Deutsche Telekom Full Year 2005 Earnings Conference Call Transcript (DT)

Deutsche Telekom (DT)
Full Year 2005 Earnings Conference Call
March 2nd 2006, 7:30 AM.

Executives:

Thilo Kusch, Head of IR
Kai-Uwe Ricke, Chairman of the Management Board, Chief Executive Officer, Chief Operating Officer and Head of Business Customer Segment
Dr. Karl-Gerhard Eick, Deputy Chairman of Management Board, Deputy Chief Exeutive Officer and Head of the Financial & Controlling

Analysts:

Nick Lyall, Morgan Stanley
Scott McKenzie, SG Securities
Graeme Pearson, Lehman Brothers
Brian Rusling, Cazenove
Hannes Wittig, Dresdner Kleinwort
James Golob, Goldman Sachs
Guy Peddy, Deutsche Bank
Stefan Borscheid, WestLB
Frank Rothauge, Sal Oppenheim
Andrew Beale, Arete Research
Justin Funnell, Credit Suisse
Richard Prentiss, Raymond James
Mark Cardwell, Sanford Bernstein
Jonathan Dann, Bear Stearns
James Ratzer, New Street Research
John Carlides, Man Securities
Jacques de Grayling, IXIS Securities
Stephen Garibaldi, Credit Suisse

Presentation

Operator

Good afternoon and welcome to Deutsche Telekom's Full Year 2005 Results Conference Call. On our customer's request, this conference will be recorded.

Company Speaker

This presentation contains forward-looking statements that reflect the current views of Deutsche Telekom management with respect to future events. They include statements as to market potential and the planned T-Online merger and the "Outlook 2006" statements at the end of this presentation. Forward-looking statements are based on current plans, estimates and projections. You should consider them with caution. Such statements are subject to risks and uncertainties, most of which are difficult to predict and are generally beyond Deutsche Telekom's control, including those described in the sections "Forward-Looking Statements" and "Risk Factors" of the company's Form 20-F report filed with the US Securities and Exchange Commission. Among the relevant factors are the progress of Deutsche Telekom's workforce reduction initiative and the impact of other significant strategic or business initiatives, including acquisitions, dispositions and business combinations. In addition, stronger than expected competition, technological change, litigation and regulatory developments among other factors may have material adverse effects on costs and revenue development. If these or other risks and uncertainties materialize, or if the assumptions underlying any of these statements prove incorrect, Deutsche Telekom's actual results may be materially different from those expressed or implied by such statements. Deutsche Telekom can offer no assurance that its estimates or targets will be achieved. Deutsche Telekom does not assume any obligation to update forward-looking statements to take new information or future events into account or otherwise.

In addition to figures prepared in accordance with IAS/IFRS, Deutsche Telekom presents so-called non-GAAP financial performance measures, e.g. EBITDA, EBITDA margin, adjusted EBITDA, adjusted EBITDA margin, adjusted EBT, adjusted net income, special influences, free cash flow, free cash flow before purchase of network assets and spectrum in the US, leverage, net debt, net debt adjusted, EBITDA and the adjusted figures on the page titled "FY 2005 Net Income". These non-GAAP measures should be considered in addition to, but not as a substitute for the information prepared in accordance with IAS/IFRS. Non-GAAP financial performance measures are not subject to IAS/IFRS or any other generally accepted accounting principles. Other companies may define these terms in different ways. For an explanation of some of these terms, please refer to "Reconciliation to pro-forma figures" under the "Publications" heading on Deutsche Telekom's Investor Relations webpage at: www.deutschetelekom.com.

Operator

Now please listen to the reports of Kai-Uwe Ricke and Dr. Karl-Gerhard Eick. Afterwards you are welcome to ask your questions. May I now hand you over to Mr. Thilo Kusch.

Thilo Kusch, Head of IR

Yeah -- hi good morning all from me as well. Everything is set, so let's get straight into the speeches.

Kai-Uwe Ricke, Chairman of the Management Board, Chief Executive Officer, Chief Operating Officer and Head of Business Customer Segment

Thank you, Thilo. Hello everybody. As you will have seen from this morning's announcement, the results for 2005 are very satisfactory and we have met all the financial targets that we set ourselves at the beginning of the year. Revenues have risen by nearly 4%, just under €60 billion, with an increase of 5.4% in the fourth quarter. Adjusted EBITDA increased by 5.7% to €20.7 billion, and free cash flow of nearly €8 billion represents a free cash flow yield of 14%. This results in net income for the year of €5.6 billion, which on an adjusted basis equals €4.7 billion. This excellent bottom line performance means that we will be recommending to the AGM that a dividend of €0.72 per share be paid in 2006 for the year 2005, an increase of 16% over last year.

It is Deutsche Telekom's excellent financial position, the strongest it has ever been, that allows us to recommend the highest dividend payment in our history.

Let me just highlight some of the business areas that have contributed to this strong performance, and also give you an update on our top ten targets that are part of our excellence program.

In Broadband/Fixed Networks we have been very successful in stabilizing the minute loyalty through our tariff reforms, and we have secured the IPTV football rights for our triple play platform, to be launched later this year.

The Mobile business successfully implemented its mobile data strategy with 400,000 web'n'walk devices sold during the year. The objective of providing seamless services to our customers saw the introduction at the beginning of this year of T-Mobile@home, and preparations are in hand for the launch of the customer relationship management database in April.

Within the Business Customer division, we acquired the Gedas Systemhaus business from Volkswagen in December last year, for which we got EU approval on Tuesday. This acquisition is in line with our strategy to grow ICT solutions.

At Group level, we announced back in November the objective of reducing personnel numbers in Germany by a total of 32,000 over the next three years. Let me just stress that the implementation of this program is not dependent on any accord with the trade union as it is based upon voluntary agreement with the individuals concerned.

I will go into a little bit more detail now about the results for the three divisions in turn, but I will keep my remarks to a minimum, as you will have the opportunity to hear more about each of these from their respective management teams at our Investor Day at CeBIT in a couple of weeks.

Starting with Broadband/Fixed Networks, you can see how broadband growth is accelerating. During the course of the year there were more than 2.1 million DSL net adds in Germany alone. The fourth quarter developed especially well with 660,000 DSL net adds. This is the highest annual and quarterly increase seen to date, and we expect the strong growth to continue for the foreseeable future, particularly as there is still a lot of potential in the German market. We currently have nearly 8 million domestic DSL customers, and of these Deutsche Telekom's retail share stands at around 80%. In addition, the development in Central and Eastern Europe is progressing very well with total DSL subscribers more than doubling to around half a million.

We are also seeing similar, very positive developments in Mobile in Central and Eastern Europe. Within T-Com specifically, total revenues for the full year declined by 3.5%, that is around €1 billion. Of these €1 billion, €0.2 billion were internal revenues driven by reduced prices and volumes in its relationship with T-Online and T-System.

External revenues in the fourth quarter fell year-on-year by nearly 5%. This is due in part to a loss of narrowband access lines, but mainly it is because of the deliberate policy of proactively defending our customer base through the introduction at the beginning of last March of a new optional tariff structure which led to a stabilization of our minute market share, and the focusing of DSL sales and marketing in T-Online alone.

As part of the broadband strategy, and in order to maintain its competitiveness, T-Online twice reduced its flat-rate tariff during the year. In 2006, we will be introducing the new triple play products into the market, and we will be giving you more details about this at CeBIT.

Moving now to the Mobile division, you can see clearly how Mobile revenue growth has progressively accelerated during the course of 2005. This is true for both total revenues and service revenues in all the key markets of Germany, the US and the UK. The service revenue growth in Europe was driven by a 5% increase in minutes of use of the network as SIM-card penetration grew, which over-compensated for the slight expected decline in ARPU per SIM-card.

Total Mobile customers numbers increased by 9 million to nearly 87 million. The impact of the Safe for Growth program is clearly evident in the fact that despite this very significant rise, total subscriber acquisition costs did not increase, remaining stable at below 3 billion, while Save for Growth had decreased by 14% year-on-year.

The US Mobile operations have enjoyed another spectacular year. Customers increased by more than a quarter to nearly 22 million; revenues grew by 28% to almost $15 billion, and adjusted EBITDA by 60% to over $4 billion. T-Mobile USA has been, and continues to be a key contributor to revenue and EBITDA growth within the Mobile segment, and Deutsche Telekom as a whole. In 2005, T-Mobile USA contributed 40% of the total mobile revenues, compared to 31% in 2003. The adjusted EBITDA contribution increased to 34% in 2005 from just 18% in 2003.

At T-Mobile UK, we saw a turnaround in the customer growth and revenue development in the fourth quarter. Compared to the fourth quarter of 2004, revenues grew by almost 10% to €1.1 billion. Clearly, this turnaround is partly due to the fact that the year-on-year development was no longer impacted by the termination rate cuts; however, the strong revenue growth is also a reflection of the operation improvement of T-Mobile UK, which is also evident in the strong customer growth of 845,000 in the fourth quarter.

As you will have noticed, we also took a write-down in the goodwill of T-Mobile UK of €1.9 billion. This re-evaluation as part of the annual impairment test, which is obviously a non-cash item, is a consequence of the valuation of O2 following Telefonica's takeover bid. This is quite different to the reasons that led Vodafone to its recent write-down. Karl will return to this later.

If I turn now to Business Customers, the focus has been and will continue to be on the opportunities of leveraging the Group's expertise and scale in cross-selling IT solutions to the small, medium and large customers. Although this program was only introduced during the course of the year, the impact is already clearly visible and the increase of nearly 30% in IT revenues from this customer group to over €400 million.

I now hand over to Karl to take you through the numbers in more detail.

Dr. Karl-Gerhard Eick, Deputy Chairman of Management Board, Deputy Chief Exeutive Officer and Head of the Financial & Controlling

Thank you Kai. From a financial perspective I can only underline Kai's remark that we generated excellent results. We delivered on all our financial targets; revenue at €59.6 billion came in above the low end of the guidance range due to strong growth in Mobile in particular. Adjusted EBITDA with €20.7 billion was precisely in line with guidance. CapEx, excluding the acquisition of network assets and spectrum in the US, at €7.2 billion came in slightly below the low end of our guidance range.

We are pleased with the free cash flow performance. For the year we achieved a free cash flow of €7.8 billion, despite significantly higher cash taxes and an adverse development in working capital and accruals.

With a net debt to adjusted EBITDA ratio of 1.9, we improved our leverage further, compared to our guidance of no further improvement of this ratio. The net debt to adjusted EBITDA ratio is actually slightly below our target range of 2 to 3. Our yearend 2005 gearing of 0.8 is at the low end of the target range of 0.8 to 1.2. Finally, our equity ratio of 38.8% is back to the historical high in 2001, and above our target range of 30% to 35%.

Reported net income increased by almost €4 billion to €5.6 billion, while adjusted net income improved by 26.7% to € 4.7 billion. This strong bottom line performance allowed us to increase the dividend per share by 16% to €0.72 per share, which is our proposal for the AGM in May. You will recall that we said that the dividend was dependent on the profitability development.

Looking at the divisions, Broadband/Fixed Network continued to experience top line pressure in 2005. Both revenues and adjusted EBITDA came in at the low end of the guidance ranges in each case. Revenue at T-Com Germany decreased by 4%. This was partially offset by stable revenues at T-Com Eastern Europe and at 3.8% revenue growth at T-Online. Despite a revenue decrease of €0.9 billion, T-Com's adjusted EBITDA nearly stabilized at €9.6 billion, after €9.7 billion the year before, continuing its strong record in terms of improving cost efficiency. This strong adjusted EBITDA performance at T-Com was partially offset by the development at T-Online, where adjusted EBITDA decreased by more than 30% in 2005. This is a reflection of the intense competition in the ISP market, and T-Online's successful attempts to stabilize its market share. However, even including T-Online, Broadband/Fixed Network's overall adjusted EBITDA decreased only by €0.3 billion year-on-year compared to the revenue decrease of €1 billion.

Mobile had great results in almost every aspect; revenue grew by 11% to €29.5 million, and exceeded our guidance from November of €29.3 billion. Adjusted EBITDA came even at the high end of the guidance range with €9.8 billion. The customer base grew by 9 million customers to almost 87 million internationally. Almost half or 4.4 million of these new customers came from the US, with Germany contributing 2.1 billion and the UK 1.4 million new customers.

T-Mobile US contributed almost 90% of the absolute growth in revenues, underscoring the importance of the US for the overall growth of Deutsche Telekom. Encouragingly service revenues grew in all mobile companies with the exception of the UK. Even in UK the trend is starting to look a lot more positive. Fourth quarter service revenues in the UK increased by 5.6% year-on-year. Total revenues increased by 9.7% due to strong handset sales as already said by Kai.

Adjusted EBITDA for the mobile segment increased by 16.3% to €9.8 billion, even faster than the 11% revenue growth. As a result, the adjusted EBITDA margin improved by 1.5 percentage points to 33.2%. Germany and the UK posted essentially stable adjusted EBITDA margin for the year with 41.8% and 31.4% respectively. T-Mobile US improved its adjusted EBITDA margin by an impressive 5.5 percentage points to 27.7%.

Compared to our guidance from November T-Systems delivered excellent results, revenues came in at the high end of the guidance range with €12.9 billion. Adjusted EBITDA exceeded the guidance range with €1.6 billion. While this is encouraging we still saw some revenue weakness at small, medium and large enterprises for the year, which was not completely offset by the revenue strength in the top 60 customer segment. However, we are encouraged by the initial success of our initiative to grow the IT revenues within the small, medium and large enterprise segment as already highlighted by Kai.

We are very pleased by our continued strong cash generation; with a free cash flow of €7.8 billion, we've fully met our target range of €7.5 billion to €8 billion. We managed to achieve this stronger side despite the adverse change in working capital and goals, significantly higher cash taxes and significantly higher cash CapEx. We benefited both from a very strong underlying cash flow of almost €20 billion and a significant reduction in net interest payments due to the lower debt level.

In 2005 the change in working capital and accruals had an impact of €0.7 billion on the cash generated from operations. Working capital increased by €0.5 billion, due in particular to higher account receivables driven by revenue growth. Accruals decreased by €0.2 billion, while associated payments increased. These apply in particular to the restructuring of the civil servants' health insurance fund.

In this context, let me say a few words about CapEx; CapEx amounted to €7.2 billion excluding €2.1 billion for the Cingular network in California and Nevada in US spectrum. Compared to 2004 with CapEx of €6.4 billion, CapEx increased in '05 due to higher investment imports and fixed network and mobile, still CapEx came in slightly below our guidance range of €7.5 to €8 billion.

We are also very pleased with the developments of the bottom line, net income more than tripled to €5.6 billion, while adjusted net income increased by almost €1 billion to €4.7 billion. Looking first at adjusted net income, EBITDA and net financial expense improved by €1.1 billion and €1.4 billion respectively. The improvement in net financial expense was due in particular to a lower net interest expense driven by the reduction in gross debt, and the impact of the improved rating on the bonds with step up clauses. This more than offset the increase in D&A and income taxes. The increase in adjusted D&A by €1.2 billion was driven primarily by higher amortization of intangible assets which in turn was driven by significantly higher amortization of UM test licenses, due to the IFRS rules that licenses can only be amortized from the date of the launch of service.

You certainly will remember that in 2004 we have only written off our UM test licenses for half a year whereas in '05, we had the full year effect of the UM test license amortization.

Adjusted income taxes increased by €0.5 billion to €2.6 billion. In terms of reported net income let me highlight the biggest special influences in the fourth quarter. In the fourth quarter reported costs including D&A, excluding D&A amounted to €12.4 billion. Adjusted for special influences costs were €11.1 billion, by far the biggest special influences where personal restructuring charges amounting to a total of €1.2 billion before taxes. Personnel related restructuring charges at Broadband/Fixed Network contributed about half of this amount, with the remainder coming from primarily from Business Customers and GHS, including the rental. These restructuring charges were made in connection with our program to reduce personnel by 32,000 employees over the next three years. Other operating income was boosted by €0.8 billion gain from the release of accruals due to restructuring of the health insurance systems of the civil servants.

In terms of D&A, essentially the entire special influence came from the --already by Kai -- mentioned €1.9 billion unscheduled write-down on the goodwill of T-Mobile UK. This write-down resulted from the regular annual impairment test that we had already selected in the third quarter interim report. The bid by Telefonica for O2 provided a comparable valuation that we were required to apply for the valuation of T-Mobile UK, which then led to the required valuation adjustment of €1.9 billion. This was not caused by any change in the outlook for the business, and let me stress that the write-down is obviously a non-cash item.

Just for clarification, this situation is clearly quite different to that of Vodafone. Vodafone had more than €120 billion of goodwill, following the international acquisition. We on the other hand, have only a small amount of goodwill in our balance sheet left, out of the total of €18.4 billion of goodwill, only €11.3 billion are in our international mobile businesses, and in any case as you will recall, we made some write-downs in the year 2002.

Returning to the special influences, taxes were positively impacted by a €2.2 billion non-cash income tax benefit related to the net operating loss carry forward for T-Mobile USA. This loss carry forward represents an asset to T-Mobile US to the extent that they can be utilized to reduce future cash income tax payments. By maintaining evaluation allowance against deferred tax assets related to these loss carry forwards, T-Mobile US had not recognized them as assets in accordance with accounting rules requiring evidence of its ability to utilize them in the future. In the fourth quarter of '05 T-Mobile US determined that its financial performance strengths were sufficiently positive to support a €2.2 billion reduction in the valuation allowance against its deferred tax assets related to its tax loss carry forwards. This then resulted in the gain we see here.

Despite significantly higher cash outlays we continued to improve our balance sheet, which is now I would say in excellent shape. Shareholders' equity improved by almost €4 billion to €49.6 billion, while net debt at yearend 2005 stood at €38.6 billion or €1.3 billion lower than at the end of the year before. As a result of these developments, all key graded metrics continued to improve as I described in my introductory statement.

Let me remind you in this context that we have nearly halved our net debt since its peak in mid 2001 by more than €35 billion. Our 2005 yearend net debt of €38.6 billion compares to an estimated net debt of approximately €74 billion under IFRS as of June 30, 2001. This achievement has also been recognized by the rating agencies where we now have a stable Single A long-term rating from all three major agencies. Back to Kai.

Kai-Uwe Ricke, Chairman of the Management Board, Chief Executive Officer, Chief Operating Officer and Head of Business Customer Segment

Thank you, Karl. Let me conclude by summarizing the revenue and EBITDA targets that we announced in November for 2006 and 2007. For revenues we are targeting between €62.1 billion and €62.7 billion in 2006 and for adjusted EBITDA the guidance is to deliver between €20.2 billion and €20.7 billion in 2006. The targets for 2007 remain unchanged as well. As I said before we look at 2006 as a year of investment, similar growth and to enhance our long-term profitability. This level of investment in the business is reflected in the CapEx expenditure. We would expect CapEx to increase to around €10 billion in 2006 driven in particular by the fiber investments in Germany and increased investments at T-Mobile UK, T-Mobile Germany and T-Systems.

This of course does not include any option of next generation rollout costs in the US AWS option where we expect to fully participate. This is going to be a very important step in the development of T-Mobile US. With the spectrum acquired in this auction we intend to rollout the next generation network with the objective of enhancing further the capacity of our network for both fixed to mobile substitution and mobile data and of driving cost benefits. But, as in the past, we will take a very discipline approach to the auction and we will not overspend. As you are probably aware, the SEC has set June 29 as the start date for the auction in its recent public notice.

Finally, let me just take this opportunity to update you on the other outstanding issues. First the online; here we do now appear to be moving forward. Last month the appeals court in Frankfurt approved the accelerated registration of the merger but did grant leave to appeal to the Bundesgericht, our federal court of justice, which is Germany's highest appeals court. The Bundesgericht has yet to determine whether it will allow an appeal. If it were to do so, then we would have to wait for a final decision which would be some time later this year.

Second, we are waiting for the revision to the Germany telecommunications act to provide us with the regulatory certainty that we require in order to continue our investment in fiber-optic network. We remain confident that this will be finalized in the not too distant future.

And third, you will have seen that there have been some points of detail raised by Brussels regarding the acquisition of tailoring; however we see no reason why these cannot be resolved and expect to be completed by May. And as you will have seen yesterday our agreement with Ortel has been extended until the middle of May.

As I have said before, future dividend development will be dependent on the profitability of the business and we remain very confident about this. In addition, let me just reiterate that Deutsche Telekom is committed to providing attractive returns for our shareholders. Thank you.

Thilo Kusch, Head of IR

Okay let's move straight into questions.

Questions & Answers

Operator

Thank you very much Mr. Ricke. The question and answer session will be started now. Operator Instructions.

Mr. Lyall from Morgan Stanley, may you ask your question please?

Q - Nick Lyall

Hello, yes if I could just ask a couple of questions firstly. Just on the movements in T-Com revenue, the overall revenue is down 1% but it looks like network communications as you mention was down about 8% this quarter year-on-year. Could you maybe explain a little bit more in depth what happened to the network communications revenue line? And also wholesale was strongly up. So is it possible for you to explain why it was so strongly up given the comp in the fourth quarter was so weak? And the second question. Could you maybe mention on dividend -- could you explain a bit more about what you mean by profitability of the business exactly? You've not set a floor this year for the dividend payment but it looks with the spending at the EBITDA line as if your net income -- there's a possibility it could be flat or even down. Could you just explain to us what you mean about profitability and what you're linking the dividend to exactly? Thank you.

A - Kai-Uwe Ricke

Well let me try to answer your first question at a glance. It reflects the developments in the business customers area. Until Q3 2005, the overall trend was increasing external revenues and slightly decreasing internal revenues. Q4 2005 saw an extraordinary change in internal to external revenue development, 1) the decreasing external revenues compared to Q4 2004 due to very strong Q4 2004 which was toll collect. And the weakness in systems integration whereas there were increasing internal revenues, and the main driver was the Windows XP rollout at Deutsche Telekom which could be completed in Q4 2005. I hope that address your question, I'm not sure whether it really was your question. Second, dividend. I'd like to stick to what I said. We have always said that the development of the dividend will depend on the development of the profitability and that we want to pay an attractive dividend. So no change to that, and we always said that. That still remains true. And I would like to add that it is our strong intention, it's the intention of the management to increase the profitability of the business. And when it comes to the dividend for 2006, we will decide it in 2007.

A - Karl-Gerhard Eick

Probably to add to the first point, you're probably looking into the backup where you have the T-Com domestic split but the explanation we have given in the presentation, on the T-Com total revenue decline of about €300 million explains exactly what is happening in the fourth quarter. And probably to the wholesale revenues in T-Com, the increase mainly was borne out of the fact that if you look at the 2004 numbers, we had a very unusually low number in Q4 so it looks as if there's a huge increase year on year but that basically is borne out of an accounting treatment of the year 2004 where we had very low wholesale revenue in 2004. I hope that was it, let's move onto the next question.

Operator

Mr. McKenzie from SG Securities, may we have your question please?

Q - Scott McKenzie

Yes I was just looking at the T-Mobile numbers and seeing that both T-Mobile Germany and T-Mobile UK have swung back into positive revenue growth territory. I was just wondering how sustainable that is going forward given various profit warnings elsewhere in the sector? I was also wondering whether you were surprised by Vodafone's downgrade of its outlook earlier this week?

A - Kai-Uwe Ricke

Whereas I do not want to comment on Vodafone and any other outlooks, let me dive a little bit into the German and the UK performance. Yes, you are right; what you see is, and that is where we are very proud of, a decent growth in service revenues, not only in Germany, but also in the UK. And that’s very specifically in the fourth quarter, which is, and I'd like to stress that, a direct result of our strategy which we started some time in 2004, as I recall it, to “Save for Growth