom, ARPU also excludes any revenue from terminating fixed to mobile calls (which is included in interconnection revenue).

ARPU is a “non-GAAP” financial measure, not being prepared in accordance with either NZ IFRS or US GAAP. It is not uniformly defined nor utilised by all companies in the telecommunications industry. Accordingly, this measure may not be comparable with similarly titled measures used by

 

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other companies. Non-GAAP financial measures should not be viewed in isolation, nor considered a substitute for measures reported in accordance with NZ IFRS or US GAAP.

The calculation of Telecom’s mobile ARPU and its reconciliation to the NZ IFRS measure mobile revenue is shown below.

 

      Year ended 30 June  

ARPU

   2006    2005   

2006/2005

% change

 

New Zealand

        

Total mobile revenue (NZ$m)

   774    706    9.6  

Less handset sales and non-customer revenues (NZ$m)

   77    84    (8.3 )
            

Mobile voice and data revenue (NZ$m)

   697    622    12.1  

Average customers (000s)

   1,723    1,446    19.2  
            

ARPU (NZ$ per month)

   33.7    35.8    (5.9 )

The reduction in Telecom’s ARPU reflects an increasing proportion of pre-paid and “Go One Bill” customers in the connection base, as these customers have a considerably lower ARPU than other post-paid customers. Go One Bill is an integrated call plan offering with a zero access fee where customers are billed monthly in arrears for mobile calls at pre-paid rates. This plan is popular with customers who would have previously utilised pre-paid plans.

Data

Data revenues arise from meeting customers’ non-voice communications needs. There has been a shift away from traditional dedicated circuit/leased line data products towards IP-based data products given the increased flexibility and cost efficiency that these products offer. Data revenue is primarily derived from business customers.

 

      Year ended 30 June  

Data

   2006    2005   

2006/2005

% change

 

New Zealand (NZ$m)

   438    414    5.8  

Australia (NZ$m)

   164    188    (12.8 )
            

Total data revenue

   602    602    —    

Australian revenues in local currency

        

Australia (A$m)

   148    174    (14.9 )

New Zealand data revenue growth was driven by growth in managed IP data, offsetting a small decrease in traditional data services.

In Australia, data revenues declined due to the cessation of the “VicOne” contract with the Victorian State Government, the cessation of the “Tradegate” contract with the Department of Customs, the loss of one high volume low margin corporate customer and price decreases on the negotiation of new contracts.

Broadband and internet

Telecom markets ADSL services in New Zealand under the Xtra brand. Broadband connections have continued to grow rapidly in 2006. Telecom had previously set itself a target of achieving 250,000 consumer broadband connections by the end of December 2005, which was achieved prior to the target date. While driving revenue growth, this increase in the customer base has also resulted in increased operating costs in the short term as a result of promotional offers and subsidies provided in order to stimulate demand, as well as increased customer care costs.

 

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In 2006, the Government announced a range of regulatory measures, aimed at increasing the rate of broadband penetration and the level of competition to Telecom’s services. These included the introduction of UBS and LLU. This is likely to have the effect of accelerating broadband penetration and may result in further downward pressure on wholesale and retail broadband prices. More importantly, as discussed previously, the advent of naked DSL and LLU pose threats to Telecom’s fixed line access relationship with customers and could accelerate the rate of decline in traditional telephony services such as calling.

Telecom remains strongly focussed on growing broadband penetration as a driver of future business growth. Telecom has set itself the target of having 500,000 retail broadband connections across the combined consumer and business customer base by 30 June 2007. At 30 June 2006, Telecom had approximately 335,000 retail broadband connections. This growth in customer numbers is expected to continue to drive growth in related costs in the short term.

Longer term, Telecom has announced that it will invest in ADSL2+ technology to deliver significantly higher broadband speeds in the future, which will enable the delivery of higher bandwidth services.

AAPT has also seen strong growth in demand for broadband services, which has resulted in strong growth in broadband and internet revenues for Australian operations.

Internet revenue arises from the provision of dial-up internet access. Internet access is generally priced on the basis of a flat monthly rate, therefore revenue is primarily driven by the number of active dial-up customers. In Telecom’s New Zealand operations, the number of dial-up internet customers has been declining as an increasing number of customers upgrade from dial-up internet to broadband services. This has resulted in a decline in internet revenue and is a trend that is expected to continue for the foreseeable future.

 

     Year ended 30 June  

Broadband and internet

   2006    2005   

2006/2005

% change

 

New Zealand (NZ$m)

   336    285    17.9  

Australia (NZ$m)

   112    91    23.1  
            

Total broadband and internet revenue (NZ$m)

   448    376    19.1  

Australian revenues in local currency

        

Australia (A$m)

   101    84    20.2  

Broadband connections at year end

        

New Zealand (000s)

   435    258    68.6  

Australia (000s)

   102    27    277.8  

Active dial-up connections at year end

        

New Zealand (000s)

   310    374    (17.1 )

Australia (000s)

   90    90    —    

Growth in New Zealand broadband and internet revenue resulted from strong growth in broadband connection numbers, partly offset by a declining dial-up internet base as customers migrate from dial-up to broadband.

In Australia, revenue growth reflects growth in broadband revenues as a result of significant growth in the consumer broadband customer base, while the dial-up customer base has remained stable.

IT Services

IT Services revenue is derived solely in New Zealand from providing services that meet customers’ integrated communications and technology needs. This includes procurement of IT equipment,

 

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provision of network-based application services, management of customers’ information, communications and technology services, and integration of these services.

In order to enhance its existing IT services capabilities, Telecom acquired IT services companies Gen-i and Computerland effective 1 July 2004 and 1 September 2004 respectively. These entities have been integrated with Telecom’s existing IT services business and all Telecom’s IT services are now delivered under the Gen-i brand.

 

     Year ended 30 June

IT Services

   2006    2005   

2006/2005

% change

IT Services revenue (NZ$m)

   346    308    12.3

IT services revenue grew by $38 million in 2006. Of this amount, $19 million was revenue from Computerland for July and August 2005 which had no comparative amount in the financial year ended June 2005, due to the acquisition of Computerland being effective from 1 September 2004. The remaining growth of $19 million reflected strong growth in procurement and network delivered services revenue.

Telecom is targeting further growth from its IT services business in future years, as it believes the IT services market will continue to grow and there is the potential for Telecom to increase its market share.

Resale

Resale revenue is earned solely in Australia from the resale to AAPT’s customers of Telstra’s local access services, primarily to Consumer customers.

 

     Year ended 30 June

Resale

   2006    2005   

2006/2005

% change

Resale revenue (NZ$m)

   363    336    8.0

Australian revenues in local currency

        

Resale revenue (A$m)

   325    310    4.8

Resale revenue from consumer customers decreased as a result of price reductions and price capping to retain market share in a very competitive market. This was more than offset by strong growth in resale revenue from business customers, with growth coming primarily from wholesale operations.

Yellow Pages Group

Yellow Pages Group publishes White Pages® and Yellow Pages® directories in New Zealand. Revenue from the directories business is primarily derived from the sale of advertising in Yellow Pages® directories. Sundry revenue is obtained from fees for enhanced listings in White Pages® directories and online directories.

Telecom has traditionally earned its directories revenues from print products. Telecom believes that there will be a shift within the sector from print to online products and is attempting to position its business to respond to this shift. The timing of the shift, and its impact on Telecom’s revenues, are presently uncertain.

Telecom has also recently announced a scoping study of its directories business, which could ultimately result in a disposal of this business if it is determined that this option would realise more value for the Telecom group than continuing to remain the owner of the directories business.

 

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     Year ended 30 June

Directories

   2006    2005   

2006/2005

% change

Directories revenue (NZ$m)

   248    229    8.3

Growth in directories revenue resulted from both price and volume increases in print directories and increasing revenues from online services.

Miscellaneous other revenue

 

     Year ended 30 June  

Miscellaneous other revenue

   2006    2005   

2006/2005

% change

 

New Zealand (NZ$m)

   76    79    (3.8 )

Australia (NZ$m)

   70    57    22.8  
            

Total miscellaneous other revenue (NZ$m)

   146    136    7.4  

Australian revenues in local currency

        

Australia (A$m)

   63    53    18.9  

The increase in miscellaneous other revenue arose in Australian operations, New Zealand revenues were relatively stable. The increase in Australian revenues reflected Gen-i services revenue not previously included within Australian operations and the introduction of new fee structures in the Consumer division.

Other gains

Other gains arise from activities outside Telecom’s normal operations or are of a size and/or infrequent nature that make them not comparable with other periods.

 

     Year ended 30 June  

Other gains

   2006    2005   

2006/2005

% change

 

Other gains (NZ$m)

   60    154    (61.0 )

The other gain in 2006 represents a gain of $60 million pertaining to the acquisition of a 100% shareholding in Southern Cross Cables (NZ) Limited (“SCCL”), a wholly-owned subsidiary of Southern Cross Cables, in which Telecom holds a 50% shareholding. SCCL’s sole asset at the time of acquisition was a tax operating loss carryforward. The value of this tax loss carryforward was $70 million and Telecom’s acquisition cost was $10 million. The value in excess of Telecom’s acquisition cost has been reflected as a gain in Telecom’s consolidated income statement for the year ended 30 June 2006.

Other gains for 2005 comprise the following five items:

 

  a gain of $10 million realised from the sale of 15 of Telecom’s business-focused retail stores to the Leading Edge Group;

 

  a gain of $9 million realised on the re-purchase of debt prior to its scheduled maturity. Telecom issued $300 million of convertible notes in 2001, which it bought-back in two tranches during 2005. Owing to market movements since the notes were issued, the amount required to buy the notes back was $291 million, resulting in the gain on re-purchase;

 

 

in March 2005, Telecom recognised $41 million of credit support fees that were due from Southern Cross. As part of a refinancing of Southern Cross’ banking facilities in April 2003, Telecom agreed to provide contingent credit support for a portion of the refinanced debt. In return for this, support fees were payable by Southern Cross. Telecom had not previously recognised these fees, owing to uncertainty over their collectibility. However, acceleration

 

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in bandwidth utilisation significantly improved the outlook for Southern Cross culminating in substantial new sales being generated early in the 2005 calendar year. As a result of the cash generated by the additional sales, the support fees became expected to be received and accordingly, Telecom accrued $41 million at 31 March 2005 for support fees not previously recognised relating to the period from April 2003 to March 2005. Cash receipts from the additional sales was used by Southern Cross to repay the debt guaranteed by Telecom in October 2005. Support fees ceased to be receivable from Southern Cross at that point. All accrued support fees have since been paid to Telecom by Southern Cross.

 

  a gain on sale of $8 million realised from the sale of Telecom’s 0.5% stake in Intelsat Limited for $22 million in March 2005; and

 

  a gain on sale of $86 million realised on the sale of Telecom’s 12% stake in Independent Newspapers Limited for $272 million in June 2005.

Group Expenses

Total reported expenses in 2006 and 2005 were significantly impacted by asset impairments and other expenses as follows:

 

  In 2006, asset impairment write-downs of $1,301 million were recognised in respect of Telecom’s Australian operations. Additionally, a charge of $22 million was recognised in relation to intercarrier and regulatory matters and a charge of $12 million was also recognised in relation to other contractual matters.

 

  In 2005, a further write-down of $24 million was recorded in respect of the TDMA mobile network. Additionally, a one-off charge of $31 million was recorded in relation to inter-carrier accruals and disputes in Telecom’s Australian operations.

Excluding the impact of these items, increased operating expenses were recorded as growth areas of the business, particularly mobile and broadband drove increased costs. Significant customer acquisition activity in mobile and broadband resulted in accelerating cost of sales growth.

A breakdown of Telecom Group expenses is shown in the table below.

 

     Year ended 30 June  

Group expenses

  

2006

NZ$m

  

2005

NZ$m

  

2006/2005

% change

 

Labour

   796    738    7.9  

Intercarrier costs

   1,199    1,185    1.2  

Other operating expenses

   1,563    1,479    5.7  

Impairment and other expenses

   1,335    59    NM1  
            

Total operating expenses

   4,893    3,461    41.4  

Depreciation

   538    546    (1.5 )

Amortisation

   167    152    9.9  
            

Total expenses

   5,598    4,159    34.6  

 

1 Not meaningful

An analysis of significant line items within expenses follows.

 

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Labour

Labour expense includes:

 

  salary and wages of full-time and part-time employees;

 

  the costs of contractors and temporary staff;

 

  overtime and shift payments;

 

  bonuses and commissions;

 

  holiday pay and long service leave; and

 

  other personnel costs including allowances, benefits and employee welfare costs.

Where permanent and contract staff are engaged in the construction of fixed assets the related labour costs are capitalised as part of the cost of the asset, to be depreciated over its useful life.

The most significant factors driving labour expense are movements in staff and contractor numbers, salary increases to reflect labour market conditions, the extent to which staff are engaged in capital projects and the extent to which targeted business objectives are achieved (which drives commission and bonus payments).

 

     Year ended 30 June

Labour

   2006    2005   

2006/2005

% change

New Zealand (NZ$m)

   587    549    6.9

Australia (NZ$m)

   209    189    10.6
            

Total labour expense (NZ$m)

   796    738    7.9

Australian expenses in local currency

        

Australia (A$m)

   190    175    8.6

Personnel numbers at year end

        

New Zealand

   6,934    6,502    6.6

Australia

   2,099    2,058    2.0
            

Total group personnel numbers

   9,033    8,560   

Labour expense for New Zealand operations increased as a result of growth in average staff numbers. This increase in staff numbers was due to a move to build internal capability to support the IT capital programme, increased resources to support strategic initiatives (including additional call centre support and frontline sales) and in-sourcing core activities (broadband helpdesk and IT operations staff).

Australian labour expense increased largely due to higher average staff numbers during the year. As part of the strategic initiatives to reposition the business, existing telesales centres were expanded and new outbound telesales established in Brisbane and Melbourne late in the 2005 financial year. Additional customer care staff were also recruited, while there was a decrease in staff numbers in support functions.

 

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Intercarrier costs

Intercarrier costs are payments to other telecommunications companies for the carriage or termination of voice and data traffic. These costs vary directly in proportion to revenue.

In New Zealand, the components of intercarrier costs are:

 

  the interconnection costs paid to terminate traffic on other carriers’ fixed line and mobile networks; and

 

  payments made to other international carriers for the cost of terminating outwards international calling from New Zealand and international transits.

Given the lesser amount of infrastructure owned by AAPT, it is more heavily reliant on services purchased from other carriers, particularly local access. The intercarrier costs of Australian operations is therefore considerably greater in proportion to revenue compared to New Zealand operations.

 

      Year ended 30 June  

Intercarrier costs

   2006    2005   

2006/2005

% change

 

New Zealand (NZ$m)

   500    468    6.8  

Australia (NZ$m)

   699    717    (2.5 )
            

Total intercarrier costs (NZ$m)

   1,199    1,185    1.2  

Australian expenses in local currency

        

Australia (A$m)

   630    664    (5.1 )

The increase in intercarrier costs is the result of growth in payments to other international carriers for terminating international transit traffic. As discussed in the section on international revenue, growth in transit volumes in 2006 led to an offsetting increase in both transit revenues and associated intercarrier costs.

Domestic interconnection costs in New Zealand were stable. As discussed in the section on mobile revenues, the Commerce Commission has recommended the implementation of regulation to lower the cost of terminating calls to mobile phones. If regulation does proceed it is likely that the cost to Telecom of interconnecting with other mobile operators would fall significantly (as would revenue for calls to mobile networks and mobile interconnection revenue).

In Australia, the reduction in intercarrier costs reflects lower operating revenues. There are however a number of disputes and uncertainties between AAPT and the carriers it uses. These include:

 

  AAPT’s previous contract with Telstra expired on 31 December 2005. Following this date, Telstra tabled revised contractual arrangements with adverse terms and conditions to the previous contract. AAPT and Telstra continue to discuss the basis of future supply arrangements and have been unable to reach agreement to date. The latest contractual offer from Telstra has subsequently been withdrawn by Telstra;

 

  in addition to the change in contractual arrangements, wholesale residential line rental prices were increased by Telstra in December 2005. This increase was the basis of a dispute lodged with the ACCC, and in April 2006 the ACCC issued a competition notice against Telstra alleging anti-competitive conduct. AAPT has accounted for the consumer line rental costs at the historic rates; and

 

  there are a number of other substantive disputes with Telstra related to 1-900 charges and interconnect.

There is uncertainty around the timing and nature of the resolution of these disputes. As at 30 June 2006, approximately $28m was subject to dispute and being withheld. Subsequent to balance date, AAPT and Telstra agreed to a six week “negotiating window” on this matter. As part of this

 

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agreement, AAPT agreed to pay A$20 million of the amount outstanding to Telstra, although this money remains in dispute despite the agreement. Management has separately estimated possible outcomes and accounted for intercarrier costs accordingly. Local call prices and local call override penalties have been accrued for based on the current Telstra agreement.

To the extent that these disputes are resolved in a manner that is unfavourable to AAPT, this could result in an increase in intercarrier costs going forward.

Other Operating Expenses

Other operating expenses include:

 

  direct costs, which consist of direct contractor costs, international cable maintenance and restoration, support contracts and other direct costs;

 

  non-carrier, sales related costs, including the cost of mobile acquisitions, upgrades and dealer commissions, costs associated with IT Services revenues, directories publishing costs, broadband acquisition costs and other sales related costs;

 

  computer costs;

 

  advertising, promotion and communications;

 

  accommodation costs; and

 

  other costs, including bad debts, consultants, office expenses, insurance, legal and other general costs.

 

      Year ended 30 June

Other operating expenses

   2006    2005   

2006/2005

% change

New Zealand (NZ$m)

   1,306    1,238    5.5

Australia (NZ$m)

   257    241    6.6
            

Total other operating expenses (NZ$m)

   1,563    1,479    5.7

Australian expenses in local currency

        

Australia (A$m)

   230    223    3.1

In New Zealand, other operating expenses increased by NZ$68 million (5.5%). Of this amount, NZ$14 million was costs from Computerland for July and August 2005 which had no comparative amount in the financial year ended June 2005, due to the acquisition of Computerland being effective from 1 September 2004. Excluding this amount, other operating expenses increased by NZ$54 million (4.4%). The main contributors to this increase were higher mobile acquisition, upgrade and dealer commission costs and higher procurement sales costs reflecting the growth in procurement revenue within IT services.

Despite an increase in costs associated with broadband provisioning due to the substantial growth in broadband connections, direct costs decreased slightly due to savings generated from the rationalisation of maintenance and provisioning contracts. If the substantial increase in broadband connections targeted in the 2007 financial year is achieved, this would be expected to drive growth in direct costs as a result of the provisioning costs associated with new connections.

Increased advertising costs were the main contributor to the overall increase in other operating expenses for Australian operations. Advertising costs increased markedly in 2006 to support the launch of new products. This was partly offset by a reduction in bad debt expense due to improved debtor management and collection performance.

 

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Asset impairments and other expenses

 

      Year ended 30 June  

Asset impairments and other expenses

  

2006

NZ$m

  

2005

NZ$m

  

2006/2005

% change

 

Asset impairments and other expenses (NZ$m)

   1,335    59    NM 1

 

1 Not meaningful

Asset impairments and other expenses for 2006 comprise the following items:

 

  asset impairment charges totalling $1,301 million in respect of its Australian operations recognised in 2006, resulting from reviews that determined that the carrying value exceeded the stand-alone fair value of the business (calculated on a value in use basis). The decline in value was a consequence of a number of negative trends that are adversely affecting the short and long term earnings outlook for Australian operations, in particular:

 

    a significant tightening of wholesale prices and terms with Telstra (the principal supplier to Telecom’s Australian operations);

 

    continued downward pressure on retail prices; and

 

    the deferral of major project expenditure by key corporate customers.

As a result of these impairment charges, all remaining goodwill resulting from Telecom’s acquisition of AAPT has been written off. The remainder of the write-down applied to property, plant and equipment, as well as some smaller adjustments to current assets where realisation was no longer considered likely;

 

  a charge of $22 million recognised in relation to intercarrier and regulatory matters. This was made up of a settlement of $17.5 million agreed with TelstraClear in January 2006 to resolve a number of longstanding commercial issues (principally involving backdating of pricing) between the two companies, and a one-off adjustment to the accrued TSO receivable to reflect a determination by the Commerce Commission; and

 

  a provision of $7 million for the estimated potential liability that would result from unsuccessful outcomes relating to historic issues under the Fair Trading Act. Telecom has also provided $5 million for the cost of terminating an agreement with Hutchison Whampoa.

Asset impairments and other expenses for 2005 comprise the following three items:

 

  an asset impairment write-down of $24 million recognised at 30 June 2005 in respect of Telecom’s TDMA mobile network. The TDMA network had already been substantially written down in 2004. A further charge was recorded in 2005 to write the carrying value of the network down to zero to reflect the fact that the present value of expected future net cash flows expected to be generated from the network had fallen to zero at 30 June 2005;

 

  a charge of $31 million recognised by AAPT following an extensive reassessment of accruals and provisions in the inter-carrier area. The charge was a one-off adjustment required to revise cost of sale accrual assumptions and to adjust the carrying value of disputed amounts receivable to amounts considered recoverable. These accruals and disputes relate to prior periods; and

 

  a restructuring charge of $4 million.

Depreciation

Depreciation represents a significant component of Telecom’s total expenses, given the major investment in property, plant and equipment required to support its operations.

The level of capital expenditure impacts on depreciation expense. Within New Zealand operations, annual capital expenditure is currently in excess of the annual depreciation and this is expected to be the case again in the 2007 financial year. This will ultimately be expected to flow through to higher depreciation charges in future periods.

 

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Asset write-downs also have a substantial impact on depreciation expense. The write-down in prior years of the TDMA network has resulted in reduced depreciation charges for New Zealand operations in 2006. The significant impairment write-downs recognised in respect of Australian operations have substantially reduced the asset base of Australian operations at 30 June 2006 and are, therefore, expected to reduce Australian operations depreciation expense for the year ended 30 June 2007 by approximately A$80 million.

 

      Year ended 30 June  

Depreciation

   2006    2005   

2006/2005

% change

 

New Zealand (NZ$m)

   415    416    (0.2 )

Australia (NZ$m)

   123    130    (5.4 )
            

Total depreciation (NZ$m)

   538    546    (1.5 )

Australian expenses in local currency

        

Australia (A$m)

   110    120    (8.3 )

New Zealand depreciation expense declined 1.2% in 2006, with lower depreciation resulting from previous write-downs of the TDMA network largely offset by the impact of increased capital expenditure.

The decrease in depreciation for Australian operations reflects a declining asset base as assets become fully depreciated coupled with impairment write-downs recognised during the year.

Amortisation

Amortisation expense reflects the amortisation of computer software, international cable capacity, spectrum licences and other miscellaneous intangible assets. Following the adoption of NZ IFRS, goodwill is no longer amortised but instead is subject to an impairment test at least annually. As a result of such an impairment test, all goodwill in relation to AAPT has been written off in 2006.

 

      Year ended 30 June  

Amortisation

   2006    2005   

2006/2005

% change

 

New Zealand (NZ$m)

   121    122    (0.8 )

Australia (NZ$m)

   46    30    53.3  
            

Total amortisation (NZ$m)

   167    152    9.9  

Australian expenses in local currency

        

Australia (A$m)

   41    28    46.4  

The increase amortisation expense reflects increasing expenditure on computer software, particularly within Australian operations, where significant investment is being made in business support and operating support systems.

 

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Interest

 

      Year ended 30 June  

Interest

  

2006

NZ$m

   

2005

NZ$m

   

2006/2005

% change

 

Gross interest expense

   293     328     (10.7 )

Less interest capitalised

   (11 )   (8 )   37.5  
              

Interest expense

   282     320     (11.9 )

Less interest income

   28     31     (9.8 )
              

Net interest

   254     289     (12.1 )

The most significant factor in determining Telecom’s net interest expense over the two-year period has been the level of Telecom’s net debt.

Telecom uses net debt as a measure of its liquidity. Management believes that this measure provides useful information about the liquidity and indebtedness of the company by taking into account cash and other short-term liquid investments available to repay debt as well as adjusting for the impact of derivative financial instruments on debt balances reported in the balance sheet.

Telecom calculates net debt as the total of debt due within one year and long-term debt, less cash and short-term investments, plus/minus all short and long-term derivative liabilities and assets.

Net debt is a non-GAAP financial measure, not being prepared in accordance with either NZ IFRS or US GAAP. It is not uniformly defined nor utilised by all companies in the telecommunications industry. Accordingly, this measure may not be comparable with similarly titled measures used by other companies. Non-GAAP financial measures should not be viewed in isolation, nor considered a substitute for measures reported in accordance with GAAP.

The calculation of Telecom’s net debt and its reconciliation to the NZ IFRS measures debt due within one year and long-term debt is as follows.

 

      Year ended 30 June  

Net debt

  

2006

NZ$m

   

2005

NZ$m

   

2006/2005

% change

 

Debt due within one year

   955     863     10.7  

Long-term debt

   2,543     2,973     (14.5 )
              

Gross debt

   3,498     3,836     (8.8 )

Less cash

   (155 )   (235 )   (34.0 )

Less short-term investments

   (64 )   (81 )   (21.0 )

Less short-term derivative assets

   (26 )   —       NM 1

Less long-term derivative assets

   (88 )   —       NM 1

Add short-term derivative liabilities

   125     —       NM 1

Add long-term derivative liabilities

   362     —       NM 1
              

Net debt

   3,652     3,520     3.8  

 

1 Not meaningful

This calculation has been impacted by the adoption of NZ IFRS. As permitted by NZ IFRS 1, Telecom’s debt and derivative financial instruments were accounted for under NZ GAAP in 2005 and these balances have not been restated. The reduction in gross debt reflects the revaluation of foreign denominated debt at spot rates at 30 June 2006, while 2005 debt was accounted for at historic rates. The reduction in gross debt was offset by an increase in the value of derivative liabilities, which is taken into account in calculating net debt.

 

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Telecom went through a sustained period of debt reduction from June 2002 until June 2005, as strong operating cash flows, reduced capital expenditure and reduced purchases of long-term investments enabled Telecom to substantially reduce its net debt. In 2006, while operating cash flows have remained strong, increased dividend payments and capital expenditure have resulted in a 3.8% increase in net debt at 30 June 2006 compared to 30 June 2005.

Despite the increase in net debt, interest expense decreased in 2006. This reflected the fact that while net debt at year end increased, the average net debt for 2006 was lower than that for 2005 as net debt had declined substantially between 1 July 2004 and 30 June 2005. Given the levels of capital expenditure and dividend payments expected in the 2007 financial year, management currently anticipate that net debt levels will remain relatively stable during the 2007 financial year and hence 2007 net interest expense is expected to be at or above the level recorded in 2006.

Income tax expense

 

      Year ended 30 June

Income tax expense

   2006    2005   

2006/2005

% change

Income tax expense (NZ$m)

   394    386    2.1

The increase in income tax expense reflects higher operating earnings in New Zealand operations. Australian operations incurred operating losses, however, these were not able to be fully tax effected due to uncertainty as to the realisation of these benefits. In 2006, AAPT became resident in New Zealand for income tax purposes and was able to group losses for approximately four months of the financial year. Legislative proposals have been announced that would prevent that grouping continuing in 2007, however, there is currently uncertainty as to whether or not these proposals will affect AAPT once the detail is finalised.

The impairment write-downs of Australian operations totalling NZ$1,301 million only gave rise to a tax benefit of NZ$10 million, so were largely not subject to tax. The gain of $60 million on the acquisition of SCCL was also not subject to tax. Excluding these items, 2006 tax expense was 33.6% of earnings before tax, similar to the New Zealand corporate tax rate of 33%.

Included in earnings before tax in 2005 were gains on the sale of Telecom’s stakes in Independent Newspapers and Intelsat, a gain on the sale of 15 retail stores and a gain on the buyback of convertible notes, none of which were subject to tax, and credit support fees receivable from Southern Cross that were subject to a reduced tax rate. Excluding these items, tax expense was 31.9% of earnings before tax. This was lower than the New Zealand tax rate of 33% due to income in offshore subsidiaries that was not subject to tax.

SEGMENTAL RESULTS OF OPERATIONS

Telecom operates an integrated business in New Zealand and a separate integrated business in Australia.

Within its New Zealand business, marketing units are organised along products and services lines. Within its Australian business, marketing units are organised based on customer segments.

Telecom had five reportable business segments at 30 June 2006:

 

  NZ Wired;

 

  NZ Wireless;

 

  International;

 

  IT Services; and

 

  Australian operations.

Corporate expenses are not allocated to the operating segments and are included separately in a Corporate and Other category.

 

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In light of the change in Telecom’s organisational structure that is currently underway, under which the business is being structured around customer segments rather than product lines, it is expected that Telecom’s reportable segments will change in 2007. It is expected that reporting will change to reflect customer segments rather than the current product-based segments.

Telecom management monitors business unit performance based on segment earnings, which is defined as earnings from operations before interest and taxation. This is not the same as earnings before income tax in the financial statements, as interest is not allocated to individual segments.

A breakdown of segment revenues and earnings follows, as well as a discussion of the material factors affecting these results. This discussion should be read in conjunction with the analysis of the results of the consolidated results of operations, which generally analyses the results of the New Zealand and Australian operations separately.

 

     Year ended 30 June  
    

2006

NZ$m

   

2005

NZ$m

   

2006/2005

% change

 

Revenues from external customers

      

NZ Wired

   2,941     2,921     0.7  

NZ Wireless

   865     799     8.3  

International

   265     231     14.7  

IT Services

   368     328     12.2  

Australian operations

   1,305     1,354     (3.6 )
              

Total revenues for operating segments

   5,744     5,633     2.0  

Corporate and other

   11     17     (35.3 )
              

Total group revenue

   5,755     5,650     1.9  

Segment earnings (earnings before interest and income tax)

      

NZ Wired

   1,374     1,403     (2.1 )

NZ Wireless

   220     161     36.6  

International

   44     40     10.0  

IT Services

   27     17     58.8  

Australian operations

   (1,386 )   (28 )   NM1  
              

Total earnings before interest and income tax for operating segments

   279     1,593     (82.5 )

Corporate and other

   (62 )   52     (219.2 )

Interest expense

   (282 )   (320 )   (11.9 )

Interest income

   28     31     (9.7 )
              

Group (loss)/earnings before income tax

   (37 )   1,356     NM1  

 

1 Not meaningful

NZ Wired

Operating revenues increased by 0.7% in 2006, as growth in broadband and internet and directories revenue was largely offset by declining calling and to a lesser extent local service revenue. Growth in broadband revenues reflected the substantial growth in total broadband connections experienced in 2006, while directories revenue growth was a function of both price and volume increases for print directories coupled with an increasing amount of revenue being generated from on-line services. The decline in calling resulted from product substitution restricting volumes and competition driving down prices.

 

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Segment earnings decreased by 2.1% in 2006 due to increased cost from expanding and servicing the broadband customer base together with growth in labour costs due to additional resources focussed on key customer related areas. Depreciation expense also increased as a result of higher levels of capital expenditure.

NZ Wireless

NZ Wireless’ operating revenue grew 8.3% in 2006. Growth principally reflects growth in mobile data revenues, driven by increased text messaging volumes resulting from growth in the customer base, and increased penetration of high speed mobile data services.

As well as a $10 million gain on the sale of 15 retail stores, 2005 segment earnings were also impacted by a $24 million charge to write-down the TDMA network. As well as these items, growth in segment earnings of 36.6% reflects robust revenue growth, while costs remained relatively stable. This was partly due to reduced depreciation in 2006 as a result of the aforementioned TDMA write-down in 2005.

International

International revenue grew by 14.7% as a result of growth in transit revenues. This growth was volume driven and was partly offset by a decline in average prices. The growth in transit revenues, however, brought with it an equal and offsetting increase in intercarrier costs leaving the net of transit revenues and transit intercarrier costs for 2006 unchanged from 2005. Segment earnings grew by 10.0% as a result of increased revenue from the provision of services to other operating segments.

Australian Operations

Segment earnings in 2005 were impacted by a charge of NZ$31 million following an extensive reassessment of accruals and provisions for dispute in the intercarrier area. The charge was a one-off adjustment to revise cost of sale accrual assumptions and to adjust the carrying value of disputed amounts receivable to amounts considered recoverable.

Included in segment earnings for 2006 were impairment write-downs totalling NZ$1,301 million. These reflected adverse trends impacting the short and long term earnings outlook for Australian operations, particularly:

 

  a significant tightening of wholesale prices and terms with Telstra (the principal supplier to Telecom’s Australian operations);

 

  sustained downward pressure on retail prices; and

 

  the deferral of major project expenditure by key corporate customers.

As well as leading to the impairment charge, these factors also had a significant negative impact on results for Australian operations in 2006. Excluding the impairment charge, segment earnings for 2006 were a loss of NZ$85 million. This compares to a profit of NZ$3 million for 2005 (excluding the charge of NZ$31 million referred to above).

The downwards trend in retail prices and the deferral of project expenditure by key corporate customers coupled with a continuing decline in mobile revenues and the loss of several significant contracts with major corporate and Government customers led to a decline in total revenues for Australian operations. This was despite strong growth in broadband and internet revenue in line with rapid growth in broadband connections and the fact that a depreciation in the NZ dollar has resulted in higher reported NZ dollar revenues in 2006.

The tightening of wholesale prices has put considerable pressure on margins for Australian operations. There has also been an increase in operating expenditure as a result of strategic initiatives to reposition the business in the small to medium enterprise and consumer market segments. This has included investment in product development, sales capability and business and operating support systems, as well as significantly increased advertising expenditure to promote new product offerings. Together with the decline in revenue, these factors have resulted in the substantial decline in financial performance for Australian operations in 2006.

 

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There is no immediate sign of the negative trends impacting Australian operations abating. Accordingly, Telecom does not expect an improvement in the operating results of its Australian operations in 2007. The asset base of Australian operations has, however, reduced considerably as a result of the impairment write-downs. All other things being equal, this is expected to result in a reduction in depreciation and amortisation expense, and hence an increase in earnings from operations, of approximately A$80 million in the 2007 financial year compared to 2006.

Supplementary Information

Telecom evaluates its financial performance using the additional financial measure Earnings Before Interest, Tax, Depreciation and Amortisation (“EBITDA”).

EBITDA is a non-GAAP measure as it is not presented in accordance with either NZ IFRS or US GAAP. This measure is not uniformly defined nor utilised by all companies in the telecommunications industry. Accordingly, this measure may not be comparable with similarly titled measures used by other companies. Non-GAAP financial measures should not be viewed in isolation, nor considered a substitute for measures reported in accordance with NZ IFRS or US GAAP. EBITDA should not be considered as a substitute for net earnings in evaluating Telecom’s operating performance, nor as a substitute for net cash flow from operating activities in evaluating Telecom’s liquidity.

Telecom believes that EBITDA is a relevant and useful financial measure that management uses to evaluate the operating profitability of the company and its segments. EBITDA excludes depreciation and amortisation expense in order to eliminate the impact of generally long-term capital investments that cannot be significantly influenced by management on a short-term basis. Likewise interest expense and tax expense generally cannot be significantly influenced by management on a short-term basis. EBITDA is also useful to investors as it is a widely recognised key measure of operating performance amongst analysts and other members of the investment community.

The calculation of EBITDA is set out in the table below.

 

     Year ended 30 June  
    

2006

NZ$m

   

2005

NZ$m

   

2006/2005

% change

 

Net (loss)/earnings

   (435 )   967     (145.0 )

Add back/(deduct):

      

Minority interest

   4     3     33.3  

Income tax expense

   394     386     2.1  

Interest expense

   282     320     (11.9 )

Interest income

   (28 )   (31 )   (9.7 )

Amortisation

   167     152     9.9  

Depreciation

   538     546     (1.5 )
              

EBITDA

   922     2,343     (60.6 )

Reported EBITDA has been substantially impacted by impairments and other non-recurring items, particularly the impairment write-down of Australian operations. Even allowing for the impact of these items, EBITDA decreased in 2006. This reflects the adverse performance of Australian operations.

 

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LIQUIDITY AND CAPITAL RESOURCES

Overview

Telecom’s principal sources of liquidity are:

 

  operating cash flows; and

 

  external borrowing from established debt programmes and bank facilities.

The debt-funded acquisition of AAPT in 1999-2000, and subsequent acquisition of remaining minorities in 2000-2001, caused a fundamental shift in Telecom’s balance sheet, significantly increasing gearing. The period immediately following this acquisition was characterised by high levels of capital expenditure and several strategic investments in other entities, including minority stakes in Sky Network, Independent Newspapers and Hutchison 3G Australia. These investments saw debt levels peak at $5.6 billion in March 2001.

Following this period of investment and increasing debt, Telecom embarked on a period of focused de-leveraging. Sustained periods of strong operating cash flows coupled with tightly controlled capital expenditure and investment and a lower dividend pay-out than historic levels, resulted in a significant decrease in debt.

With operating cash flows remaining strong, this enabled Telecom to increase the amount of cash returned to shareholders, initially by way of an increased dividend pay-out ratio in 2005, and in 2006 by the payment of additional special dividends. Capital expenditure also increased in 2006 and is expected to do so again in the year ended 30 June 2007.

The increase in distributions and capital expenditure saw the previous trend of debt reduction cease, with net debt at 30 June 2006 increasing slightly to $3,652 million.

The extent of funds available to pay dividends will be driven by the level of earnings as well as future capital expenditure requirements and investment needs. The Board of Telecom remains committed to Telecom maintaining strong “single A” credit ratings from Moody’s Investor Services and Standard and Poor’s and its capital management policies will be designed to ensure that this objective is met. Relevant factors include Telecom’s debt profile, operating outlook, cash flow, cost of capital and level of imputation credits. As a guide, the Board expects Telecom to maintain a relatively stable capital structure with the intention that, in normal circumstances, the ratio of gross debt to EBITDA would not materially exceed 1.7 times on a long-run basis. To ensure that Telecom remains within its target settings, Telecom anticipates making lower total dividend payments in 2007. No special dividends are currently planned and regular quarterly dividends are expected to be lower than in 2006.

Cash Flows

The following table sets out information regarding Telecom’s cash flows and liquidity during the two-year period:

 

     Year ended 30 June  
    

2006

NZ$m

   

2005

NZ$m

   

2006/2005

% change

 

Net cash provided by/(used in)

      

Operating activities

   1,807     1,703     6.1  

Investing activities

   (453 )   (583 )   (22.3 )

Financing activities

   (1,434 )   (1,123 )   27.7  
              

Net (decrease)/increase in cash

   (80 )   (3 )   NM1  

 

1 Not meaningful

 

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Net cash provided by operating activities

As stated above the primary source of liquidity is cash generated from Telecom’s operations. Net cash from operating activities include interest received and paid, income tax paid and dividends received.

Net cash flows from operating activities increased by 6.1% in 2006 due to favourable movements in certain working capital items (principally receivables) and lower interest and tax payments. The decline in interest paid was in line with the reduction in interest expense resulting from lower average debt levels compared to the prior year. Tax payments reduced as a result of increased tax credits on supplementary dividend payments, tax deductions arising on the revaluation of foreign denominated intercompany debt and the receipt of tax refunds from prior years.

Net cash used in investing activities, including capital expenditure

The net cash outflow for investing activities decreased by $130 million (22.3%) for 2006 compared to the prior period. Despite payments for capital expenditure being higher in the current year, the proceeds from Telecom’s stake in Independent Newspapers Limited were received in 2006, while the prior year included the purchase of Gen-i and Computerland. Offsetting this, surplus funds were applied to the purchase of short-term investments in the current year, compared to the sale of short-term investments in the previous year.

Telecom’s capital expenditures for the two year period (on an accruals rather than cash basis) are set out below. These have been entirely funded from operating cash flows:

 

     Year ended 30 June  
    

2006

NZ$m

  

2005

NZ$m

  

2006/2005

% change

 

NZ Fixed Line

   479    426    12.4  

NZ Mobile

   93    89    4.5  

International

   14    35    (60.0 )
            

Total New Zealand operations

   586    550    6.5  

Australian operations

   131    118    11.0  

Corporate and Other

   34    35    (2.9 )
            

Total Group capital expenditure

   751    703    6.8  

Total capital expenditure of $751 million grew by $48 million (6.8%) in 2006, with increases across all business areas except International and Corporate and Other.

Expenditure on the NZ Fixed Line networks accounted for the majority of the increase. Investment for upgrades and replacements of network assets increased by $18 million, largely due to planned increased activity, including the renewal of core network capability, information systems for improved robustness, and refreshing client networks. Investment in new capabilities increased by $34 million mainly as a result of network infrastructure investment and development of new services including Ferrit. New investment involves the development of new products and the deployment of new capabilities into the network (such as VoIP capability) or IS systems (such as a new billing capability).

NZ Mobile investment of $93 million increased by $4 million (4.5%) resulting from growth in data services and the expansion of EV-DO 3G mobile network coverage into provincial centres.

International investment of $14 million reduced by $21 million (60.0%) reflecting the purchase of Southern Cross Cable capacity in the prior year.

Australian operations investment for 2006 of $131 million increased by $13 million (11.0%) compared to 2005. Expenditure for 2006 continued to move away from networks towards ‘enabling’ infrastructure such as call centre functionality and IT platforms.

 

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For the year ended 30 June 2007, Telecom currently expects total capital expenditure of approximately $800 million. Of the $800 million, approximately $495 million relates to NZ Fixed Line, $100 million to NZ Mobile, $25 million to International, $145 million to Australian operations and $35 million to Corporate and Other. It is expected that this expenditure will be financed from operating cash flows.

Management believes Telecom’s net cash flows to be generated from operations and its existing available borrowings will be sufficient to fund Telecom’s expected capital expenditure, working capital and investment requirements for 2007. Management also considers that Telecom is in a satisfactory position to meet its longer term cash requirements. Telecom has a satisfactory spread of debt maturities, with maturities extending up to 15 years for its longest dated debt issues. Telecom has access to sufficient borrowing capacity to meet its needs and in the event that operating cash flows declined to levels that are materially lower than those being generated at present, Telecom could respond by reducing dividend payments and/or capital expenditure.

Net cash flow used in financing activities

Cash flows for financing activities largely reflect borrowing activities and dividend payments to shareholders.

The net cash outflow for financing activities increased by $311 million (27.7%) in 2006. The increase in financing cash outflows was primarily due to an increase in the dividend paid as a result of special dividends paid in the current year. Telecom also repurchased $114 million of capital during the year as a result of a policy introduced in 2006 of buying back on-market an equivalent number of shares to that issued under the dividend reinvestment plan. Partly offsetting these movements, Telecom made lower net repayments of debt in 2006.

Telecom expects total dividend payments in 2007 to be lower than 2006, as further special dividends are not currently anticipated and the regular quarterly dividend payment is expected to be lower than the prior year. Telecom is also ceasing the practice of buying back shares to offset issues under the dividend reinvestment plan, resulting in the retention of more cash within the company.

Balance Sheet

Working capital

Telecom’s current liabilities are typically in excess of its current assets, in common with a number of other international telecommunications companies. It believes that its negative working capital position does not create a liquidity risk because it could delay the timing of Telecom’s discretionary capital expenditure and reduce dividend pay-out ratios should cash inflows from its diverse customer base diminish at any point in time. Also, Telecom’s commercial paper programmes, committed standby facility and uncommitted bank lines provide it with additional sources of liquidity should the need arise.

Telecom defines its working capital as the difference between current assets and current liabilities. Telecom’s working capital position is shown in the table below:

 

     As at 30 June  
    

2006

NZ$m

   

2005

NZ$m

   

2006/2005

% change

 

Current assets

   1,325     1,683     (21.3 )

Current liabilities

   (2,119 )   (1,907 )   11.1  
              

Deficit in working capital

   (794 )   (224 )   254.5  

The reduction in current assets is largely a reflection of an increase in shareholder distributions with special dividends being paid during the year. As set out above, Telecom anticipates lower dividend payments in 2007 and the share buy-back pursuant to the dividend reinvestment plan has also been suspended, which will result in a greater amount of cash being retained within the company.

 

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The increase in current liabilities resulted from an increase in debt due within one year, with an increase in the amount of short term debt on issue as well as a small increase in long-term debt maturing within one year. Telecom anticipates completing further term-debt issuances to replace long-term debt maturing within the next twelve months. In the unlikely event that such debt issues could not be executed, Telecom has adequate cash and short-term investments, committed standby facilities and short-term borrowing capacity to cover repayments of existing debt.

As a result of the anticipated term debt issuances replacing debt due within one year, a reduced amount of term debt scheduled to mature in 2007 and lower dividend distributions, Telecom currently expects a reduced deficit in working capital at 30 June 2007.

Cash and short-term investments

Telecom’s cash and short-term investment balances are shown in the table below:

 

     As at 30 June  
    

2006

NZ$m

  

2005

NZ$m

  

2006/2005

% change

 

Cash

   155    235    (34.0 )

Short-term investments

   64    81    (21.0 )
            

Total cash and short-term investments

   219    316    (30.7 )

Cash represents deposits with financial institutions available on call or with an original maturity of less than three months, less bank overdrafts. Short-term investments are held with financial institutions and have an original maturity of less than six months. Of the total balance at 30 June 2006, 55% was held in NZ dollars. The remainder was held by offshore subsidiaries primarily for their own liquidity purposes, with balances being maintained in Australian dollars, US dollars and British pounds.

The reduction in cash and short-term investments in 2006 reflected the utilisation of surplus cash to repay short-term debt.

Telecom’s liquidity policy is to maintain unutilised committed facilities and or liquid resources (comprising cash and short-term investments) of 100% of the next 12 months’ funding requirements.

Debt – general

At 30 June 2006, Telecom had total borrowings amounting to NZ$3,498 million (net of unamortised discount and excluding the impact of cross currency and interest rate swaps entered into to manage the currency and interest rate risk associated with these borrowings). All of Telecom’s debt is issued on an unsecured basis. The maturity profile of Telecom’s debt is set out in Note 22.

Telecom has a number of established debt programmes that offer the ability to access various markets depending on investor demand. The debt programmes include the following:

 

  US$2 billion Euro Medium Term Note Programme, under which there was NZ$2,160 million outstanding at 30 June 2006;

 

  NZ$500 million Note Facility, under which there was NZ$235 million outstanding at 30 June 2006;

 

  A$1.5 billion Short-Term Note and Medium-Term Note Programme under which there was A$55 million short term notes outstanding at 30 June 2006;

 

  US$1 billion Euro-Commercial Paper programme under which there was US$30 million outstanding at 30 June 2006; and