- Oakton result weak but well flagged
- Victorian operations showing signs of improvement
- Potential for further improvement makes Oakton a turnaround story
- Ratings upgraded to reflect potential upside

By Chris Shaw

IT group Oakton ((OKN)) delivered what was generally regarded as a weak full year earnings result, the result in itself no surprise given such an outcome had been well flagged by management. 

New information in the result, according to RBS Australia, was the progress being made in turning around Oakton's Victorian operations. Key metrics for that division have all improved, with staff churn falling and utilisation and sales conversion all rising. 

The latter was helped by two new clients being secured in the June half. This suggests to RBS while there is more work to do, the Victorian operations appear to have reached a turning point with further improvement expected going forward.

Goldman Sachs agrees the Victorian business still needs to improve, noting while utilisation rates improved in 4Q11 in particular, more outcome-based work needs to be secured. As Goldman Sachs notes, this form of work currently accounts for 54% of sales against management's target of 70%.

The other major positive for Oakton according to Macquarie is the removal of the Tenix legal case overhang, that matter having recently been settled. This will free up both management and billable staff, as six staff members were working full time on the case.

The Tenix settlement was certainly not a positive for the Oakton share price, Goldman Sachs noting the stock has lost 27% since settling the case. On the flip side, the settlement has returned Oakton to a net cash position of around $10 million. This should allow for an increase in dividend payout ratio from the 61% recorded in FY11 to 70-80% in FY12.

Looking to the future, management at Oakton has guided to FY12 sales growth of 5-10% on headcount growth of 4-6%. Margins are also expected to improve by 100-200 basis points, so driving stronger earnings growth in the view of Goldman Sachs.

To reflect both the FY11 result and the latest guidance from management, brokers across the market have adjusted earnings estimates for Oakton. Goldman Sachs has lowered its earnings per share (EPS) estimates by 8-9% for FY12 and FY13, while Macquarie has trimmed FY12 numbers by 1% but lifted FY13 estimates by 5%. 

Consensus EPS forecasts for Oakton according to the FNArena database now stand at 20.5c for FY12 and 23.4c for FY13, which compares to the 18c earned in FY11. 

Macquarie notes the growth expected in FY12 depends in good part on further gains in the Victorian operations, so there is some risk. There is also solid potential, as had Oakton delivered a flat result in Victoria in FY11 group earnings would have been $7 million higher.

Following the recent weakness in the Oakton share price the stock is now trading on an earnings multiple for FY12 of around 9.4 times on Macquarie's numbers. At this level the broker suggests downside risk to earnings is largely factored into the share price, while there is also growing dividend yield support given an expected higher payout ratio. Oakton is forecast to yield better than 8.0% fully franked in FY12.

This is enough for Macquarie to see good turnaround potential and so upgrade to an Outperform rating from Neutral previously. Others have followed suit, as both RBS Australia and Credit Suisse have upgraded to Buy ratings for the same reason – an attractive risk/reward profile at current levels.

Goldman Sachs has similarly upgraded to a Buy rating, this despite an 18% decrease in price target to $2.44. The fall in target reflects a collapse in market multiples given recent weakness in the market generally.

The upgrades to ratings means aside from the Buy rating of Goldman Sachs, Oakton is now rated as Buy by all five brokers in the FNArena database to cover the stock. The database shows a consensus price target of $2.35, down slightly from $2.52 prior to the profit result.

Shares in Oakton today are down slightly and as at 11.30am the stock was 2c lower at $1.885. This compares to a trading range over the past year of $1.60 to $3.20. The current share price implies upside of around 20% to the consensus price target in the FNArena database.
 

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- Telstra has updated investors on its Sensis strategy
- Focus is on new revenue streams in SME market
- Competition and high cost base remain issues

By Chris Shaw

Sensis, the advertising and directories arm of Telstra ((TLS)), represents about 9% of group revenues and 17% of earnings before interest and tax. This makes the division an important part of Telstra's overall business. 

The division briefed the market yesterday on a revised strategy for growth. The update highlighted an investment in systems and multi-platform products designed to reduce customer churn levels.

As RBS Australia points out, this investment is to help target SMEs (small to medium-sized enterprises) in an attempt to generate new revenue streams (online instead of print). The strategy is aimed at offsetting a decline on the print side of the directory operations. 

Credit Suisse sees the approach as an attempt to create a one-stop advertising solution for SMEs, the expectation being enhanced online capabilities should translate into better lead generation for advertisers.

An extensive sales force is seen as an advantage in this regard, as are strong existing relationships with customers. Credit Suisse views the strategy as having merit, especially given only around 17% of SMEs have a digital advertising strategy.

One issue for Credit Suisse is Sensis will need to compete in the online space with the headwind of a higher cost base. This creates difficulties as a move to online operations generally means an erosion in revenues.

BA Merrill Lynch also makes this point, as while it too saw some positives in the new strategy for Sensis, the lack of any cost-out options is expected to prove an issue. The other issue for BA-ML is revenue targets from new customer growth, which are seen as challenging. 

This is particularly the case as a price optimisation program conducted by Telstra in FY08 and FY09 may mean some potential customers choose not to return to the service.

Morgan Stanley takes the view what didn't work in print is unlikely to work in the digital market as the strategy essentially remains one of cross-selling where possible. This is in a more competitive market, where the likes of Google continue to make inroads in directories offerings.

Post the briefing, Morgan Stanley has moved its bear case assumptions of 15% annual revenue declines and a reduction of long-term margins from 50% to 30% to its base case expectation.

In contrast, Telstra's briefing suggested a mid single-digit decline in sales and a high single-digit decline in EBITDA (earnings before interest, tax, depreciation and amortisation) in FY11. Similar trends are forecast for FY12 and FY13, before a return to organic revenue growth in three years. Both UBS and Goldman Sachs sit below these numbers with their respective forecasts (as does, of course, Morgan Stanley).

While Sensis continues to face problems, UBS suggests for Telstra overall an earnings rebound in FY12 remains likely. This reflects the benefits of Project New and improving subscriber momentum. 

As well, UBS notes the sell-down of part of its Telstra stake by the Future Fund will reduce the overhang in the stock and increase Telstra's weight in Australian indices. Add in more definite NBN agreements in coming months and UBS continues to see value in Telstra shares at current levels.

The market appears to agree, as the FNArena database shows six Buy ratings for Telstra against one Hold recommendation and one Underperform, this courtesy of BA-ML. Goldman Sachs is not in the database but rates Telstra as a Hold, while Morgan Stanley has a Buy rating within an In-Line view on the Australian telco sector.

The consensus price target for Telstra according to the FNArena database stands at $3.22, which implies upside of around 16% from current levels. Goldman Sachs has a target of $3.08, while Morgan Stanley's price target is $3.20.

The price target is based on consensus earnings per share forecasts of 24.9c in FY11 and 26.8c in FY12. These forecasts are essentially unchanged post the briefing.

Shares in Telstra today are stronger and as at 11.35am the stock was up 5c at $2.81. Over the past year Telstra shares have traded in a range of $2.55 to $3.46.

By Greg Peel

The story so far...

Last December legislation was passed to install the Australian Competition & Consumer Commission as the body responsible for setting telecommunications access prices in Australia ahead of the move to a National Broadband Network. In September the ACCC issued a preemptive draft pricing schedule and sought industry feedback. On Friday the ACCC issued in response its Interim Access Determination and a final version is due late this year. Whatever the final schedule, pricing will apply retrospectively for all of 2011.

Amongst a wealth of complex and confusing prices and measurements, the important factors are the wholesale line rental price, the value ascribed to Telstra's ((TLS)) legacy copper network ahead of a sale into the NBN, and the pricing of ULL bands. The “unbundled local loop” refers to third party telcos renting the copper lines from exchange-to-premises and then providing customers with full service on those lines.

The draft ACCC paper had the wholesale line rental falling to $20.00 from $25.57, but after adjusting its valuation for the copper network on Telstra's encouragement the ACCC has come back with $22.10.

The ACCC has agreed to Telstra's insistence that valuation of cables and ducting should also include a value for the land occupied which is adjusted for inflation. The September draft put the figure at $13.3bn, Telstra came back with a value of $28.2bn, and the ACCC has now settled on $17.5bn.

It seems like Telstra is still missing out by a margin here but given the company's future under an NBN is very dependent on just what the NBNCo pays for Telstra's legacy infrastructure, it would stand to reason Telstra would come in high.

Without going into too much detail on ULL, suffice to say there are four bands and previously each band came with a different price. The ACCC has now averaged out bands in between and cutting a long story short, the net result is a fall in the average price to $19.17 from $28.50 with the majority of services paying $16.00. As this represents an unchanged price for most, the impact here is minimal.

To round out the changes, line sharing service charges have dropped to $1.80 from $2.50 and local call costs to 9.1c from 17c, up from 7c in the draft schedule.

So what does it all mean?

Well on the assumption the NBN continues to roll out as planned, we are now in a transition phase. The beast that is Telstra has always been a failed attempt to marry private investment with public price-setting that satisfied both shareholders and customers alike. That's a bit like asking the north pole of one magnet and the south pole of the other if they would please stick together. The failure will finally be behind us if and when Telstra sells its infrastructure into the NBN and becomes a telco competitor on an even playing field with other providers. But Telstra shareholders still need to vote on the sale and its price in a couple of months and no one can be certain what might happen in Canberra in either the short or longer terms.

But taking this latest ACCC price schedule as a given, and analysts do not expect the final determination to look much different, the bottom line is an earnings reduction for Telstra of around 1-3% just on the pricing. But because we are talking wholesale prices, the end result comes down to how Telstra and its competitors respond. Do they keep charging the same retail prices and hence increase their margin over wholesale prices or do they play the competition card by dropping retail prices by some or all of the amount?

This is not yet clear.

What is clear is that Telstra will only find itself a small loser, and, as Macquarie notes, that the new prices are in line with what the market has been expecting. So the share price impact should be minimal. Potentially the big winner on the new prices is iiNet ((IIN)).

Analysts agree that iiNet should be able to hold on to most of the drop in wholesale cost rather than having to pass it on to retail customers, which translates into something in the order of a 20% increase in earnings. The benefits won't be felt until October however (despite retrospectivity) given that is when iiNet's current pricing contracts elapse.

Yet while the earnings and valuation impact to Telstra may not be significant, BA-Merrill Lynch points out that the change to the structure of ULL pricing could open regional areas to ULL competition. Hence as we await the NBN rollout there is a chance more customers will take up ULL options which puts downward pressure on Telstra's average revenue per unit (ARPU) and implies loss of market share. A flipside winner here could be TPG Telecom ((TPM)).

Deutsche Bank also notes the determination also has the potential to cause further price disruption in the fixed voice market, which would then impact on Telstra's retail fixed line ARPUs.

So the bottom line is: no great shock from the new prices; Telstra's valuation is not greatly impacted at this stage; iiNet stands to be a big winner; Telstra may yet suffer a flow-on to reduced ARPUs.

All of the above depends on how all the players react and how they readjust their individual retail prices to best cope with/benefit from the lower wholesale prices. In other words, stay tuned.