FINANCING THE TELSTRA´S PROJECT: SUBMARINE CABLE FROM AUSTRALIA TO

JAPAN

Doctorate of FinancePrepared for the Project Finance ClassOctober 2011Servio Fernando Lima ReinaBased on Harvard HBR 9-203-029 case

BACKGRO

UN

DBackgroundProject

To build a submarine cable between Australia and Japan (year: 1999)Partners

Telstra, Teleglobe, Japan Telecom

Investment$520Mn ($567Mn if major delay) , 12,500Km cable, 40 Gbps (up to x8 capacity) 256 STM-1 (up to 2048 STM-1)

PathAustralia-Guam-Japan-US

Useful life of cable15 years (contract term: IRU of 15 years)

RisksPrice decline of avg 25% per year. Volatility of submarine price capacityLenders base decision on sponsor´s background. Sponsors may change in time.

Competitors (as of 1999)Three competitors: SCC, Pac Rim, SEA-ME-WE3

PROJECT FIN

ANCIN

G FO

R EXPOSU

RE MITIG

ATION

PROJECT FINANCING AS A WAY TO LIMIT EXPOSURE FOR TELSTRA

Traditional ways of financing submarine cable projects

1. CLUBS (early 90´s)Comprised of as many as 90 sponsorsUse of equityTIME ESTIMATE TO COMPLETION: 5-7 yearslimited 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 executionLimited partnership: 2-4 carriersUse of debt and equityTIME ESTIMATE TO COMPLETION: 2 yearsCarriers could not use all cable capacity. They began to sell capacity to other carriers (Wholesale market)

3. NON PRIVATE CARRIER STRUCTURENon carriers invest on submarine cable to sell capacity laterProfile of non carrier: Private investorsTIME ESTIMATE TO COMPLETION: 2 years

PROJECT´S M

AJOR O

PERATION

AL RISKSPROJECT MAJOR OPERATIONAL RISKS

Landing stationRight-of-way permitsHarbor clearanceLocal fishing permits

Permit delays

Fiber CableRepeatersDevices

Few electronicsuppliers

High installationTimes. Few ships(2 yrs)

Mitigation strategy: Implement a delay contingency fund (9% of total investment)

PORTER FIVE FO

RCESPROJECT OVERVIEW BASED ON PORTER FIVE FORCES

Competitive rivalry

MediumFew submarine

options between Australia-Japan

Threat of new entrants

SCC, other entrants attracted by excess demand

Bargaining power of customers

High (few carriers as buyers (6) @

Pacific)

Threat of substitute products

Low (satellite, low quality)

Bargaining power of suppliers

High @1999: High lead times for

electronics, submarine cable, landing stations

PROJECT´S SPO

NSO

RSSPONSORS

FINDINGS Initial sponsors were not so strongProject accounts for 28% of Telstra´s net income, 8% fo AT&T´s and 32% of NTT´s. These were

the strongestStrongest sponsors contribute with landing stations (i.e. it means less time to get permits)

Strongest but unconfirmed sponsors

Strongest sponsor

PROJECT´S PO

SSIBLE FINAN

CING

SCENARIO

SPROJECT´S POSSIBLE FINANCING SCENARIOS

Possible scenarios to finance AJC project

ScenarioGroup Ownership # sponsors Equity Tranche A

Tranche B Pros Cons

Corporate Finance Telstra 1

$567

$-

$-

Simple, 100% equity. Investment is 28% of

Telstra net income. Fast TTM

High risk, excess capacity and fast price

erosion

Corporate Finance

Telstra-Japan Telecom-Teleglobe 3

$567

$-

$- 100% equity. Fast TTM

High risk, excess capacity and fast price

erosion

Project Finance

Telstra-Japan Telecom-Teleglobe-AT&T-NTT-MCI 3

$85

$337

$145

15% equity. 85% of investment financed

by bank lends guaranteed by presold

capacity to sponsors and other carriers

Low risk, capacity sold in advance to any kind of sponsors (high, mid,

low)

Project Finance

Telstra-Japan Telecom-Teleglobe-AT&T-NTT-MCI 3

$85

$337

$145

Tranche B may be covered by issuing

bonus in stock markets. More

probability of finding investors. 59% presold to high rated sponsors

only

Low risk, but issuing bonus may delay more

the beginning of the project

PROJECT´S CAPITAL STRU

CTURE

TELSTRA 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 1999and 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 M

AIN CO

NSID

ERATION

SPROJECT´S MAIN CONSIDERATIONS

Main aspects AJC submarine system

Financing scheme 15% corporate finance, 85% project finance

assetscable system (submarine cable, electronic 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 G

OVERN

ANCE

Project Governance

1. NEW COMPANY FOR PROJECT´S GOVERNANCEA new company has to be created out of the projectDifficult 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

Demand forecasting (Oct

1999)

New entity: structure,

shareholderagreement

(March 2000)

MOU signedLand party

agreementsSupply

contracts(April 2000)

Financing definition

(June 2000)

Construction(1 year)

Ready for Service (June 30, 2001)

Decisions has to be taken before start of construction

1 year 8 months

FIND

ING

S IN TH

E CASEFINDINGS IN THE CASE

FINDINGS 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.

AJC cableLaunch date

First year wheredemand exceedsSupply ( if no new Entrants)

Units (STM-1)

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 excess

supply excess

supply excess

supply excess

supply deficit

supply deficit

supply deficit

PRICE EROSIO

NPRICE EROSION

Observed 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 concern of this project (source: ABN AMRO)

1999E 2000E 2001E 2002E 2003E 2004E 2005E 2006E 2007E 2008E0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00 8.00

5.60

3.92

2.74

1.921.34

0.94 0.66 0.46 0.32

Extrapolation price per STM-1 ($Mn)

First year wheredemand exceeds supplyBut we will assume constant price erosion

SENSITIVITY AN

ALYSISPresent value of revenues (absolute values)

Sensibility analysis based on price erosion and/or WACC

FORECASTED DEMAND IN STM-1 1999E 2000E 2001E 2002E 2003E 2004E 2005E 2006E 2007E 2008E

AJC supply (STM-1) 60 0 196 0 256 0 256 0 256 0

Price per STM-1 ($Mn) 8.00 5.60 3.92 2.74 1.92 1.34 0.94 0.66 0.46 0.32

Price erosion per year 30% 30% 30% 30% 30% 30% 30% 30% 30%

price erosion % 30%

Revenues ($Mn) 482 0 767 0 492 0 241 0 118 0

WACC 10%

NPV ($Mn) 10 years $1,494 $1,015 $1,320 $1,444 $1,494

% of NPV 32% 68% 88% 97% 100%

Upgrades to the system would cost approximately $25 million per 256 STM-1and would take approximately 12 to 15 months to implement.

SENSITIVITY AN

ALYSISImpact of declining STM-1 prices in Revenues

Impact of price per STM-1 decline in Net Present Value of Revenues

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 marketor the SCC project fail to be executed (because the failure to get landing permits).

Price erosions % per year %NPV yr 1 %NPV yr3 %NPV yr5 %NPV yr7NPV Revenues

$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

SENSITIVITY AN

ALYSISWACC calculation

Is it right that the Discount rate should be 10%? Why?

Unlevered Beta Calculation

company symbolBeta L (S&P 500)

Debt/Equity ratio taxes

Unlevered beta

AT&T T 0.44 58.34% 3.25% 0.28

Verizon VZ 0.48 59.51% 3.25% 0.30

Sprint-nextel S 0.96 139% 3.25% 0.41

Average U Beta 0.33

Levered Beta for AJC cable Telstra

Project name CountrySector Avg U Beta Debt/equity ratio Taxes Au Levered BetaAJC cable project

Australia Telecom 0.33 567% 30% 1.65

k = Rf + β Δ + PRP

(Discount rate calculation)

Project name CountrySector Levered BetaΔ (market premium) PRP (Au) Discount rate (k)

AJC cable project

Australia Telecom 1.65 2.87% 84.16 10.8%

A discount rate of 10.8% has no significant impact in expected revenuesAustralia and Telstra are safe investments!

CON

CLUSIO

NS AN

D RECO

MM

ENDATIO

NS

CONCLUSIONS AND RECOMMENDATIONS

CONCLUSIONS 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.

•