Is Telstra’s Dividend Outlook At Risk?

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Brokers are weighing up whether the latest operational restructuring might prevent Telstra from lifting its dividend in the years to come.

-Telstra announced restructuring, including staff cuts
-Telco removed CPI-linked price increases for mobiles
-Question marks around the outlook for expected dividend increases
-Two brokers respond by downgrading their ratings
-Did key competitor Optus just surprise friend & foe?

By Mark Woodruff

Last week, Telstra Group ((TLS)) reaffirmed FY24 guidance, while inaugural FY25 guidance was in line with consensus expectations, but the way in which these targets will be achieved now requires a greater emphasis on cost reductions, including “resetting” the cost base for the Enterprise business.

Along with cost-cutting measures, Australia's number one telco also announced an organisational shakeup, along with changes to mobile customer contracts, prompting sector analysts to weigh up potential impact upon Telstra’s precious dividend payments.

Taking all the various announcements into account, two brokers in the FNArena database downgraded their ratings for Telstra shares, and the average 12-month target price by six covering brokers fell by nearly -10%.

Management noted trading conditions for the Network Applications and Services (NAS) segment within the Enterprise business remain challenging. The telco will respond with cost-out across the whole group, albeit targeted at NAS, which will lose two thirds of existing employees.

Across the group, the direct workforce will be reduced by -2,800 employees, equating to a -9% reduction in full-time equivalents. One-off restructuring costs of -$200-250m are expected across FY24 and FY25.

Telstra may save -$360m/year in gross employee costs, of which Jarden forecasts around 75% may be realised in FY25.

At first glance, all of this sounds appealing for investors, but Jarden points out management commentary back at first half results in mid-February indicated a target of -$500m for the T25 cost program. Without these additional cost actions, which were unlikely to be a part of the original T25 cost ambitions, management may have only achieved -$50-100m in net cost savings.

This negative aside, the decision to remove annual inflation-linked price increases from postpaid mobile customer contracts was the key negative announcement on the day, according to both Jarden and Macquarie.

In response, Jarden lowered its FY25 mobile earnings forecast by -$170m, while Macquarie bemoaned pricing decisions are now increasingly dependent on Telstra's peers who have had a mixed track record in this area.

Removing these automatic price increases is meant to provide management with greater flexibility to respond to market conditions. 

Regardless of the reason, this move makes Morgans seriously reassess its previous bullish stance that Telstra and the industry would remain in a period of pricing rationality for a few more years. Now, competition is likely to re-intensify, in this broker's view.

On the day after these announcements, Macquarie downgraded to Neutral from Outperform and Morgans lowered its rating to Reduce from Hold.

Now that Telstra will no longer be clearly signalling its intent to lead market pricing higher each year, Goldman Sachs has become concerned, while also acknowledging Optus has not followed this lead in recent years.  Also, the broker notes the potential for greater price rises than CPI, but at the same time was dubious this would actually occur.

On the other hand, Ord Minnett is not anticipating irrational competitive behaviour, especially given the capital deployed in rolling out 5G, and notes Telstra shares are trading at an attractive discount to the broker's fair value assessment of at $4.50 per share.

At the time of the trading update and associated announcements, Jarden felt Telstra’s mobile pricing decision for FY25 will now be significantly impacted by pricing decisions made by Optus.

These decisions were unlikely to be unveiled until after the company’s new CEO commences this November, according to the broker.

And then, almost on cue, Optus increased pricing/data for its mobile plans this week.

In the first increase since July 2022, explains Goldman Sachs, prices for entry/mid-level plans will rise by $3/month, alongside data increases of 20-80GB/month.

UBS believes this move by Optus points to ongoing mobile rationality across the industry. Consequently, this broker remains positive on Telstra’s ability to put through further price hikes in Mobiles, despite the CPI indexation removal for postpaid mobile contracts.

Looking at the big picture, Morgan Stanley cautioned Telstra is facing a structural headwind with software companies globally displacing traditional telcos for telephony and connectivity, after management stated the decline in Enterprise division revenue had accelerated.

Based on learnings from covering other businesses in structural decline (e.g. stocks within the traditional Media sector on the ASX), this broker believes Telstra is facing two potential evils.

Decisive action is required by management, suggest the analysts, as divisions with high fixed costs can potentially turn free cash flow (FCF) negative and detract from other growing businesses.

Cash wind-down costs (such as cutting -2,800 FTE jobs) can also be expensive and absorb free cash flow otherwise destined for dividends/capital returns.

Dividend forecasts 

While Enterprise represents less than 2% of Morgan Stanley’s valuation for Telstra, the broker is laser-focused on anything that may jeopardise its forecast for a progressively rising dividend, which forms the basis of the analysts’ Overweight investment thesis. 

This broker retained its dividend forecasts across FY24 to FY26 at 18c, 19c and 20c, respectively.

Macquarie is more alarmed on dividends than Morgan Stanley, suggesting Telstra will look to rectify impacts from one-off restructuring costs (-$200-250m) by keeping the dividend flat at 18c into FY25. These impacts relate to the franking credit balance, which will likely be eroded as these costs will reduce tax paid.

Goldman Sachs lowered its FY25 dividend forecast to 18.5c from 19c, while UBS anticipated an 8% compound annual growth rate (CAGR) over the next two years, resulting in a 21c dividend in FY26.

Outlook

Last week's trading update confirmed Telstra's mobile business continues to perform strongly, contributing positively to the outlook, notes UBS, which left its Buy rating and $4.40 target unchanged.

FY24 guidance was reaffirmed and new FY25 guidance was for underlying EBITDA (excluding restructuring costs) of between $8.4-8.7bn, which compares with forecasts by the broker and consensus for $8.5bn and $8.6bn, respectively.

UBS maintained optimism around Telstra’s ability to continue to lift mobile prices.

Management commentary suggests strong subscriber growth momentum has continued from the first half into the first four months of 2024, with minimal mix shift between Postpaid/Prepaid/Wholesale.

This outlook has provided UBS with comfort on the willingness of consumers to continue paying higher prices for network differentiation over the medium-term.

This broker also notes Telstra’s peers have raised prices after making CPI adjustments back in late-March, with consumers a bit more conditioned to an annual price rise for mobile contracts.

The average target for Telstra Group in the FNArena database has fallen to $4.00 from $4.38 following last week’s announcements, suggesting 14.2% upside to yesterday's closing share price (Telstra shares weakened post the announcement).

Of the six covering brokers updated daily in the database, four have Buy (or equivalent) ratings, while Morgans and Macquarie are now on Reduce and Neutral, respectively. 

In mid-March, Bell Potter upgraded to Buy but the analyst hasn’t refreshed research since.

Buy-rated Jarden and Goldman Sachs (two covering brokers not updated daily) have an average target of $4.13. 

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