Telstra Approaching A Crossroads

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

-Large productivity savings needed
-Off-market buy-back most likely in FY17
-Investing in technology overlay
 

By Eva Brocklehurst

Telstra Corp ((TLS)) is approaching a crossroads. The company is moving from being an owner of infrastructure, namely the fixed line network, to competing for access to infrastructure – the National Broadband Network (NBN).

The company is facing an earnings gap once the NBN is completed in FY20/21. This will be difficult to fill, brokers maintain, as competition continues to intensify in mobiles, fixed line and corporate offerings.

The company has indicated there is a $2-3bn negative impact from the transition to the NBN. NBN access costs are expected to be around $2bn by the end of the roll-out. The company's access costs are expected to reduce as it decommisions the copper network, which should partially offset the new NBN access costs.

Credit Suisse estimates that access costs make up 30% of the company's existing fixed line cost base, equivalent to $1.2bn in FY16. This highlights the size of the productivity savings needed to achieve even modest fixed line profits under an NBN. Credit Suisse calculates the fixed line business will be loss making under the NBN, without productivity savings.

Credit Suisse describes it as a timing mismatch, where new NBN costs ramp up while the savings take longer to come through. The broker calculates that the mid point of the stated NBN impact range implies fixed line earnings of $200m for Telstra before productivity savings.

In order to achieve the $1bn in longer-term fixed line earnings, which the broker currently forecasts, Telstra would need to achieve productivity savings of $1.2bn and this is not expected to be easy.

Meanwhile, Telstra confirmed a $1.5bn capital management program, funded by the sale of Autohome and supported by its under-geared balance sheet, with the details to be forthcoming at the August results. Credit Susise calculates this should be 1.4% accretive to earnings.

The question now is what form this will take. UBS believes a special distribution is unlikely as it would not reduce the dividend burden or improve earnings. An off-market buy-back is therefore preferable, given domestic investors will benefit from a partially franked dividend and investors tendering into the buy-back benefit from a lower capital base. Still, rulings from the Australian Taxation Office will be critical to the eventual mix.

UBS also noted more disclosure in the briefing around dividends. The company's view of sustainable earnings that underpin the dividend appear to be based on exit-rate earnings once one-off NBN earnings wash through. The company also reminded the market it should expect group margin dilution for major products, in aggregate.

Telstra's intention to look through short-term earnings fluctuations and a continuation of the positive sub trends gives UBS confidence that the current dividend will be, at the least, maintained although the quantum of growth remains at issue.

Macquarie currently incorporates $2.9bn in capital management in its estimates for FY17, although considers some of this amount is interchangeable with future M&A decisions. The broker envisages scope for a $1bn-plus discounted off-market buy-back which could be completed in the first half.

The quantity of the earnings impact from the NBN is conservative, Macquarie maintains. The broker expects it to be more like $2.3bn, but with plenty of offsets from associated restructuring and reduced capital intensity

The broker believes the concept of the earnings gap is well understood by the market and should not cause a shift in considerations. Macquarie continues to expect pressure on the core business and mobiles but believes valuation support is provided by the dividend yield.

Deutsche Bank assumes an off-market buy-back of $1.5bn at a 10% discount to the current price and that Telstra has $2.5bn in surplus captial after dividends, buy-backs and interest payments which can be delivered to further capital management, acquisitions and investment.

Morgan Stanley was critical of the company's more risky capital allocation strategy so lauds the decision to adopt a more conservative approach and return capital to shareholders. The broker estimates a share buy-back will be 2-3% accretive, but a lack of franking credit will likely limit off-market share buy-backs or special dividends.

Further afield the company will need to come up with more than what Morgan Stanley forecasts, in terms of earnings, once the NBN is completed. Telstra is likely to witness its quasi-monopoly returns transfer to its rising competitors, the broker suspects.

The broker believes the strategy to significantly invest in technology assets which add value to the network is sound. Still, there are risks in moving into the software realm as it is characterised by lower barriers to entry, and industry verticals where the broker observes the winner takes all.

This means earnings from the Network Application Services (NAS) and global NAS business, whilst attractive, carry a higher level of risk than traditional telco networks. Morgan Stanley envisages Telstra's normalised returns on equity are declining and will fall from 26% in FY16 to 23% by FY20. The broker maintains an Underweight rating.

FNArena's database has one Buy rating, five Hold and two Sell for Telstra. The dividend yield on FY16 and FY17 consensus estimates is 5.8% and 5.9% respectively. The consensus target is $5.42, suggesting 1.3% in downside to the last share price.
 

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