Assessing the Telstra/NBN Deal

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

By Chris Shaw

Last Sunday Telstra ((TLS)) and the National broadband Network Company (NBNCo) signed a financial heads of agreement that will see Telstra migrate customers to the NBN and lease its infrastructure to that company.

The deal was valued at around $11 billion, $9 billion coming from NBNCo and $2 billion from the Federal Government. The market has generally viewed the deal as a positive outcome for Telstra, both financially and because it removes some of the uncertainty that has been overhanging the stock.

Credit Suisse suggests the deal is a win for shareholders as it provides enhanced regulatory certainty for the company. This is especially the case if the Labor Party is re-elected in the broker's view, as the deal means Telstra will avoid any scenario of increased regulation and the introduction of competing networks.

The deal was also at the top end of market expectations from a value perspective according to Credit Suisse, as speculation of the value of any deal had ranged between $8-$12 billion. Citi points out the agreement has yet to be finalised and there remain a number of hurdles, but Citi expects the deal will go ahead given its importance to both parties.

One advantage for Telstra in the deal, in Citi's view, is the $9 billion in cash payments for assets and customer migration. This means Telstra has locked in value for a fixed line business in structural decline, which Citi notes will help protect post NBN cash flows for the company.

As well, Citi suggests the cash can be used by Telstra for a number of options including the repayment of debt, capital returns or reinvestment in the retail business as the company attempts to retain or grow market share.

The disappointing element of the announcement for Bank of America Merrill Lynch was a lack of detail relating to the agreement. As an example, Telstra cannot advise how the $9 billion is being split with respect to customers transferred and infrastructure access. This means valuing the deal on actual cash flows is not yet possible.

The other issue for BA Merrill Lynch is the deal requires a number of conditions being met, meaning there are still some risks of the deal falling through. Given this uncertainty, the broker suggests the share price is unlikely to reflect the full value of the deal until it is actually completed, something that will also require shareholder approval.

BA Merrill Lynch estimates by assuming the full value of payments is received the deal would increase its valuation for Telstra to $3.85. But the current uncertainty with respect to the deal means Telstra shares are likely to continue to trade at a discount to this level, so the broker makes no change to its Neutral rating on the stock.

GSJB Were agrees and retains its Hold rating, suggesting maybe 50-75% of the agreement is likely to be priced into Telstra immediately. This equates to around 45-65c per share above its stand-alone valuation of $3.00.

In GSJB Were's view, the shares are likely to settle at the bottom end of a range of $3.45-$3.65, reflecting the ongoing share overhang from the Future Fund and the fact the NBN deal has not been finalised.

JP Morgan agrees with a Neutral rating, pointing out while the deal means Telstra has avoided a worst-case outcome there remains a lack of certainty relative to future earnings and free cash flows. As with BA Merrill Lynch, JP Morgan argues the lack of detail in the deal announcement means there is no basis to accurately assess the impact on Telstra of the transition to the NBN.

In the view of JP Morgan, Telstra is likely to need to transform from a high capex/high margin company to a lower capex/lower margin model. This implies great difficulty in currently estimating key long-term drivers of value such as future fixed retail share, future margins and future capex levels.

Others are more positive however, as the FNArena database shows Telstra is rated as Buy and Hold five times each. Credit Suisse is one of those rating the stock as a Buy, which is related to its $3.80 price target.

This assumes the current non-binding agreement is implemented, which Credit Suisse points out would remove much of the downside regulatory risk associated with Telstra. There is also value on offer at current levels, Credit Suisse estimating the shares are currently trading on a FY11 earnings multiple of 10.5 times and a gross dividend yield of 12.8%.

This is based on Credit Suisse's forecasts for earnings per share (EPS) of 31.2c this year and 31.7c in FY11. These compares to consensus EPS estimates according to the FNArena database of 31.3c and 31.9c respectively.

Citi also rates Telstra as a Buy, lifting its price target to $4.05 from $3.70 to factor in the agreement. While Citi agrees investors are likely to be concerned by the lack of details announced, the fact is more details will come over time and significant work has already been done in terms of bringing the deal to fruition. This increases the stockbroker's confidence the deal proceeds and supports its positive rating.

Citi's new target puts it at the top of the range according to the FNArena database, while Deutsche Bank is the low mark with a target of $3.15. The average price target according to the database is $3.66.

Shares in Telstra rose yesterday as the market first digested the news, but the stock has weakened slightly today in line with a lower overall market. At 11.35am Telstra was down 5c at $3.29, which compares to a range over the past year of $2.88 to $3.71. The average price target of $3.66 implies around 11% upside from current levels.

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