2005 annual report

management's discussion & analysis

• financial review
  • CFO letter to investors
  • forward looking statements
  • corporate reporting & governance
  • financial statistics
• management's discussion & analysis
  • overall performance
  • core business, vision and strategy
  • key performance drivers
  • capability to deliver results
  • results from operations
  • financial condition
  • liquidity and capital resources
  • critical accounting estimates and accounting policy developments
  • looking forward to 2006
  • risks & risk management
  • reconciliation of non-GAAP measures and definition of key operating indicators
• consolidated financial statements
  • management's report
  • auditors' report
  • consolidated statements of income
  • consolidated statements of retained earnings
  • consolidated balance sheet
  • consolidated statements of cash flows
  • notes to consolidated financial statements

7. liquidity and capital resources

A discussion of cash flow, liquidity, credit facilities, off-balance sheet arrangements and other disclosures

7.1 Cash provided by operating activities

Cash provided by operating activities increased by $376.5 million in 2005, when compared with 2004. Changes in cash provided by operating activities were mainly due to the following:

• Cash was provided by a $350 million increase in proceeds from securitized accounts receivable in 2005, compared with a $150 million reduction in securitized accounts receivable in 2004
• EBITDA increased by $204.7 million
• Restructuring and workforce reduction payments decreased by $52.3 million
• Interest received increased by $20.0 million
• Employer contributions to employee defined benefit plans decreased by $18.0 million due to updated actuarial valuations and net acceleration of funding in 2004. The Pension Plan for Management and Professional Employees of TELUS Corporation ceased accepting new participants on January 1, 2006. See Note 18 of the Consolidated financial statements for further infor-mation on TELUS employee future benefits.

Partly offsetting the above were:

• Income tax recoveries net of installment payments decreased by $125.1 million
• In 2004, TELUS received $33.3 million from Verizon, recorded as a reduction of prepaid and deferred services. The $33.3 million was part of the $148.1 million (U.S. $125 million) received when the independent Directors of TELUS agreed to facilitate the divestiture by Verizon of its entire 20.5% equity interest in TELUS
• Interest paid increased by $5.4 million due to the $30.9 million paid in respect of early redemption of 7.50%, Series CA, Notes on December 1, 2005, partly offset by lower interest due to conversion and redemption of Convertible debentures in 2005, and debt repayments in 2004
• Other changes in non-cash working capital in 2005 including a reduction in payroll and employee-related liabilities, and the payment of lump sum amounts to bargaining unit employees.

7.2 Cash used by investing activities

Cash used by investing activities increased by $55.7 million in 2005, when compared with 2004. The increase was primarily from the $29.4 million investment in Ambergris (compared with the acquisition of ADCOM for $12.2 million in 2004) and lower proceeds from the sale of non-core assets. Assets under construction increased to $516.4 million at December 31, 2005, compared with $329.6 million at December 31, 2004, due to delays in completing capital projects caused by the labour disruption, as well as capitalized costs related to development of a new billing system in the wireline segment.

Capital expenditures by segment

• Wireline segment ILEC capital expenditures decreased by 3.3% to approximately $799 million in 2005, when compared with 2004. The decrease included some deferral of capital expenditures due to the work stoppage. Greater investment in internal systems and processes was more than offset by lower expenditures on network infrastructure and other projects.

  For the full year of 2005, non-ILEC capital expenditures decreased by 16.6% to $115 million, when compared with 2004, as spending in 2004 required up-front investment to support certain major enterprise customers.

  The wireline segment capital expenditure intensity ratio was 18.5% in 2005, compared with 19.8% in 2004. Cash flow (EBITDA less capital expenditures) decreased by 4.7% to $938.1 million in 2005, when compared to 2004, due to lower EBITDA.

• Wireless segment capital expenditures increased by $50.1 million in 2005 and were attributed to strategic investments in next-generation EVDO-capable wireless network technology and continued enhancement of digital wireless capacity and coverage.

  Capital expenditure intensity for the wireless segment was 12.2% in 2005, as compared with 12.5% in 2004, as growth in capital expenditures paralleled growth in revenues. The work stoppage resulted in lower than originally planned capital expenditures for the full year of 2005. Wireless cash flow in 2005 exceeded wireline cash flow for the first time on a full year basis, increasing by 31.8% over 2004 to a wireless segment record $1,038.2 million.

TELUS’ EBITDA less capital expenditures (see Section 11.1 EBITDA for the calculation) increased by 11.6% to $1,976.3 million in 2005, when compared with 2004, as a result of higher EBITDA.

7.3 Cash used by financing activities

Cash used by financing activities increased significantly in 2005, when compared with 2004, primarily due to the early redemption on December 1, 2005, of the remaining $1.578 billion of 7.50%, Series CA, Notes, as well as purchases of shares under Normal Course Issuer Bids (NCIBs). Financing activities included:

• Proceeds from Common Shares and Non-Voting Shares issued were $219.4 million in 2005, an increase of $70.6 million when compared with 2004. The increase was mainly due to the exercise of options and warrants in 2005, partly offset by lower proceeds from share purchases for employee share plans, as TELUS now purchases these shares in the market, rather than issue shares from treasury.

  In addition, during the second quarter of 2005, convertible debentures with a principal value of $131.7 million were converted into approximately 3.3 million Non-Voting Shares. Due to the non-cash nature of these transactions, the conversions are shown as balance sheet adjustments and are not included in the financing activities of the cash flow statements.

• Cash dividends paid to shareholders were $312.2 million in 2005, representing an increase of $63.5 million when compared with 2004. The increase arose principally from the declaration of higher per share dividends in 2005, when compared with 2004, as well as the purchase of dividend reinvestment plan shares in the market rather than issuing shares from treasury. Dividends declared were 87.5 cents per share in 2005, compared with 65 cents per share in 2004.
• Under the first NCIB program that was initiated on December 20, 2004 and expired on December 19, 2005, TELUS purchased for cancellation approximately 73% of the maximum 14 million Common Shares permitted and 100% of the maximum 11.5 million Non-Voting Shares permitted. The $912.6 million total outlay under this program was comprised of a $369.5 million reduction to share capital representing the book value of shares repurchased, and a $543.1 million reduction to retained earnings representing the amount in excess of book value.

  On December 16, 2005, TELUS announced that a new NCIB program was accepted by the Toronto Stock Exchange (TSX). Under the new program, TELUS may purchase for cancellation over a 12-month period up to 12 million of its outstanding Common Shares and up to 12 million of its outstanding Non-Voting Shares, representing approximately 6.5% and 7.2%, respectively, of the public float on the date of the announcement. The new program became effective on December 20, 2005, and will expire on December 19, 2006. By December 31, 2005, TELUS had purchased for cancellation under this new program approximately 634,000 Common Shares and 608,000 Non-Voting Shares. The $57.5 million outlay under the new program was comprised of a $20.9 million reduction to share capital and a $36.6 million reduction to retained earnings.

  The following tables enumerate the shares repurchased and costs under these programs for 2005 and cumulatively.

• Long-term debt issued in 2005 was comprised of a draw of $142 million against TELUS’ three-year facility, and the balance was capital leases. Repayments in 2005 consisted of the early redemption of the $1.578 billion Canadian dollar Notes described earlier, and the June 16, 2005 redemption of convertible debentures not converted into Non-Voting Shares, of $17.9 million.
• In 2004, the redemption of all of the publicly held TELUS Communications Inc. Preference and Preferred Shares was completed for an outlay of $72.8 million.
• In 2004, TELUS received $114.8 million from Verizon, part of the $148.1 million (U.S. $125 million) received when the independent Directors of TELUS agreed to facilitate the divestiture by Verizon of its entire 20.5% equity interest in TELUS.
• Long-term debt issues in 2004 were primarily bank facilities that were repaid. Debt redemptions in 2004 included $189.5 million of TELUS Communications Inc. Series A Debentures and $20 million of TELUS Communications Inc. Medium-term Notes.

7.4 Liquidity and capital resource measures

Net debt decreased at the end of 2005, when compared to 2004, due to early redemption of Notes and the conversion and redemption of convertible debentures in 2005, partly offset by the use of cash and temporary investments (cash is netted against debt for the purposes of this calculation). The proportion of fixed-rate debt increased when TELUS terminated swap agreements concurrent with the early redemption of Notes. Total capitalization also decreased for these reasons as well as a decrease in common equity due primarily to share repurchases under NCIB programs. The net debt to EBITDA ratio measured at December 31, 2005 improved significantly, when compared with one year earlier, as a result of debt reduction and an increase in 12-month trailing EBITDA excluding restructuring.

Interest coverage on long-term debt improved because of increased income before interest and taxes, partly offset by higher interest expense. The EBITDA interest coverage ratio improved by 0.3 as a result of higher EBITDA excluding restructuring, and decreased by 0.1 due to higher interest. The free cash flow measure for 2005 increased, when compared with 2004, primarily because of improved EBITDA, lower payments under restructuring programs and higher interest received, partly offset by lower cash tax recoveries and higher interest paid. The dividend payout ratio for 2005 exceeded the target guideline of 45 to 55% of reported net earnings as a result of the temporary expenses associated with the work stoppage and the loss on debt redemption. More relevantly, the dividend payout ratio for 2005, excluding these two items, was approximately 48%.

Long-term guidelines for certain of TELUS’ liquidity measures, as defined in Section 11.4 Definition of liquidity and capital resource measures, are:

• Net debt to total capitalization of 45 to 50%
• Net debt to EBITDA of 1.5:1 to 2.0:1
• Dividend payout ratio of 45 to 55% of sustainable net earnings.

7.5 Credit facilities

TELUS arranged new credit facilities in May 2005 to replace $1.6 billion of prior credit facilities. The prior 364-day facility, which was due to expire, and a term facility with three years remaining to maturity were replaced with a new three-year facility due in May 2008 and a longer maturity five-year term facility due in May 2010. The new credit facilities have no substantial changes in terms and conditions, other than reduced pricing and the extension of term, which reflect favourable market conditions and TELUS’ strong financial position.

TELUS had unutilized available liquidity in excess of $1.4 billion at December 31, 2005.

Credit facilities

TELUS’ credit facilities contain customary covenants including a requirement that TELUS not permit its consolidated Leverage Ratio (Funded Debt to trailing 12-month EBITDA) to exceed 4.0:1 (approximately 1.7:1 at December 31, 2005) and not permit its consolidated Coverage Ratio (EBITDA to Interest Expense on a trailing 12-month basis) to be less than 2.0:1 (approximately 5.6:1 at December 31, 2005) at the end of any financial quarter. There are certain minor differences in the calculation of the Leverage Ratio and Coverage Ratio under the credit agreement as compared with the calculation of net debt to EBITDA and EBITDA interest coverage. The calculations are not materially different. The covenants are not impacted by revaluation of capital assets, intangible assets and goodwill for accounting purposes, and continued access to TELUS’ credit facilities is not contingent on the maintenance by TELUS of a specific credit rating.

7.6 Accounts receivable sale

TELUS Communications Inc. (TCI), a wholly owned subsidiary of TELUS, is able to sell an interest in certain of its receivables up to a maximum of $650 million and is required to maintain at least a BBB (low) credit rating by Dominion Bond Rating Service (DBRS), or the purchaser may require the sale program to be wound down. The necessary credit rating was exceeded by three levels at A (low) as of February 24, 2006. The proceeds of securitized receivables increased from $150 million to $500 million on November 30, 2005. The balance of proceeds from securitized receivables was reduced on January 31, 2006 to $325 million.

7.7 Credit ratings

During 2005, each of the four credit rating agencies that cover TELUS increased their investment grade ratings for the Company’s debt instruments. On June 27, Moody’s Investors Service Inc. increased its rating for TELUS Corporation Notes from Baa3 with a positive outlook to Baa2 with a stable outlook. On September 27, Standard & Poor’s (S&P) raised its ratings for long-term corporate credit and senior unsecured debt of TELUS Corporation and TCI from BBB to BBB+, while revising the outlook to stable. On October 18, Fitch Ratings upgraded its long-term BBB ratings for TELUS and TCI to BBB+ with a stable outlook. On October 24, DBRS upgraded its BBB rating for TELUS Corporation Notes and its BBB (high) ratings for TCI to BBB (high) and A (low), respectively, while the trend was revised to stable.

TELUS has an objective to preserve access to capital markets at a reasonable cost by maintaining and improving investment grade credit ratings in the range of BBB+ to A–, or the equivalent.

Credit rating summary

7.8 Off-balance sheet arrangements, commitments and contingent liabilities

Financial instruments (Note 4 of the Consolidated financial statements)

The Company’s financial instruments consist of cash and temporary investments, accounts receivable, investments accounted for using the cost method, accounts payable, restructuring and workforce reduction accounts payable, dividends payable, short-term obligations, long-term debt, interest rate swap agreements, restricted stock unit compensation cost hedges, and foreign exchange hedges.

The Company uses various financial instruments, the fair values of some which are not reflected on the balance sheets, to reduce or eliminate exposure to interest rate and foreign currency risks and to reduce or eliminate exposure to increases in the compensation cost arising from specified grants of restricted stock units. These instruments are accounted for on the same basis as the underlying exposure being hedged. The majority of these instruments, from a notional amount view, which were newly added during 2001, pertain to TELUS’ U.S. dollar borrowing. Use of these instruments is subject to a policy, which requires that no derivative transaction be effected for the purpose of establishing a speculative or a levered position, and sets criteria for the credit worthiness of the transaction counterparties.

Price risk – interest rate: The Company is exposed to interest rate risk arising from fluctuations in interest rates on its temporary investments, short-term obligations and long-term debt.

Price risk – currency: The Company is exposed to currency risks arising from fluctuations in foreign exchange rates on its U.S. dollar denominated long-term debt. Currency hedging relationships have been established for the related semi-annual interest payments and principal payments at maturity, as further discussed in Note 1(h) and set out in Note 14(b).

The Company’s foreign exchange risk management also includes the use of foreign currency forward contracts to fix the exchange rates on short-term foreign currency transactions and commitments. Hedge accounting is applied to these short-term foreign currency forward contracts on an exception basis only.

As at December 31, 2005, the Company had entered into foreign currency forward contracts that have the effect of fixing the exchange rates on U.S. $47.0 million of fiscal 2006 purchase commitments; hedge accounting has been applied to these foreign currency forward contracts, all of which relate to the wireless segment.

Credit risk: The Company is exposed to credit risk with respect to its short-term deposits, accounts receivable, interest rate swap agreements and foreign exchange hedges.

Credit risk associated with short-term deposits is minimized substantially by ensuring that these financial assets are placed with governments, well-capitalized financial institutions and other credit-worthy counterparties. An ongoing review is performed to evaluate changes in the status of counterparties.

Credit risk associated with accounts receivable is minimized by the Company’s large customer base, which covers all consumer and business sectors in Canada. The Company follows a program of credit evaluations of customers and limits the amount of credit extended when deemed necessary. The Company maintains provisions for potential credit losses, and any such losses to date have been within management’s expectations.

Counterparties to the Company’s interest rate swap agreements and foreign exchange hedges are major financial institutions that have all been accorded investment grade ratings by a primary rating agency. The dollar amount of credit exposure under contracts with any one financial institution is limited and counterparties’ credit ratings are monitored. The Company does not give or receive collateral on swap agreements and hedges due to its credit rating and those of its counterparties. While the Company is exposed to credit losses due to the nonperformance of its counterparties, the Company considers the risk of this remote; if all counterparties were not to perform, the pre-tax effect would be limited to the value of any deferred hedging asset.

Fair value: The carrying value of cash and temporary investments, accounts receivable, accounts payable, restructuring and workforce reduction accounts payable, dividends payable and short-term obligations approximates their fair values due to the immediate or short-term maturity of these financial instruments. The carrying values of the Company’s investments accounted for using the cost method would not exceed their fair values.

The fair values of the Company’s long-term debt are estimated based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same maturity as well as the use of discounted future cash flows using current rates for similar financial instruments subject to similar risks and maturities. The fair values of the Company’s derivative financial instruments used to manage exposure to interest rate and currency risks are estimated similarly. The carrying amount and fair value of long-term debt are as follows:

Commitments and contingent liabilities (Note 16 of the Consolidated financial statements)

The Company has $57.1 million in outstanding commitments for its restructuring programs as at December 31, 2005, of which $15.1 million relates to programs initiated prior to 2005. In addition, the Company disclosed in its targets for 2006 that it expected to record approximately $100 million of restructuring and employee reduction costs in 2006. See Forward-looking statements at the beginning of Management’s discussion and analysis.

In accordance with CRTC Price Cap Decisions 2002-34 and 2002-43, the Company defers a portion of revenues in a deferral account, which at December 31, 2005 was $158.7 million. Due to the Company’s use of the liability method of accounting for the deferral account, the CRTC Decision 2005-6, as it relates to the Company’s provision of Competitor Digital Network services, is not expected to affect the Company’s revenues. To the extent that the CRTC Decision 2005-6 requires the Company to provide discounts on Competitor Digital Network services, both for current and prior periods, the Company draws down the deferral account by an offsetting amount. For the year ended December 31, 2005, the Company drew down the deferral account by $50.5 million in respect of discounts on Competitor Digital Network services.

The Company’s known contractual obligations at December 31, 2005, are quantified in the following table. For further information, refer to Note 16(c) of the Consolidated financial statements.

Canadian generally accepted accounting principles (GAAP) require the disclosure of certain types of guarantees and their maximum, undiscounted amounts. The maximum potential payments represent a worst-case scenario and do not necessarily reflect results expected by the Company. Guarantees requiring disclosure are those obligations that require payments contingent on specified types of future events. In the normal course of its operations, the Company enters into obligations that GAAP may consider to be guarantees. As defined by Canadian GAAP, guarantees subject to these disclosure guidelines do not include guarantees that relate to the future performance of the Company. As at December 31, 2005, the Company has no liability recorded in respect of performance guarantees, and $0.5 million (December 31, 2004 – $1.0 million) recorded in respect of lease guarantees. The maximum undiscounted guarantee amounts as at December 31, 2005, without regard for the likelihood of having to make such payment, were not significant.

In the normal course of operations, the Company may provide indemnification in conjunction with certain transactions. The term of these indemnification obligations range in duration and often are not explicitly defined. Where appropriate, an indemnification obligation is recorded as a liability. In many cases, there is no maximum limit on these indemnification obligations and the overall maximum amount of the obligations under such indemnification obligations cannot be reasonably estimated. Other than obligations recorded as liabilities at the time of the transaction, historically the Company has not made significant payments under these indemnifications.

In connection with its 2001 disposition of TELUS’ directory business, the Company agreed to bear a proportionate share of the new owner’s increased directory publication costs if the increased costs were to arise from a change in the applicable CRTC regulatory requirements. The Company’s proportionate share would be 80% through May 2006, declining to 40% in the next five-year period and then to 15% in the final five years. As well, should the CRTC take any action that would result in the owner being prevented from carrying on the directory business as specified in the agreement, TELUS would indemnify the owner in respect of any losses that the owner incurred. As at December 31, 2005, the Company has no liability recorded in respect of indemnification obligations.

A number of claims and lawsuits seeking damages and other relief are pending against the Company. It is impossible at this time for the Company to predict with any certainty the outcome of such litigation. However, management is of the opinion, based upon legal assessment and information presently available, that it is unlikely that any liability, to the extent not provided for through insurance or otherwise, would be material in relation to the Company’s consolidated financial position, excepting items disclosed in Note 16(f) of the Consolidated financial statements. See also Section 10.10 Litigation and legal matters.

Pay equity

On December 16, 1994, the Telecommunications Workers Union (TWU) filed a complaint against BC TEL, a predecessor of TELUS Communications Inc., with the Canadian Human Rights Commission, alleging that wage differences between unionized male and female employees in British Columbia were contrary to the equal pay for work of equal value provisions in the Canadian Human Rights Act. As a term of the settlement between TELUS Communications Inc. and the TWU that resulted in the collective agreement effective November 20, 2005, and subject to acceptance by the Canadian Human Rights Commission of the settlement and closure of its file on this complaint, the parties have agreed to settle this complaint without any admission of liability, on the basis that the Company will establish a pay equity fund of $10 million to be paid out during the term of the new collective agreement and the TWU will withdraw and discontinue this complaint.

On December 21, 2005, the TWU withdrew and discontinued this complaint. On January 10, 2006, the Canadian Human Rights Commission advised the Company that its investigator had recommended no further proceedings in this complaint, however, the Company is awaiting the Canadian Human Rights Commission’s decision in this regard. Should the Canadian Human Rights Commission refuse consent or the complaint continue for any other reason and its ultimate resolution differ from management’s assessment and assumptions, a material adjustment to the Company’s financial position and the results of its operations could result.

7.9 Outstanding share information

The following is a summary of the outstanding shares for each class of equity at December 31, 2005 and at January 31, 2006. In addition, for January 31, 2006, the total number of outstanding and issuable shares is presented, assuming full conversion of options. Issuable shares at January 31, 2006 include shares held in reserve, but not issued.