Telstra Investment Leaves Brokers Unsure

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Telstra has surprised the market with the announcement of an additional capital injection of $3bn across its network. A $1.5bn share buy-back program is also planned.

-Capex needed to defend market share and deliver new earnings streams
-Without NBN payments core earnings would be lower to flat
-Will risks around future earnings growth offset positives from buy-backs?
 

By Eva Brocklehurst

The focal point and main surprise in Telstra’s ((TLS)) FY16 results was the announcement of an additional capital injection of $3bn to be spread across the network. As a percentage of sales, capex will lift to 18% over FY17-19 and result in free cash flow in FY17 slipping to $3.5-4.0bn.

Additionally, Telstra announced it would buy back shares to the tune of $1.5bn, with $1.25bn in off-market purchases and $250m on market, reflecting the gain on the sale of its stake in China’s Autohome classifieds.

The company is aiming for a return on its increased investment via a defence of existing earnings and market share, trading operational expenditure for capital expenditure and delivering new revenue streams, UBS notes. The expenditure can help underpin existing mobile network share without having to materially re-price the back book and the broker estimates mobile margins will hold up at 41% in the medium term.

This investment decision draws a parallel with FY10, UBS recalls, when Telstra aggressively targeted market share by provisioning for a high single digit earnings decline. This time the lever is via capital expenditure.

While the market’s response to the decision was muted, if the new investment cannot fill the $2-3bn earnings hole created by the NBN, or if the higher capex profile does not normalise, then UBS believes the stock would be fundamentally overvalued.

Telstra has identified new earnings streams such as in Asia, health and software but these are either at an early stage or contribute only a small amount to earnings. Risks to the upside appear limited, in the broker’s view, unless there is more visibility regarding a return to positive mobile momentum, success in new revenue initiatives and/or greater certainty around the ability to lift dividends.

Macquarie also considers the return profile from the investment is unclear. The ability to differentiate on products, deepen client integration and improve customer service is expected to ultimately determine the incremental return Telstra can achieve.

The investment does send a signal to competitors and the broker expects this to have implications for other participants such as Optus. It may cause others to increase investment if they feel the need to compete in some areas.

Critically, the broker observes, subscriber trends are robust and this provides some confidence heading into FY17, and offers support for existing price premiums. Excluding NBN payments, core earnings would be lower or flat. This is the reality, Macquarie maintains, given the challenges and impact of the NBN. The broker expects mobiles should complete a re-basing in FY17 and return to more robust growth after that.

Morgans was impressed with the headline result, noting customer additions were better than expected and more mobile customers were added in the second half despite the network challenges, which proves to the broker there is a loyal customer base which values the network dominance, prepared to put up with the short term challenges.

On the negative side fixed earnings deteriorated 4.5% and data and IP earnings declined 5.5%. The broker observes, with the NBN now servicing around 10% of households there is still a way to go. The broker suggets that if Telstra is not able to replace the lost income with new business, it will simply look to buy back share to ensure that earnings per share are not adversely affected by lower overall income.

From a share price perspective the broker finds the stock attractive on a relative basis, arguing that based on the fact the stock is not far from its long-term average trading multiple, it is not as heavily enmeshed in the asset inflation bubble and, consequently, has lower downside risk.

Dividend support is strong, but Ord Minnett also questions just how difficult it will be for margins in the longer term with the NBN in place. Regardless, the broker notes the company has a leading position in the Australian mobile market and a clean balance sheet which affords some flexibility.

Morgan Stanley expects the company’s monopoly returns to ease and profit margins and returns on equity to decline as competition increases across 75% of its revenue base. The broker contends the risk profile around future earnings growth is widening and the increased capital intensity underscores these concerns. This largely offsets the positive aspects of the share buy-backs.

The broker believes the new capital expenditure is consistent with a view that Telstra faces additional competitive pressure in a mature industry and needs to invest to defend its share and find new revenue to fill the earnings gap.

FNArena’s database has six Hold ratings and two Sell for Telstra. The consensus target is $5.41, suggesting 1.4% downside to the last share price. Targets range from $4.99 (Deutsche Bank) to $5.72 (Morgans, Citi). The dividend yield on FY17 and FY18 forecasts is 5.8% and 6.0% respectively.
 

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