AUSTRALIA TLS AU Price (at 13:07, 19 Apr 2012 GMT) Outperform A$3.39 Volatility index Low 12-month target A$ 3.55 12-month TSR % +13.0 Valuation A$ - DCF (WACC 9.6%, beta 0.9, ERP 6.0%, TGR 1.0%) 3.55 GICS sector Telecommunication Services Market cap A$m 42,182 30-day avg turnover A$m 166.8 Number shares on issue m 12,443 Investment fundamentals Year end 30 Jun 2011A 2012E 2013E 2014E Revenue m 25,027 25,243 25,646 25,833 EBIT m 5,710 5,927 6,661 6,462 Reported profit m 3,231 3,513 3,983 3,809 Adjusted profit m 3,237 3,513 3,983 3,768 Gross cashflow m 7,715 7,922 8,275 8,209 CFPS 62.0 63.7 67.2 69.1 CFPS growth % -8.7 2.7 5.6 2.8 PGCFPS x 5.5 5.3 5.0 4.9 PGCFPS rel x 0.65 0.62 0.66 0.68 EPS adj 26.0 28.2 32.4 31.7 EPS adj growth % -20.1 8.5 14.7-2.0 PER adj x 13.0 12.0 10.5 10.7 PER rel x 1.03 0.94 0.91 1.00 Total DPS 28.0 28.0 28.0 34.0 Total div yield % 8.3 8.3 8.3 10.0 Franking % 100 100 100 100 ROA % 14.8 15.6 17.3 16.7 ROE % 26.1 29.5 35.5 35.9 EV/EBITDA x 5.3 5.2 4.8 4.8 Net debt/equity % 93.9 87.0 114.4 112.4 P/BV x 3.5 3.6 3.8 3.9 TLS AU vs ASX 100, & rec history Note: Recommendation timeline - if not a continuous line, then there was no Macquarie coverage at the time or there was an embargo period. Source: FactSet, Macquarie Research, April 2012 (all figures in AUD unless noted) 20 April 2012 Macquarie Securities (Australia) Limited Briefing highlights strong FCF pipeline Event Telstra held its Investor Day, focussed on capital management and the NBN. Impact Capital management discussion highlights Telstra s improving FCF profile: The presentations emphasised Telstra s high levels of cash generation over the medium term as its underlying operations are boosted by the arrival of NBN payments. In this context Telstra noted that it expects to generate $2-3bn (16-24cps) of excess cash flow (ie, incremental to dividends) over the next three years. This adjusts for the debt-funding of spectrum and also Telstra s contribution to FOXTEL for the Austar deal. Put another way, on this same basis, we see underlying free cash flow of $4.4-4.8bn or 37-39cps per annum through to FY15. This compares favourably with the 28cps dividend that has been pledged for FY12 and FY13. We continue to see scope for increased dividends from FY14, and possibly a share buyback in the interim: Against this backdrop, and with the company operating at the conservative end of its target gearing parameters, Telstra is well positioned to undertake capital management over the next few years. It signalled a strong preference for doing this via fully franked dividends once surplus franking credits are available (from FY14). We see dividend levels increasing to 34cps in FY14 and 36cps in FY15 partly contingent on the progress of the NBN rollout (which we assume to track around two years behind its December 2010 Corporate Plan). While the preference is for fully franked dividends, we also see capacity for a $2bn buyback in 2013 should Telstra not make any major acquisitions along the way. Well positioned to deal with any change in Government policy: Telstra management reiterated its view that the finalisation of the NBN agreements puts it in a strong position to deal with any change in Government policy. Given a change in policy from the Coalition would likely lead to a substantial reduction in capital invested into the NBN itself, we do see plenty of scope for both the Government and Telstra to reach an agreement that satisfies the stakeholders of each. In addition, we see Telstra as being able to lock in $2-3bn of value from the NBN deal over the next 12-18 months, which offers another layer of defence to policy change. Earnings and target price revision EPS changes: FY12 +0.7%, FY13 +1.4%, FY14 +1.2%. 10cps increase in TP to $3.55/sh reflects minor modelling changes and time value of NBN cashflow. Price catalyst 12-month price target: A$3.55 based on a DCF methodology. Catalyst: FY12 result (August). NBN progress updates. Action and recommendation Outperform maintained. Earnings outlook is stable and the Investor Day brings to the fore the strong FCF generation to come from Telstra over a number of years. On our revised estimates, Telstra s dividend yield stands at 8.3% for FY12-13, 10.0% in FY14 and 10.6% in FY15 cash backed and fully franked. Please refer to the important disclosures and analyst certification on inside back cover of this document, or on our website www.macquarie.com/disclosures.
Analysis Plenty of surplus free cash flow coming down the line The Investor Day update confirms that Telstra is well positioned to generate significant levels of free cash over the coming years on the back of its underlying operations and also due to NBNrelated cash flows. On the company s own definition of excess cash flow this amounts to $2-3bn (16-24cps) of excess cash being generated over the next three years. On a more traditional FCFE basis, and after adjusting for spectrum purchases and Telstra s subordinated loan to FOXTEL for the Austar transaction, we see Telstra s annual run-rate FCFE tracking at between $4.4-4.8bn or 37-39cps between FY12 and FY15. This compares to the 28cps dividend level that has been pledged for FY12 and FY13. Our numbers bias us toward the higher end of Telstra s excess cash flow range for two reasons: First, Telstra has historically allowed for $500m of bolt-on acquisitions in its free cash flow guidance. In recent years it has spent well below this level, and we expect its run-rate going forward to be $200-250m pa. Second, we expect Telstra will be able to contain its capex spend to around 13% of sales by FY15 (once some of the early stage NBN-related capex is deployed). 1% of sales equates to around $250m pa. Fig 1 Telstra FCF reconciliation Free cash flow generation FY12e FY13e FY14e FY15e Cash flow from operations $m 8,547 8,270 8,146 8,140 Less: Capex $m - 3,559-3,435-3,389-3,498 Less: Spectrum purchases - - 1,400 - - Less: Acquisitions allowance $m - 200-250 - 250-250 Less: Austar $m - 450 - - - FCFE $m 4,338 3,185 4,507 4,392 FCFE cps 34.9 25.9 37.9 37.0 Add back spectrum/austar purchases* $m 450 1,400 - - FCFE adj for spectrum/austar $m 4,788 4,585 4,507 4,392 FCFE adj for spectrum/austar cps 38.5 37.2 37.9 37.0 Macquarie dividend forecast cps 28.0 28.0 34.0 36.0 NBN contribution to FCF (post-tax) cps 2.6 1.4 2.7 4.8 Source: Macquarie Research, April 2012 Clear principles for capital management outlined As part of the briefing, Telstra outlined five key principles that underpin its capital management strategy: Maintain a balance sheet with a single A credit rating. Grow dividends over the longer term and have them fully franked. No change at this stage to the strategy of paying 28cps for FY12 and FY13. Excluding spectrum, capex/sales to be around 14% pa (partly subject to NBN rollout). Over the course of a year not to borrow to either fund the dividend or pay out capital returns. Retain the financial flexibility for portfolio management and to make strategic investments. On this basis, we have pushed back our share buyback, and increased medium-term dividend forecasts In the context of this briefing and the principles outlined above, we have made two changes to our capital management assumptions for Telstra going forward. 20 April 2012 2
Dividend forecasts increased for FY14 and FY15: We have increased our dividend assumptions for FY14 to 34cps (from 32cps) and for FY15 to 36cps (from 34cps), with no changes after that point. This is a slightly more aggressive repatriation of capital, reflecting Telstra s financial parameters being slightly more aggressive than we had previously assumed. Our analysis suggests that this level of dividend could be fully franked. (We had targeted gearing of ~1.4x vs the Telstra comfort zone gearing of 1.5-1.9x). $2bn share buyback from 2H13: As discussed, Telstra will generate significant levels of free cash flow over the next few years. Discussion by management today highlighted that while a buyback would be considered, it would need to be meaningful to shareholders in terms of the value and accretion that it would deliver. While Telstra did not quantify the term meaningful, we assume a buyback of ~$2bn (4.7% of equity) will meet the criteria and be possible over calendar 2013. This may still prove aggressive particularly if Telstra is to make any acquisitions over the period. However as the company has highlighted it will benchmark acquisitions against the value to shareholders of an equivalent buyback, we are happy to incorporate the buyback now and adjust should acquisitions be made down the track.(note: if we assumed $500m of acquisitions per annum from FY12-14, the scope for this buyback would reduce by $700m). Fig 2 Telstra FCFE and DPS outlook (Macq estimates) Fig 3 Telstra capex outlook (Macq estimates) cps 50 45 40 35 30 25 24.5 41.6 30.7 38.5 37.9 37.0 25.9 38.8 43.7 42.5 cps 50 45 40 35 30 25 $m 6000 5000 4000 3000 18.1% 14.0% 13.6% 14.1% 18.9% Spectrum payments % 14.7% 13.1%13.3% 13.1%12.9% 20% 18% 16% 14% 12% 10% 20 15 20 15 2000 8% 6% 10 5 10 5 1000 4% 2% 0 FY09 FY10 FY11 FY12e FY13e FY14e FY15e FY16e FY17e FY18e 0 0 FY09 FY10 FY11 FY12eFY13eFY14eFY15eFY16eFY17eFY18e 0% FCF per share DPS Capex Capex as % of sales Source: Company data, Macquarie Research, February 2012 Source: Company data, Macquarie Research, February 2012 Telstra gearing profile Telstra believes that it can achieve its credit rating goal and maintain flexibility for portfolio management and/or strategic investments under its existing target financial parameters, which are outlined in the following table. Our capital management assumptions above are consistent with these metrics. Fig 4 Telstra gearing profile (FY12-15e) Financial parameters Telstra "comfort zone" 1H12a FY12e FY13e FY14e FY15e Net Debt / EBITDA 1.5-1.9x 1.5x 1.2x 1.3x 1.3x 1.3x Net Debt / (Net Debt + Equity) 50% to 70% 55% 51% 57% 57% 57% EBITDA Interest Cover >7x 10.6x 10.5x 9.7x 8.8x 8.6x Source: Macquarie Research estimates, April 2012 20 April 2012 3
Swing factors in FCF generation Acquisitions, capex and NBN On a medium term view, Telstra s earnings outlook is fairly stable. Three swing factors to FCF are likely to be the level of acquisitions, capex spend and the level of NBN payments. We discuss each below: Acquisitions: Telstra s FY12 free cash flow guidance assumes that it spends $500m a year on bolt-on acquisitions. Spend in the first half was minimal, and it does not appear to have made any significant investments in the second half (excluding the $450m subordinated note to FOXTEL for the Austar takeover). Going forward, the level of acquisitions spend (and the acquired earnings) will clearly have an impact on Telstra s excess free cash flow. Capex spend: Telstra s current guidance and capital management philosophy is premised on it maintaining a capex/sales ratio of 14% (or ~$3.5bn). That envelope currently includes spend on NBN infrastructure provision, which we estimate could be up to $400m in FY13. We think there is some scope for Telstra to reduce its Group capex spend once the NBN commitments reduce (from 2H14). Each 1% of revenue reduction would free up another $250m in FCF. NBN payments: Clearly the schedule of payments has a significant impact on Telstra s FCF profile. The lumpiest part of the NBN payments come from the migration payments, and this is directly correlated to the speed at which the NBN rolls out. As a base case we assume a twoyear lag in the NBN rollout, which means that migration payments are unlikely to ramp up until FY15. The table below summarises our medium-term expectations for NBN payments. It is worth noting that the components of Telstra s cash flow that are dependent on NBNCo-driven milestones (eg, migration payments) are only small over the next few years, and hence Telstra has only a limited exposure during FY13 and FY14 to a slowdown in the rollout. Fig 5 NBN payment schedule (Macquarie estimates) NBN payments FY12e FY13e FY14e FY15e Infrastructure related nmf 116 273 429 Migration payments nmf nmf 58 250 USO cash receipts* - - 100 103 Customer information campaign 321 - - - Re-training payment** - 100 - - Other Government reforms - 42 42 43 Total NBN-related payments (pre-tax) 321 258 474 824 *Benefits from the TUSMA structure accrue to the P&L in FY12, with the cash impact in FY13. **Re-training payment may fall into 2H12. Source: Macquarie Research, April 2012 Well positioned to deal with a change in Government Telstra reiterated its view that the NBN deal as it stands puts it in a good position to protect shareholder value should there be a change in Government broadband policy. The key protections highlighted by Telstra include: The long-term contractual commitments for infrastructure leases and similar arrangements for a period of 30-35 years. A rollout termination payment of up to $500m should the network rollout be terminated (assuming it reaches 20% penetration); The natural hedge that arises from ownership of the copper network with any delays to the NBN rollout seeing Telstra extract more value from its legacy network; and Value capture from Government reforms. This includes the introduction of the TUSMA program for providing universal services which is worth around $100m per annum to Telstra when compared to the old USO arrangements. It also includes ~$420m of payments expected to have been received by Telstra in relation to staff re-training ($100m) and derived from the Information Campaign and Migration Deed ($321m). 20 April 2012 4
(TLS AU) - Closing Price $3.39 Interim results 1H11a 2H11a 1H12a 2H12e Profit & Loss FY11a FY12e FY13e FY14e Sales Revenue $m 12263 12720 12405 12838 Sales Revenue $m 24983 25243 25646 25833 Total Operating Revenue $m 12341 12916 12501 13026 Total Operating Revenue $m 25257 25527 25994 26187 EBITDA $m 4646 5523 4750 5560 EBITDA $m 10169 10310 10816 10750 Depreciation $m 1708 1746 1661 1671 Depreciation $m 3454 3332 3251 3394 Amortisation $m 496 509 525 525 Amortisation $m 1005 1050 1005 1005 Consolidated EBIT $m 2442 3268 2564 3363 Consolidated EBIT $m 5710 5927 6560 6351 Non-recurring items $m (63) 45 0 0 Non-recurring items $m (18) 0 0 58 Share of Associates $m 0 0 0 0 Share of Associates $m 0 0 101 112 Reported EBIT $m 2379 3313 2564 3363 Reported EBIT $m 5692 5927 6661 6521 Net Interest expense $m 571 564 396 475 Net interest expense $m 1135 871 962 1067 Pre-Tax Profit $m 1808 2749 2168 2888 Pre-Tax Profit $m 4557 5056 5699 5454 Tax consolidated $m 577 742 689 828 Tax consolidated $m 1319 1517 1679 1585 Tax on NRIs $m 21 (33) 0 0 Tax on NRIs $m (12) 0 0 18 Total tax expense $m 598 709 689 828 Total tax expense $m 1307 1517 1679 1603 Net profit after tax $m 1210 2040 1479 2060 Net profit after tax $m 3250 3539 4020 3851 Outside equity interests $m 13 6 11 15 Outside equity interests $m 19 26 37 42 Reported Earnings $m 1197 2034 1468 2045 Reported Earnings $m 3231 3513 3983 3809 Adjusted Earnings 1 $m 1281 1956 1468 2045 Adjusted Earnings 1 $m 3237 3513 3983 3768 Gross Cashflow 2 $m 3498 4217 3665 4257 Gross Cashflow 2 $m 7715 7922 8275 8209 2 Gross Cashflow is Profit after Tax plus Depreciation and 1 Adjusted for NRIs and Goodw ill Amortisation Amortisation Profit and Loss ratios 1H11a 2H11a 1H12a 2H12e Profit and Loss ratios FY11a FY12e FY13e FY14e PER (adj Earnings) x 16.5 10.8 14.4 10.3 PER (adj Earnings) x 13.0 12.0 10.5 10.7 EPS (Reported) c 9.6 16.3 11.8 16.4 EPS (Reported) c 26.0 28.2 32.4 32.1 EPS (Adjusted) c 10.3 15.7 11.8 16.4 EPS (Adjusted) c 26.0 28.2 32.4 31.7 DPS c 14.0 14.0 14.0 14.0 DPS (Adj Earnings) c 28.0 28.0 28.0 34.0 Dividend Yield % 4.1% 4.1% 4.1% 4.1% Dividend Yield % 8.3% 8.3% 8.3% 10.0% Revenue Growth % -0.5% 1.8% 1.2% 0.9% Revenue Growth % 0.7% 1.0% 1.6% 0.7% Reported EBITDA Growth % -12.6% -3.1% 2.2% 0.7% Reported EBITDA Growth % -7.7% 1.4% 4.9% -0.6% Reported EBITDA Margin % 37.6% 42.8% 38.0% 42.7% Reported EBITDA Margin % 40.3% 40.4% 41.6% 41.0% Reported EBIT Growth % -24.0% -1.7% 7.8% 1.5% Reported EBIT Growth % -12.4% 4.1% 12.4% -2.1% Reported EBIT Margin % 19.3% 25.7% 20.5% 25.8% Reported EBIT Margin % 22.5% 23.2% 25.6% 24.9% Effective tax rate % 33.1% 25.8% 31.8% 28.7% Effective tax rate % 28.7% 30.0% 29.5% 29.4% Payout ratio % 145.5% 85.6% 118.7% 85.2% Payout ratio % 107.8% 99.2% 86.5% 106.0% EV/EBIT x 11.6 8.5 10.9 8.1 EV/EBIT x 9.8 9.2 8.6 8.5 EV/EBITDA x 6.1 5.1 5.9 4.9 EV/EBITDA x 5.5 5.3 5.4 5.2 Balance sheet ratios Balance sheet ratios ROE % 19.2% 33.3% 24.8% 34.9% ROE % 25.7% 29.1% 35.2% 35.9% ROA % 13.4% 18.3% 14.6% 19.0% ROA % 16.2% 16.7% 18.4% 18.1% ROFE % 20.1% 27.4% 21.9% 30.0% ROFE % 24.0% 26.4% 28.2% 28.2% Net Debt $m 14432 13603 13930 12504 Net Debt $m 13603 12504 14483 13984 Net Debt/Equity % 118.2% 110.7% 120.1% 104.2% Net Debt/Equity x 110.7% 104.2% 133.4% 131.9% Net Debt/EBITDA x 1.6 1.2 1.5 1.1 Net Debt/EBITDA x 1.3 1.2 1.3 1.3 Net Interest Cover (EBIT) x 4.2 5.9 6.5 7.1 Net Interest Cover (EBIT) x 5.0 6.8 6.9 6.1 Net Interest Cover (EBITDA) x 8.1 9.8 10.6 10.5 Net Interest Cover (EBITDA) x 9.0 10.5 9.7 8.8 Price/NTA x 9.1 9.0 10.6 9.7 Price/NTA x 9.0 9.7 12.9 13.6 NTA per share $ 0.4 0.4 0.3 0.4 NTA per share $ 0.4 0.4 0.3 0.2 EFPOWA m 12443 12443 12443 12443 EFPOWA m 12443 12443 12319 11878 Cashflow Analysis 1H11a 2H11a 1H12a 2H12e Cashflow Analysis FY11a FY12e FY13e FY14e EBITDA $m 4646 5523 4750 5560 EBITDA $m 10169 10310 10816 10750 - Incr. in WC $m (891) 997 (685) 682 - Incr. in WC $m 106 (3) (6) (3) - Net interest expense $m (512) (501) (511) (475) - Net interest expense $m (1013) (986) (962) (1067) - Tax paid $m (758) (753) (800) (828) - Tax paid $m (1511) (1628) (1679) (1603) + Other op. cashflows $m 438-1,114 553 301 + Other op. cashflows $m -676 854 101 70 Total operating cashflows $m 2923 4152 3307 5240 Total operating cashflows $m 7075 8547 8270 8146 - Capex $m (1,831) (1,420) (2,137) (1,422) - Capex $m (3,251) (3,559) (4,835) (3,389) - Acquisitions / (Divestments) $m 0 (36) 0 (200) - Acquisitions / (Divestments) $m (36) (200) (250) (250) + Other inv. Cashflows $m 381 173 66 (450) + Other inv. Cashflows $m 554 (384) 0 0 Total investing cashflows $m (1450) (1283) (2071) (2072) Total investing cashflows $m (2733) (4143) (5085) (3639) - Dividends paid $m (1737) (1752) (1738) (1742) - Dividends paid $m (3489) (3480) (3484) (3688) + Equity raisings $m 0 0 0 0 + Equity raisings $m 0 0 (1680) (320) - Debt raisings $m 932 (1128) 891 (1426) - Debt raisings $m (196) (566) 1979 (499) + Other fin. cashflows $m (44) (9) (32) 0 + Other fin. cashflows $m (53) 0 0 0 Total Financing cashflow $m (849) (2889) (879) (3168) Total Financing cashflow $m (3738) (4046) (3185) (4507) Free Cashflow $m 1092 2732 1170 3818 Free Cashflow $m 3824 4988 3435 4757 Net Change in cash/debt $m 624 (20) 357 0 Net Change in cash/debt $m 604 357 0 0 Source: Company data, Macquarie Research, April 2012 20 April 2012 5
Important disclosures: Recommendation definitions Macquarie - Australia/New Zealand Outperform return >3% in excess of benchmark return Neutral return within 3% of benchmark return Underperform return >3% below benchmark return Benchmark return is determined by long term nominal GDP growth plus 12 month forward market dividend yield Macquarie Asia/Europe Outperform expected return >+10% Neutral expected return from -10% to +10% Underperform expected return <-10% Macquarie First South - South Africa Outperform expected return >+10% Neutral expected return from -10% to +10% Underperform expected return <-10% Macquarie - Canada Outperform return >5% in excess of benchmark return Neutral return within 5% of benchmark return Underperform return >5% below benchmark return Macquarie - USA Outperform (Buy) return >5% in excess of Russell 3000 index return Neutral (Hold) return within 5% of Russell 3000 index return Underperform (Sell) return >5% below Russell 3000 index return Volatility index definition* This is calculated from the volatility of historical price movements. Very high highest risk Stock should be expected to move up or down 60 100% in a year investors should be aware this stock is highly speculative. High stock should be expected to move up or down at least 40 60% in a year investors should be aware this stock could be speculative. Medium stock should be expected to move up or down at least 30 40% in a year. Low medium stock should be expected to move up or down at least 25 30% in a year. Low stock should be expected to move up or down at least 15 25% in a year. * Applicable to Australian/NZ/Canada stocks only Recommendations 12 months Note: Quant recommendations may differ from Fundamental Analyst recommendations Financial definitions All "Adjusted" data items have had the following adjustments made: Added back: goodwill amortisation, provision for catastrophe reserves, IFRS derivatives & hedging, IFRS impairments & IFRS interest expense Excluded: non recurring items, asset revals, property revals, appraisal value uplift, preference dividends & minority interests EPS = adjusted net profit / efpowa* ROA = adjusted ebit / average total assets ROA Banks/Insurance = adjusted net profit /average total assets ROE = adjusted net profit / average shareholders funds Gross cashflow = adjusted net profit + depreciation *equivalent fully paid ordinary weighted average number of shares All Reported numbers for Australian/NZ listed stocks are modelled under IFRS (International Financial Reporting Standards). Recommendation proportions For quarter ending 31 March 2012 AU/NZ Asia RSA USA CA EUR Outperform 53.90% 60.60% 57.50% 43.59% 66.67% 46.89% (for US coverage by MCUSA, 10.86% of stocks covered are investment banking clients) Neutral 31.56% 23.00% 32.50% 51.09% 30.00% 32.60% (for US coverage by MCUSA, 9.50% of stocks covered are investment banking clients) Underperform 14.54% 16.40% 10.00% 5.32% 3.33% 20.51% (for US coverage by MCUSA, 1.36% of stocks covered are investment banking clients) Company Specific Disclosures: The Macquarie Group acted as financial advisor to in relation to their response to the new $43bn Fibre-to-the-Premise NBN proposal from the Federal Government. Within the last 12 months, Macquarie Group has received compensation for investment advisory services from. Macquarie Bank Limited makes a market in the securities in respect of Limited. Macquarie and its affiliates collectively and beneficially own or control 1% or more of any class of Limited's equity securities. Important disclosure information regarding the subject companies covered in this report is available at www.macquarie.com/disclosures. General Disclaimers: This research has been issued and distributed in Australia by Macquarie Equities Limited ABN 41 002 574 923 ("MEL"). MEL holds Australian Financial Services Licence No. 237504 and is a Participant of the Australian Securities Exchange Group. MEL is not an authorised deposit-taking institution for the purposes of the Banking Act (Cth) 1959 and MEL's obligations do not represent deposits or other liabilities of Macquarie Bank Limited ABN 46 008 583 542. Macquarie Bank Limited does not guarantee or otherwise provide assurance in respect of the obligations of MEL. This research has been prepared for the use of the clients of Macquarie Group Limited and its related entities (the "Macquarie Group") and must not be copied, either in whole or in part, or distributed to any other person. 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Disclosures with respect to issuers, if any, mentioned in this research are available at www.macquarie.com.au/disclosures, or can be obtained from your Macquarie representative. Macquarie Group 20 April 2012 6