What Then To Do About Telstra?

This story features TELSTRA GROUP LIMITED. For more info SHARE ANALYSIS: TLS

By Greg Peel

Over the weekend we have learned that the Greens will now vote to pass legislation forcing the structural separation of Telstra ((TLS)) into a retail business and a wholesale business, the latter of which will be absorbed into the National Broadband Network on the assumption the NBN itself becomes a reality. We are yet to learn which way the rural independents will vote, but they in varying degrees made their support of an NBN clear in post-election negotiations.

To support separation the Greens needed the concession to be made that the NBN would not be automatically privatised at a given date down the track, but would at the time be subject to a parliamentary vote. The risk, suggested the Greens, is that of “another Telstra disaster”.

While the Greens might be ignorantly misguided in pushing for government control of mortgage rates, on this point I do firmly agree. On the one hand there is always a risk that the government of the day would prematurely hand over the NBN to the private sector in order to return a balanced budget and thus look good politically (See: QR National), and on the other hand the Howard government's partial privatisation of the Australian people's vital communications infrastructure into a listed monopoly subject to government price controls has been nothing short of an unmitigated disaster, and was always going to be. How can a conflict of shareholder interest and rural equality ever be resolved?

Now we have the proposition of, at least for a period, a return to a publicly owned national communications network based on fibre to every premises in Australia, no matter if that premises is in the Sydney CBD or on a remote outback cattle station the size of a European country. Clearly in order to achieve equality of pricing, the city must subsidise the bush which means that while Australia may finally catch up with the rest of the world on broadband speed, it will still be perhaps the most expensive broadband service on the planet.

This point has now been made by everyone from Malcolm Turnbull to Mexican billionaires and the OECD. Given the Opposition's stance is to be directly adversarial on everything other than defence deployment, anything the Opposition says has to be taken with a grain of salt (See: Joe Hockey). Nevertheless I firmly disagree with Turnbull's insistence on a “cost-benefit analysis” given it is the job of governments to provide services the private sector would not on a cost-benefit basis (See: Sydney public transport system). Otherwise why not just privatise Australia? Rupert would probably be interested.

I do, however agree with the argument of FTTP being too expensive to deliver to every single premises, and were it up to me I would be building FTTP infrastructure in the cities and major regional centres and wireless networks into remote rural areas, with options of cable and satellite thrown in. Such a diversified and competitive network would have a much better chance of reducing prices naturally, but would also allow the government to mandate a lesser price. But there is a problem.

The real problem is that Australia is a country the same size as mainland USA but with only 22 million people to America's 300 million. Thus any “equitable” service, be it broadband, health services or even railroads is either impossible or destructively costly for all. The immediate problem is that both sides of politics need the rural vote to form a government, a point now made abundantly clear by the current hung parliament which is “controlled” by the votes of a Green and three rural MPs (and Andrew Wilkie, and a wobbly National party MP on the Coalition side). Thus it is impossible to envisage a national broadband solution which would leave the bush complaining that the city is getting a better deal. We are simply trapped.

All of the above leads to ongoing uncertainty surrounding the NBN, and while the initial separation legislation has made it through the lower house the Senate still has to cast its vote, which it will do so before Christmas. Hence Telstra management noted at its AGM on Friday that it hoped an NBN structure would be made clear before end-2010 allowing Telstra shareholders to vote on the company's participation by mid-2011.

While there has been much wailing and gnashing of teeth from Telstra shareholders in being forced to structurally separate, at the end of the day the $11bn compensation is worth around 30c to the share price, according to analysts, and analysts agree that a Telstra left in the wilderness with its aging copper infrastructure would likely suffer a slow and painful death.

As it is, Telstra is already effectively dying quietly as the country awaits an NBN outcome.

Telstra has launched Project New which reflects a belated attempt to catch up with the real world – one in which home “land lines” are slowly becoming redundant and voice-over-internet-protocol (VoIP) more popular. At the same time, reliable mobile internet access has suddenly become of vital importance in the “smart phone” and “tablet” revolution and frustrating experiences with unreliable wireless services has led to fixed broadband being the choice for home or office computers.

The upshot is that Telstra has spent a great deal of effort and money in recapturing its eroding customer base by offering sexy deals on the above, and the company's September quarter subscriber growth results show the policy is working. Analysts estimate that Telstra captured some 60% of the market share of subscriber growth in the period, with mobile subs up 264% and fixed broadband up 321% on the previous quarter.

Is Telstra thus baaaack? Not necessarily. The simple fact of the matter is Telstra has “bought” this market share and questions arise as to how this has impacted on average revenue per user (ARPU). A clue came from management itself, which at the AGM reiterated FY11 earnings guidance. This means Telstra still expects its earnings before interest, tax, depreciation and amortisation (EBITDA) to fall by 8.5% in FY11 from FY10.

With earnings declining, and as yet no clear resolution on the NBN, the question of Telstra's generous dividend comes into focus.

Recently analysts have come to the conclusion that Telstra will be unable to keep paying a discreet 28c dividend as earnings decline. Management noted that consensus forecasts now have an FY11 dividend of 27.6c and an FY12 dividend of 27c, so management took the opportunity of the AGM to make it absolutely clear that Telstra will maintain a 28c dividend in both years. Only if something really untoward came out of left field would that policy be amended.

A 28c dividend means Telstra shares are offering a fully franked yield of 10.6% (FNArena's Stock Analysis shows forecasts of 10.4% in FY11 and 10.2% in FY12 to reflect analyst consensus). For any stock, a double-digit yield would normally suggest the investment is bordering on “junk” in that such a yield could only reflect a very high earnings risk. But Telstra is a utility – supposedly one of the most “defensive” sectors of all – which generates a large amount of free cash flow. Typically, utilities offer a yield only slightly better than a government bond.

In other words, one would think that Telstra could reduce its discreet dividend in the face of declining earnings and still deliver a very attractive yield, while at the same time alleviating fears that the dividend commitment itself could get the company into more trouble than anything else. But no – management is insistent on maintaining the yield that has been the Telstra investor's most important (only?) attraction these past few years. There have even been times when the company has “burned cash” by having to borrow money to make good on its dividend when cashflow has fallen short.

It is not the case at present however, and UBS (Buy) is forecasting that Telstra will generate $4.3bn in free cashflow in FY11 to well exceed its $3.5bn dividend commitment. By pre-paying FY12 tax, the dividend should remain franked, UBS suggests.

BA-Merrill Lynch (Underperform) has nevertheless recently been a strong advocate for a dividend cut. Citing various issues surrounding tax, depreciation charges, margin pressures and NBN volatility, Merrills believes the Telstra dividend should be only 23c. Despite management's two-year 28c pledge, Merrills suggests the dividend will be 25-27c over the next four years.

There is another factor to consider, however.

It is management's intention to buy back shares. It won't happen immediately because management will sensibly postpone such a decision until after it knows exactly what the NBN outcome will be. UBS suggests a $2m buyback at current prices would be 4% accretive to earnings per share.

A buyback increases earnings per share not by increasing absolute earnings but by reducing the number of shares, such that everyone enjoys a greater piece of the pie (except for those who sell into the buyback of course). And naturally the same result occurs for dividends per share. Therefore, were Telstra to buy back stock it could actually reduce the total amount of its dividend obligation while still maintaining a 28c discreet dividend per the lesser number of shares on issue.

In other words, a buyback takes the pressure off maintaining this magical 28cps number when earnings are dodgy.

Of course, Telstra is not intending that earnings will always be in decline. They will be in decline in FY11 because the company has been spending all this money to reposition itself through Project New and analysts expect that, in some sort of post-NBN decision world, the repositioning will start to “pay dividends”, if you pardon the expression.

So forecasts look a little better for FY12-13, and on that basis Telstra shares look pretty cheap at the sort of multiples they are currently marking.

But those multiples will most likely remain low, analysts suggest, while the pall of uncertainty continues to hang over the company. Aside from an NBN decision, the ACCC is still looking into fixed line pricing, so regulatory risks also remain. So really we need an outcome on that, an outcome on the NBN, and some evidence that Project New is actually working (rather than just being a case of “buying” market share) before the market is ever likely to once more get excited about owning the shares of Australia's biggest listed company.

A lot of that is down to Australia's politicians, God help us. But with NBN compensation, a buyback, an ongoing guaranteed dividend perhaps some earnings upside, there may be yet some light at the end of the tunnel.

The FNArena database currently shows Telstra with a Buy/Hold/Sell ratio of 3/4/1 with a consensus target of $3.22 to provide 22% consensus upside. However, brokers are quite divergent in their views as exhibited by the range from target low marker Merrills at $2.70 (which is nevertheless still above today's trading price) to high marker UBS at $4.00.

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