Teleus Corporation Case Summary

1.0 INTRODUCTION
The chief financial officer (CEO) of TELUS Corporation (Telus) has just been informed that Moody's, a bond rating service, has downgraded the firm's credit rating to one notch below investment grade. The CFO's challenge is to determine what specific actions, if any, to recommend to the firm's audit committee.
In solving this problem, the members of this group decided to divide the work into four main parts. The first part will contain the major problem that led Moody to downgrade TELUS’ bond. The second part will look into the impact of the downgrade on TELUS Corporation, the third part looks at TELUS’ performance analysis with ratio and graph and finally, the fourth part, takes care of the proposed CFO's recommendation
to the audit committee.
2.1 MAJOR PROBLEMS THAT LED TO MOODY'S DOWNGRADE
Moody’s decision to downgrade TELUS bond might have been influenced by a lot of factors which: 1. Increment in debt to total capital ratio to 58.6% in June 2002. This was a total deviation from TELUS forecasted debt to capital ratio of 50%, within three years of purchasing Clearnet. Even though Clearnet was purchased in 2000 and the three years is not yet up, increment in debt to equity ratio after one and half years, was not a good indication. 2. The fall in TELUS' stock price from $16.67 to $10.40 from April 2002 to July 2002 and the drop in dividend reinvestment program (DRIP) from 47% to 10%. This was as a result of Verizon (25% owner of TELUS) and others (13% owners of TELUS) declining to participate in the DRIP. 3. TELUS experienced negative free cash flow for the first and second quarters 2002. This resulted in TELUS' cutting down its dividends from $0.35 to $0.15 in January 2002. This represents 57.14% reduction in dividends. 4. Reduction in credit facility to TELUS as a result of industry's reaction to Teleglobe's bankruptcy. TELUS' ability to go for credit facility was also reduced. 5. Canadian Radio-television and Telecommunication Commission’s (CRTC) decision to modify subsidies or contributions incumbents could receive for providing basic residential service at below-cost rates in high-cost service areas. This regulation led to a reduction in TELUS’ EBITDA by $300 million commencing in 2002. 6. TELUS' inability to repay its debts. 7. Finally, it can be noticed that TELUS Corporation made so many acquisition between 2000 and 2001. Much of their investments were in fixed cost rather than variable cost-operating leverage. When fixed cost forms the major part of the capital structure, a slight decline in revenue will lead to a drastic reduction in profit which will in the end affect free cash flow. This could also be the reason why TELUS experienced negative free cash flow in 2002. Although the above reasons might have led specifically to TELUS’ bond being downgraded by Moody, the entire telecommunication industry was not without problems. Prominent among these was the financial crisis which led to some companies going bankrupt and others being rated low whilst others reported losses

3.0 IMPACT OF DOWNGRADING ON TELUS' CORPORATION Moody's downgrading brought a lot of negative impacts on TELUS Corporation. Among some of these negative impacts are: • First of all, when Moody publicly announced the downgrading of TELUS’ bond, market value fell from $96 to $66. This was the steepest decline in pricing in the history of the Canada's debt capital market. • Not only did the TELUS' debt fall but also their stock price reduced drastically by 37.6% from $16.67 to $10.40. • Aside this, TELUS experienced an unfavorable credit facility terms. TELUS' cost of borrowing cost increased by 25 basis points which represented $3.7 million a year including standby fees. • TELUS shares were also affected by Moody's downgrading. Investors did not even wait for the second quarter to withdraw. TELUS shares traded under $7.0 when the market opened on July 25 from a closing price of $9.82 the previous day. A fall of 40.29%.

4. ANALYSIS OF TELUS PERFORMANCE FROM 1998-2002 1ST HALF
|Ratios |1998 |1999 |2000 |2001 |1st Half 2002 |
|Control over Expenses | | | | | |
|Interest expense on |4% |3% |4% |9% |10% |
|borrowed funds/Operating Revenue | | | | | |
|Operating Expenses/ |78% |78% |81% |88% |87% |
|Operating Revenue | | | | | |
| | | | | | |
|Activity or Efficiency | | | | | |
|Operating revenue/Total Assets |74% |75% |34% |37% |19% |
|Average Collection Period |40.7 |38.6 |59.5 |48.6 |97.1 |
|Inventory Turnover |126.5 |104.3 |40.3 |60.7 |34.1 |
| | | | | | |
|Liquidity | | | | | |
|Current ratio |0.662 |0.695 |0.270 |0.776 |0.834 |
|Acid Test |0.635 |0.663 |0.247 |0.712 |0.777 |
|Working Capital |-588.2 |-548.2 |-4889.7 |-417.5 |-295.5 |
| | | | | | |
|Marketability | | | | | |
|Net profit Margin |1% |6% |8% |6% |5% |
| | | | | | |
|Coverage | | | | | |
|Interest coverage |4.83 |3.45 |3.11 |0.21 |0.19 |
| | | | | | |
|Profitability Indicators | | | | | |
|Before tax net income/Total assets |14% |8% |5% |1% |0% |
|Before tax net income/Total Revenue |19% |11% |14% |2% |2% |
|Before tax net income/ Net worth |26% |15% |13% |2% |1% |
|After tax net income/ Total assets |1% |4% |3% |2% |0% |
|After tax net income/Total Revenue |1% |6% |8% |6% |1% |
|After tax net income/Net worth |2% |8% |7% |6% |0% |
| | | | | | |
|Leverage | | | | | |
|Debt-Sales |28% |26% |50% |120% |253% |

Table 1

| |1998 |1999 |2000 |2001 |1st Half 2002 |
|Net Cash Flow |1089 |1412 |1643 |1948 |777 |
|NOWC |78 |-244 |-35 |-166 |-129 |
|TOC |961 |447 |4676 |4897 |4746 |
|NOPAT |602 |354 |418 |40 |19 |
|OPC |1624 |1416 |1576 |1423 |610 |
|NI | |-514 |4229 |221 |-151 |
|GI | |548 |5387 |1604 |440 |
|FCF | |867 |-3811 |-181 |170 |
| | | | | | |

Table
2

5.0 RECOMMENDATIONS
Based on afore mentioned factors, we would like to make the following recommendations to the audit committee of TELUS Corporation as the CFO.
Our recommendations cover the following areas. 1. Capital structure 2. Liquidity management 3. Working capital management 4. Reduction in expenses 5. Improvement in free cash flow 6. Reducing Operating leverage 7. Risk management

4.1 Capital structure
TELUS’ debt forms a higher portion of its capital structure and its shareholders receive the lowest return, based on a comparison of the three year averages of some selected companies in the industry. Our first recommendation with regards to capital structure is that TELUS should have a debt policy. As Modigliani and Miller (MM) observed, borrowing increases the expected rate of return on shareholder’s investment, debt also increases the risk of the firm’s shares. As at June 30th, 2002, TELUS’ long-term debt as a percentage of EBITDA was 360.1% and net debt to total capitalization was 58.3%. We recommend that TELUS should work towards achieving an optimal capital structure of 50% debt and 50% equity which will maximize its market value.

How do they get this combination? There are two things TELUS can do. The first option is to hold on to their borrowings and negotiate with their creditors for more time to repay the short-term debts which are falling due or they can issue more equity to pay the debt holders. This will send a good signal to the capital market and credit rating agencies that TELUS is serious about achieving its debt target.

The money raised with the new issue will not only pay debt holders but also TELUS can use part of it to increase its shareholders dividend as well to make them better-off than they are now. This development will motivate shareholder to support the new issue. The new issue will also bring a balance between TELUS’ debt and equity combination.

As part of changing the capital structure to have a balance between debt and equity, we recommend that TELUS should accept New York-based hedge fund’s offer to swap its millions of dollars bonds for shares. This will relieve TELUS from having to raise money to settle the bondholder as well as avoid the cost of new issue and at the same time, it will help achieve the new capital structure policy.

4.2 Liquidity Management
It can be noticed from the case that over the years TELUS has been experiencing a current ratio of less than 1 (as shown in table 1). The average over the past five years is 0.647. The ultimate liquid asset, cash, in 2002 first half was nil. Most of TELUS’ investments are in long-term assets which are difficult to liquidate. According to Saunders and Cornett, 2006, holding relatively small amount of liquid asset exposes an organization to enhanced illiquidity and risk. Excessive illiquidity can result in an organization’s inability to meet required payments on liability claims and, at the extreme, in bankruptcy. This explains why TELUS could not settle its debt. We therefore we will like to recommend that TELUS divert some its investments plans from long-term assets to short-term assets like T-bills, T-notes and T-bonds which are much easier to liquidate, has a lower cost, with little or no loss in principal value(Saunders and Cornett, 2006).

3. Working Capital Management
Working capital is needed to run the day-to-day business activities without any interruptions. TELUS has been operating with negative working capital (as shown in table 1). This is not good enough. The negative working capital could be as a result of the major components of working capital ( That is, Cash, receivables and inventories) forming a small portion of TELUS’ assets. It can also be seen from the trend of working capital that efforts are being made by TELUS to achieve a positive working capital. We therefore recommend that TELUS should have a cash conversion cycle which will be aimed at minimizing the time between cash expenditure on materials and collection of cash sales. If the firm is able to minimize its average collection period and inventory conversion period, cash will always be available for working capital to improve.

4.4 Reduction in Expenditure
TELUS’ expenditure increases at a very faster rate than revenue. From table 1, it can be noticed that 2001 expenditure as a percentage of revenue was 88.4% and as at 30th June 2002, expenditure as a percentage of revenue stood at 87.4%. This is not a good sign since TELUS spends most of its revenue on expenditure. We therefore recommend that TELUS should cut its expenditure in order to increase its net income.

4.5 Improvement in Free Cash Flow
TELUS’ free cash flow for 2001 was negative (As shown in table 2). We recommend that TELUS should focus on improving free cash flow from negative to positive. They can do this by reducing capital expenditure and also aim at increasing EBITDA as well by reducing its operating expenditure.

4.6 Reducing Operating Leverage
Between 2000 and 2001, TELUS’ operating leverage was very high. They made too much acquisition which made them highly risky. We do understand that due to the nature of TELUS’ business-telecommunication-as a result of technology, they are likely to invest more in technology but all the same, We will like to recommend that TELUS invest more in variable cost rather than fixed cost since too much fixed cost in the capital structure can make the firm’s earnings and ROE decline with the slightest reduction in revenue. Also TELUS can consider merging with other Telecommunication companies instead of always acquiring. This will also reduce the operating leverage.

4.7 Risk Management
Aside the above, we also recommend that TELUS should also aim at managing its risks. It should manage both business and financial risks. Business risk depends on a number of factors such as demand variability, sales price variability, input cost variability, ability to adjust output prices for changes in input cost, foreign risk exposure, and the extent to which costs are fixed: operating leverage and ability to develop new products in a timely, cost-effective manner. TELUS should control these factors to minimize the risks involved. TELUS can do so by reducing the volatility of future input costs, they can negotiate a long term labor and materials supply contract which will lock in the input prices. They can also engage in hedging to reduce the business risk. With financial risk, TELUS should reduce the intake of debts since more debts results in more financial risk. They can resort to hedging by accepting offer of New York-Based hedge fund to swap millions of dollars of TELUS bonds for share. This would cover its position now.

REFERENCES 1. Brigham F. and Ehrhardt C., (2002), "Financial Management: Theory and Practice", 10th edition, Ohio, Thomson, South-Western.

1. Mishkin, F., 1997, "The Economics of Money, Banking, and Financial Market", 5th edition, United States of America, Addison Wesley Longman, Inc 2. Saunders, A. and Cornett, M., (2006), "Financial Institutions Management: a Risk Management Approach", 5th edition, New York, McGraw-Hall.

3. Brealey, et al, 2008, “Principles of Corporate Finance”, 9th Edition, McGrwa-Hill/ Irwin, New York.