FINANCING THE TELSTRA´S PROJECT: SUBMARINE CABLE FROM AUSTRALIA TO JAPANDoctorate of FinancePrepared for the Project Finance ClassOctober 2011Servio Fernando Lima ReinaBased on Harvard HBR 9-203-029 case
BACKGROUNDBackgroundProject To build a submarine cable between Australia and Japan (year: 1999)Partners Telstra, Teleglobe, Japan TelecomInvestment $520Mn ($567Mn if major delay) , 12,500Km cable, 40 Gbps (up to x8 capacity) 256 STM-1 (up to 2048 STM-1)Path Australia-Guam-Japan-USUseful life of cable 15 years (contract term: IRU of 15 years)Risks Price decline of avg 25% per year. Volatility of submarine price capacity Lenders base decision on sponsor´s background. Sponsors may change in time.Competitors (as of 1999) Three competitors: SCC, Pac Rim, SEA-ME-WE3
PROJECT FINANCING FOR EXPOSURE MITIGATIONPROJECT FINANCING AS A WAY TO LIMIT EXPOSURE FOR TELSTRATraditional ways of financing submarine cable projects 1. CLUBS (early 90´s) Comprised of as many as 90 sponsors Use of equity TIME ESTIMATE TO COMPLETION: 5-7 years limited exposure : many carriers contributed small amounts of equity. 2. PRIVATE CARRIER DEAL STRUCTURE (mid 90´s) Carriers needed much larger blocks of capacity and quicker execution Limited partnership: 2-4 carriers Use of debt and equity TIME ESTIMATE TO COMPLETION: 2 years Carriers could not use all cable capacity. They began to sell capacity to other carriers (Wholesale market) 3. NON PRIVATE CARRIER STRUCTURE Non carriers invest on submarine cable to sell capacity later Profile of non carrier: Private investors TIME ESTIMATE TO COMPLETION: 2 years
PROJECT´S MAJOR OPERATIONAL RISKSPROJECT MAJOR OPERATIONAL RISKS Permit delays Landing station Right-of-way permits Harbor clearance Local fishing permits Few electronic suppliers Fiber Cable Repeaters Devices High installation Times. Few ships (2 yrs) Mitigation strategy: Implement a delay contingency fund (9% of total investment)
PORTER FIVE FORCESPROJECT OVERVIEW BASED ON PORTER FIVE FORCES Threat of new entrants SCC, other entrants attracted by excess demand Bargaining power of suppliers Competitive rivalry Bargaining power High @1999: High of customers lead times for Medium High (few carriers electronics, subm Few submarine as buyers (6) @ arine options between Pacific) cable, landing Australia-Japan stations Threat of substitute products Low (satellite, low quality)
PROJECT´S SPONSORSSPONSORSFINDINGS Initial sponsors were not so strong Project accounts for 28% of Telstra´s net income, 8% fo AT&T´s and 32% of NTT´s. These werethe strongest Strongest sponsors contribute with landing stations (i.e. it means less time to get permits) Strongest sponsor Strongest but unconfirmed sponsors
PROJECT´S POSSIBLE FINANCING SCENARIOS PROJECT´S POSSIBLE FINANCING SCENARIOS Possible scenarios to finance AJC project Group TrancheScenario Ownership # sponsors Equity Tranche A B Pros Cons Simple, 100% equity. Investment is 28% of High risk, excessCorporate Telstra net income. capacity and fast priceFinance Telstra 1 $567 $- $- Fast TTM erosion Telstra- Japan High risk, excessCorporate Telecom- capacity and fast priceFinance Teleglobe 3 $567 $- $- 100% equity. Fast TTM erosion Telstra- 15% equity. 85% of Japan investment financed Telecom- by bank lends Low risk, capacity sold Teleglobe- guaranteed by presold in advance to any kindProject AT&T-NTT- capacity to sponsors of sponsors (high, mid,Finance MCI 3 $85 $337 $145 and other carriers low) Tranche B may be covered by issuing Telstra- bonus in stock Japan markets. More Telecom- probability of finding Low risk, but issuing Teleglobe- investors. 59% presold bonus may delay moreProject AT&T-NTT- to high rated sponsors the beginning of theFinance MCI 3 $85 $337 $145 only project
PROJECT´S CAPITAL STRUCTURETELSTRA CAPITAL STRUCTURE Telstra´s financing: Tranche A:Presale commitment to purchase capacity as loan guarantee. Tranche B: Future sell of capacity to other parties as loan guarantee. No loans to bilateral or multilateral institutions, BUT loan to commercial banks (i.e. ABN AMRO) Project susceptible to high leverage due to high demand of capacity in 1999 and know how of over +150 years of building submarine cables. But, banks willing to lend if there are high rated sponsors of the project
PROJECT´S MAIN CONSIDERATIONSPROJECT´S MAIN CONSIDERATIONS Main aspects AJC submarine system Financing scheme 15% corporate finance, 85% project finance cable system (submarine cable, electronic assets equipments, landing stations) structure incorporated joint venture leverage (D/capital) 85% debt recourse limited-recourse debt ownership 3 sponsors (up to 6 is possible) Telstra exposure 50% of 85Mn Organization complexity High if several sponsors cash flow disposal limited (lenders priority) monitoring external (by lenders)
PROJECT´S GOVERNANCE Project Governance 1. NEW COMPANY FOR PROJECT´S GOVERNANCE A new company has to be created out of the project Difficult task to establish rules between sponsors: exit rules, valuing/selling shares, board of directors composition, etc. Sponsors financed the project and were required to sign up purchase agreements 2. TIMELINE 1 year 8 months New entity: MOU signed structure, sh Land party Demand Financing areholderag agreements Construction Ready for Serviceforecasting (Oct definition reement Supply (1 year) (June 30, 2001) 1999) (June 2000) (March contracts 2000) (April 2000) Decisions has to be taken before start of construction
FINDINGS IN THE CASEFINDINGS IN THE CASEFINDINGS Before 2002, there is an excess supply of capacity in the zone. Forecasted supply after 2002 is in deficit. This is reflected in price erosion. Price erosion can be assumed to be deeper before 2002 and smoother after 2002. FORECASTED DEMAND IN STM-1 1999E 2000E 2001E 2002E 2003E 2004E 2005E Existing capacity (STM-1) 174 174 174 174 174 174 174 Southern Cross Cable (STM-1) 0 774 774 774 774 774 774 SEA-ME-WE3 upgrade (STM-1) 0 129 129 129 129 129 129 AJC supply (STM-1) 60 0 196 0 256 0 256 Total existing & planned capacity 234 1077 1273 1077 1333 1077 1333 Forecast demand in STM-1 65 161 406 832 1348 2065 3032 Gap demand-supply in STM-1 -169 -916 -867 -245 15 987 1699 supply supply supply supply supply supply supply excess excess excess excess deficit deficit deficit Units (STM-1) AJC cable First year where Launch date demand exceeds Supply ( if no new Entrants)
PRICE EROSIONPRICE EROSION Extrapolation price per STM-1 ($Mn) 8.00 8.00 7.50 7.00 6.50 6.00 5.50 5.60 5.00 4.50 4.00 3.92 3.50 3.00 2.50 2.74 2.00 1.92 1.50 1.34 1.00 0.94 0.50 0.66 0.46 0.32 0.00 1999E 2000E 2001E 2002E 2003E 2004E 2005E 2006E 2007E 2008E First year where demand exceeds supply But we will assume constant price erosionObserved price erosion is in average 30% since 1997.Will be kept constant for the becoming years (this is a worst case scenario), despiteSupply deficit after 2002. This will make the business case more realistic.Market risk (price per STM-1, excess supply and excess demand) is the major concernof this project (source: ABN AMRO)
SENSITIVITY ANALYSISImpact of declining STM-1 prices in Revenues Impact of price per STM-1 decline in Net Present Value of Revenues NPV Revenues Price erosions % per year %NPV yr 1 %NPV yr3 %NPV yr5 %NPV yr7 $Mn 0% 10% 34% 60% 82% $ 4,806 10% 15% 44% 70% 88% $ 3,158 20% 23% 56% 80% 93% $ 2,133 30% 32% 68% 88% 97% $ 1,494 40% 44% 79% 94% 99% $ 1,090 50% 58% 88% 98% 100% $ 832 Keeping price erosion at 30% per year the expected revenues will be around $1.5Mn, Realized in less than five years. These are good news considering that we have assumed a worst case scenario. The project will generate more revenues if no more entrants comes in to the market or the SCC project fail to be executed (because the failure to get landing permits).
SENSITIVITY ANALYSISWACC calculation Is it right that the Discount rate should be 10%? Why?Unlevered BetaCalculation Beta L (S&P Debt/Equity Unleveredcompany symbol 500) ratio taxes betaAT&T T 0.44 58.34% 3.25% 0.28Verizon VZ 0.48 59.51% 3.25% 0.30Sprint-nextel S 0.96 139% 3.25% 0.41 Average U Beta 0.33Levered Beta for AJC cable TelstraProject name Country Sector Avg U Beta Debt/equity ratio Taxes Au Levered BetaAJC cable Australiproject a Telecom 0.33 567% 30% 1.65k = Rf + β Δ + (Discount ratePRP calculation) Δ (marketProject name Country Sector Levered Beta premium) PRP (Au) Discount rate (k)AJC cable Australiproject a Telecom 1.65 2.87% 84.16 10.8% A discount rate of 10.8% has no significant impact in expected revenues Australia and Telstra are safe investments!
CONCLUSIONS AND RECOMMENDATIONSCONCLUSIONS AND RECOMMENDATIONSCONCLUSIONS AND RECOMMENDATIONS• Go for it! : In the worst case scenario, the project is still attractive.• Time to market to deploy fiber is vital. Access on time to landing stations is a must.• Mitigate risks before the project´s construction starts: This is an all or nothing project that can not be stopped in the middle of the construction.• Source of risk of this kind of projects are: Market risks, operational risks, governance risks. • Market risks are mitigated selling capacity in advance and exploiting opportunities of deficit of supply • Operational risks (delays due to suppliers, landing stations, etc) may be mitigated with the allocation of contingency CAPEX (10% was used in this case). • Governance risks are mitigated choosing sponsors based on company´s debt rating.•