By Greg Peel

Over the weekend we have learned that the Greens will now vote to pass legislation forcing the structural separation of Telstra ((TLS)) into a retail business and a wholesale business, the latter of which will be absorbed into the National Broadband Network on the assumption the NBN itself becomes a reality. We are yet to learn which way the rural independents will vote, but they in varying degrees made their support of an NBN clear in post-election negotiations.

To support separation the Greens needed the concession to be made that the NBN would not be automatically privatised at a given date down the track, but would at the time be subject to a parliamentary vote. The risk, suggested the Greens, is that of “another Telstra disaster”.

While the Greens might be ignorantly misguided in pushing for government control of mortgage rates, on this point I do firmly agree. On the one hand there is always a risk that the government of the day would prematurely hand over the NBN to the private sector in order to return a balanced budget and thus look good politically (See: QR National), and on the other hand the Howard government's partial privatisation of the Australian people's vital communications infrastructure into a listed monopoly subject to government price controls has been nothing short of an unmitigated disaster, and was always going to be. How can a conflict of shareholder interest and rural equality ever be resolved?

Now we have the proposition of, at least for a period, a return to a publicly owned national communications network based on fibre to every premises in Australia, no matter if that premises is in the Sydney CBD or on a remote outback cattle station the size of a European country. Clearly in order to achieve equality of pricing, the city must subsidise the bush which means that while Australia may finally catch up with the rest of the world on broadband speed, it will still be perhaps the most expensive broadband service on the planet.

This point has now been made by everyone from Malcolm Turnbull to Mexican billionaires and the OECD. Given the Opposition's stance is to be directly adversarial on everything other than defence deployment, anything the Opposition says has to be taken with a grain of salt (See: Joe Hockey). Nevertheless I firmly disagree with Turnbull's insistence on a “cost-benefit analysis” given it is the job of governments to provide services the private sector would not on a cost-benefit basis (See: Sydney public transport system). Otherwise why not just privatise Australia? Rupert would probably be interested.

I do, however agree with the argument of FTTP being too expensive to deliver to every single premises, and were it up to me I would be building FTTP infrastructure in the cities and major regional centres and wireless networks into remote rural areas, with options of cable and satellite thrown in. Such a diversified and competitive network would have a much better chance of reducing prices naturally, but would also allow the government to mandate a lesser price. But there is a problem.

The real problem is that Australia is a country the same size as mainland USA but with only 22 million people to America's 300 million. Thus any “equitable” service, be it broadband, health services or even railroads is either impossible or destructively costly for all. The immediate problem is that both sides of politics need the rural vote to form a government, a point now made abundantly clear by the current hung parliament which is “controlled” by the votes of a Green and three rural MPs (and Andrew Wilkie, and a wobbly National party MP on the Coalition side). Thus it is impossible to envisage a national broadband solution which would leave the bush complaining that the city is getting a better deal. We are simply trapped.

All of the above leads to ongoing uncertainty surrounding the NBN, and while the initial separation legislation has made it through the lower house the Senate still has to cast its vote, which it will do so before Christmas. Hence Telstra management noted at its AGM on Friday that it hoped an NBN structure would be made clear before end-2010 allowing Telstra shareholders to vote on the company's participation by mid-2011.

While there has been much wailing and gnashing of teeth from Telstra shareholders in being forced to structurally separate, at the end of the day the $11bn compensation is worth around 30c to the share price, according to analysts, and analysts agree that a Telstra left in the wilderness with its aging copper infrastructure would likely suffer a slow and painful death.

As it is, Telstra is already effectively dying quietly as the country awaits an NBN outcome.

Telstra has launched Project New which reflects a belated attempt to catch up with the real world – one in which home “land lines” are slowly becoming redundant and voice-over-internet-protocol (VoIP) more popular. At the same time, reliable mobile internet access has suddenly become of vital importance in the “smart phone” and “tablet” revolution and frustrating experiences with unreliable wireless services has led to fixed broadband being the choice for home or office computers.

The upshot is that Telstra has spent a great deal of effort and money in recapturing its eroding customer base by offering sexy deals on the above, and the company's September quarter subscriber growth results show the policy is working. Analysts estimate that Telstra captured some 60% of the market share of subscriber growth in the period, with mobile subs up 264% and fixed broadband up 321% on the previous quarter.

Is Telstra thus baaaack? Not necessarily. The simple fact of the matter is Telstra has “bought” this market share and questions arise as to how this has impacted on average revenue per user (ARPU). A clue came from management itself, which at the AGM reiterated FY11 earnings guidance. This means Telstra still expects its earnings before interest, tax, depreciation and amortisation (EBITDA) to fall by 8.5% in FY11 from FY10.

With earnings declining, and as yet no clear resolution on the NBN, the question of Telstra's generous dividend comes into focus.

Recently analysts have come to the conclusion that Telstra will be unable to keep paying a discreet 28c dividend as earnings decline. Management noted that consensus forecasts now have an FY11 dividend of 27.6c and an FY12 dividend of 27c, so management took the opportunity of the AGM to make it absolutely clear that Telstra will maintain a 28c dividend in both years. Only if something really untoward came out of left field would that policy be amended.

A 28c dividend means Telstra shares are offering a fully franked yield of 10.6% (FNArena's Stock Analysis shows forecasts of 10.4% in FY11 and 10.2% in FY12 to reflect analyst consensus). For any stock, a double-digit yield would normally suggest the investment is bordering on “junk” in that such a yield could only reflect a very high earnings risk. But Telstra is a utility – supposedly one of the most “defensive” sectors of all – which generates a large amount of free cash flow. Typically, utilities offer a yield only slightly better than a government bond.

In other words, one would think that Telstra could reduce its discreet dividend in the face of declining earnings and still deliver a very attractive yield, while at the same time alleviating fears that the dividend commitment itself could get the company into more trouble than anything else. But no – management is insistent on maintaining the yield that has been the Telstra investor's most important (only?) attraction these past few years. There have even been times when the company has “burned cash” by having to borrow money to make good on its dividend when cashflow has fallen short.

It is not the case at present however, and UBS (Buy) is forecasting that Telstra will generate $4.3bn in free cashflow in FY11 to well exceed its $3.5bn dividend commitment. By pre-paying FY12 tax, the dividend should remain franked, UBS suggests.

BA-Merrill Lynch (Underperform) has nevertheless recently been a strong advocate for a dividend cut. Citing various issues surrounding tax, depreciation charges, margin pressures and NBN volatility, Merrills believes the Telstra dividend should be only 23c. Despite management's two-year 28c pledge, Merrills suggests the dividend will be 25-27c over the next four years.

There is another factor to consider, however.

It is management's intention to buy back shares. It won't happen immediately because management will sensibly postpone such a decision until after it knows exactly what the NBN outcome will be. UBS suggests a $2m buyback at current prices would be 4% accretive to earnings per share.

A buyback increases earnings per share not by increasing absolute earnings but by reducing the number of shares, such that everyone enjoys a greater piece of the pie (except for those who sell into the buyback of course). And naturally the same result occurs for dividends per share. Therefore, were Telstra to buy back stock it could actually reduce the total amount of its dividend obligation while still maintaining a 28c discreet dividend per the lesser number of shares on issue.

In other words, a buyback takes the pressure off maintaining this magical 28cps number when earnings are dodgy.

Of course, Telstra is not intending that earnings will always be in decline. They will be in decline in FY11 because the company has been spending all this money to reposition itself through Project New and analysts expect that, in some sort of post-NBN decision world, the repositioning will start to “pay dividends”, if you pardon the expression.

So forecasts look a little better for FY12-13, and on that basis Telstra shares look pretty cheap at the sort of multiples they are currently marking.

But those multiples will most likely remain low, analysts suggest, while the pall of uncertainty continues to hang over the company. Aside from an NBN decision, the ACCC is still looking into fixed line pricing, so regulatory risks also remain. So really we need an outcome on that, an outcome on the NBN, and some evidence that Project New is actually working (rather than just being a case of “buying” market share) before the market is ever likely to once more get excited about owning the shares of Australia's biggest listed company.

A lot of that is down to Australia's politicians, God help us. But with NBN compensation, a buyback, an ongoing guaranteed dividend perhaps some earnings upside, there may be yet some light at the end of the tunnel.

The FNArena database currently shows Telstra with a Buy/Hold/Sell ratio of 3/4/1 with a consensus target of $3.22 to provide 22% consensus upside. However, brokers are quite divergent in their views as exhibited by the range from target low marker Merrills at $2.70 (which is nevertheless still above today's trading price) to high marker UBS at $4.00.

By Rudi Filapek-Vandyck

TPG Telecom's ((TPM)) recent FY10 results revealed growth in earnings per share of no less than 45%, but investing in the share market is all about what lies ahead, not what happened yesterday, reminds us Moelis telecom analyst Adam Michell. He sees dismal growth figures ahead for one of Australia's recent success stories in the telecom sector, predominantly because mogul Telstra ((TLS)) is intent on spoiling the party for everyone else in the sector. Investors should note the same theme is apparent in analyst reports following the recent market update by Singapore Telecom's ((SGT)) Optus.

Consensus estimates for TPG are still assuming double digit growth figures for the years ahead, but Michell is suggesting this will prove too optimistic. His estimates only assume low single digits growth instead. The obvious suggestion to make is that if Michell proves correct, than others will have to cut their projections at some stage and this is likely to put downward pressure on the TPG share price. Three weeks ago, analysts at RBS downgraded their rating to Hold for exactly the same reason as Michell's - Telstra becoming more competitive.

Michell suggests mounting pressures on TPG's margins won't become apparent until the second half of fiscal 2011. No surprise, Moelis rates TPG a Sell. As mentioned above, RBS moved to Hold last month. Macquarie and BA Merrill Lynch still have an Outperform/Buy rating. Consensus price target is at $2.03, suggesting potential upside in the order of 31% - though Moelis' Michell would strongly disagree. He has a target price of $1.30.

By Chris Shaw

Recent acquisitions and product innovation has helped iiNet ((IIN)) become Australia's second largest internet service provider and the growth of the company has seen Deutsche Bank initiate coverage with a Buy rating on the stock.

Both elements of iiNet's growth are expected to continue, Deutsche seeing initiatives such as "BoB" (broadband in a box) and "fetchtv" as likely to continue to attract subscribers, while others will come from further acquisitions in the market.

The acquisitions made by iiNet in recent years have delivered in the key areas of subscriber growth and average revenue per user (ARPU), a trend Deutsche suggests shows no signs of changing.

This should deliver solid earnings growth, Deutsche Bank forecasting earnings per share (EPS) growth of 16% annually through FY13. Even stronger EPS growth of 24% is expected in FY11 as iiNet beds down the recent Netspace and AAPT Consumer Division acquisitions.

In terms of actual EPS, Deutsche Bank is forecasting 28c in FY11 and 31c in FY12. This compares to consensus forecasts according to the FNArena database of 27.8c in FY11 and 30.7c in FY12. Broker forecasts are relatively consistent around these levels.

The establishment of a National Broadband Network (NBN) will potentially impact on iiNet, but as Deutsche Bank points out this network is at least eight years away from being in operation. While higher capital expenditure is likely as iiNet adjusts to the new network, Deutsche's earnings forecasts already allow for this.

The NBN should also offer opportunities for iiNet in the view of Deutsche, as the network should remove Telstra's ((TLS)) monopoly in that space, so improving iiNet's ability to compete. What should also help here in the broker's view is iiNet can offer better customer service than Telstra, so supporting its growth outlook.

Others in the market agree as the FNArena database shows iiNet is rated as a Buy by all five brokers to cover the stock. The consensus price target is $3.23, which is in line with Deutsche's $3.15 price target.

Shares in iiNet today are stronger and as at 11.30am the stock was up 9c at $2.85. Over the past year the stock has traded in a range of $1.67 to $3.13 and at current levels there is implied upside of almost 14% to the consensus price target in the FNArena database.

By Chris Shaw

Telstra ((TLS)) yesterday held its 2010 Investor Day, the update for shareholders focused on an investment of $1 billion to drive market share, current operating momentum and Project New, the company's new three-year cost cutting program.

There were some positives in the update according to Goldman Sachs, as Telstra indicated operating momentum has improved in recent months following price revisions across the group's product range and a more aggressive approach in the marketplace.

As examples Goldman Sachs notes in July-August Telstra recorded net adds of 73,000 in postpaid mobiles, 176,000 in wireless broadband and 32,000 in fixed broadband. As well, the company recorded fewer fixed line customer losses in the period than for any two-month period since 2007.

One key issue in this drive for market share will be the impact on ARPU or average revenue per user and here Macquarie suggests the outlook is currently unknown. As revenues lag acquisition costs and both lower ARPU and higher subscriber acquisition costs will take time to become evident, the broker suggests any earnings accretion from the strategy appears at least 18 months away.

As margins are likely to come under threat from a more aggressive approach to gaining market share Macquarie sees cost cuts as important, so Project New will be a key to maintaining margins going forward.

The broker suggests the project will need be very aggressive if margins in FY13 are to be restored to FY10 levels given the likely revenue outlook, which implies achieving such a goal will be a challenge. As well, JP Morgan notes market skepticism regarding such programs is high given the failure of the previous five-year transformation project to deliver on promises.

In JP Morgan's view, the $1 billion to be reinvested in lowering costs may well have to be increased going forward, especially as competition in the industry shows no signs of easing from already high levels.

The other key point of the investor day was an update on the National Broadband Network (NBN), with management expecting to be in position to call a shareholder meeting to vote on the final NBN agreement by next June. As well, further details of the agreement are likely to be revealed at the Telstra AGM in November.

The big issue with the NBN, in Macquarie's view, is timing of any deal remains uncertain, a view shared by Credit Suisse given legislation needs to be passed through a delicately balanced parliament. This has the scope to delay any agreement, but Macquarie notes management still expects to net around $11 billion in value for shareholders from the transaction regardless of the final form of the deal.

BA Merrill Lynch suggests one other issue for Telstra is the market is concerned the dividend may be cut given it is higher than earnings at present. Management reiterated it expects to pay 28c in annual dividends despite the broker forecasting earnings will fall to 26c.

In BA-ML's view Telstra could do better things with the money given earnings are unlikely to recover in FY12, so post the update the stockbroker continues to expect a cut in payout to 26c per share in both FY11 and FY12.

Post the investor day brokers have made few if any changes to earnings estimates for Telstra and consensus EPS forecasts according to the FNArena database stand at 26.1c in FY11 and 27c in FY12 (both would be below the 28c dividend payout shareholders have enjoyed in years past). The average price target according to the database is $3.27, essentially unchanged from prior to the update.

Telstra is rated Buy three times, Hold four times and Underperform once according to the FNArena database, while non-database brokers Goldman Sachs and Morgan Stanley rate the stock as Hold and Overweight within an In-Line sector view respectively.

In the view of Morgan Stanley, if Telstra management can deliver earnings growth beyond FY13 then the market is seriously underestimating the value of the shares at current levels. But the uncertainty as to the success of current strategy, the NBN and timing of the delivery of any earnings growth is enough for most in the market to remain somewhat cautious on the stock.

Shares in Telstra today are weaker in line with the broader market and as at 11.55pm the stock was down 3c at $2.65. This compares to a range of $2.63 to $3.55 over the past 12 months and implies upside of around 21% to the average price target in the FNArena database.

By Greg Peel

Hands up. Who's had a call from Telstra lately offering all sorts of cheap new deals and packages? Nearly of all you huh? I did, but it took me half an hour to explain to Mr Patel I'm with Optus. But now that Optus has abandoned the promotion of cable television delivery, I do have a new Foxtel satellite, which makes me a quasi Telstra customer. That included all manner of freebies.

Telstra is dying. That much was clear from its recent profit warning – that which drove Telstra's price to its lowest level in history. Despite making solid inroads into the competitive mobile market, the telco has not been able to offset the flood of customers abandoning their antiquated fixed-line rental phone services forever.

And land lines are all about the old copper network that relentlessly stubborn Telstra shareholders cried foul about losing to the socialist government. Well sorry, but it looks like all is lost. Or not.

The formation of a Labor government was dependent on the support of two independent members who were strong backers of the rollout of Australia's fibre to the premises (FTTP) network. The National Broadband Network and related NBNCo will go ahead – it is certain. And thus it is all but certain Telstra will receive the $11bn the government previously offered for its now redundant infrastructure.

In reality, the government is paying up for the underground and overhead conduits and power pole networks through which Telstra's copper now runs, rather than the copper itself. But the copper is still handy as well, given it allows the fibre network to be rolled out gradually without costly replication and without cutting anyone off in the meantime.

This also means the rollout will not cost anything like the $43bn price attached to a replication network, but that's another story. The fact is Telstra is in a fight for its life which has absolutely nothing to do with government policy and everything to do with the previous blindness and recalcitrance of management. It is just as much in Telstra's interest to attempt to reposition itself to compete more effectively in the telco world of the twenty-first century as it is to, now, prepare for structural separation. And to do so the company does not need to seek expensive debt funding, or raise dilutive equity. It's about to be handed $11bn. In cash.

Citi, Credit Suisse and Deutsche Bank were all this morning in agreement that the election win to Labor is a positive for Telstra, if for no other reason that it removes the uncertainty of what was to transpire. There are a lot of things stock markets don't like, and uncertainty is right at the top of the list.

But the win, and subsequent NBN endorsement, is also positive enough for that $11bn alone.

Citi suggests that there remains downside risk to Telstra's revenues in FY11-12. This is not good, given management's FY11 guidance of around $10bn in earnings or a 40% margin is its lowest in history. But even if revenues do drift further, Citi suggests Telstra still has enough free cashflow to self-fund (and fully frank) its plus-100% dividend payout ratio. If there were any further doubt, the proceeds of the SouFun IPO will provide extra comfort.

Let's face it. Were Telstra no longer boasting a market leading yield, who'd buy it?

Furthermore, Citi notes that were Telstra's new strategies aimed at improving market share in non-fixed line businesses to be slow to show results, the $11bn is there to fund ongoing dividend obligations.

Citi believes Telstra has reached a floor in its valuation. Looking through the cycle, Citi sees the stock worth $3.20 to $3.60 in an NBN world, and backs that up with a $3.60 target price and Buy rating.

Credit Suisse has calculated, taking into account its valuations for Telstra's non-fixed line businesses and the $11bn, that the market is valuing the fixed line business at only 0.8x earnings. “This is too bearish in our view,” says CS.

Credit Suisse also believes Telstra can maintain its dividend and believes the stock should re-rate towards the analysts' $3.40 discounted cash flow valuation. This is subject, however, to the company showing it can deliver on its market share strategies.

It is also subject to shareholders actually approving the $11bn, which they'd be mad not to now that telstra has shown it can die all by itself.

CS has set its target at $3.40 (Outperform).

Deutsche Bank notes Telstra's recent decision to spend $1bn on its new strategy suggests the company is moving to position itself well ahead of the NBN rollout in order to become a more competitive and customer focused (am I hearing that right?) organisation. Says Deutsche:

“[The NBN rollout ratification] provides more certainty on industry structure and a path for compensating Telstra for decommissioning the copper network, with the accompanying benefit of short term cash flows offsetting the longer term challenge of losing the benefit of vertical integration and competing with other carriers in the NBN world.”

Got that? Another way of putting it is that while Telstra may be losing the monopoly it had on the wholesale market through its infrastructure ownership, from which it could lever off to provide competitive retail services once upon a time, the $11bn in cashflow provides an offset as Telstra looks ahead to years down the track when the fibre network will be handed over to NBNCo and the cashflow will stop.

On that basis, suggests Deutsche, the NBN is “marginally” positive for Telstra.

Deutsche (Hold) has set a target of $3.15. The stock is currently trading at $2.89 and offers a 9.5% fully-franked dividend yield.

By Chris Shaw

IT services provider SMS Management & Technology ((SMX)) reported what UBS viewed as a strong full year profit result, earnings of $27.9 million coming in a little above the broker's $27.1 million forecast. Earnings in the second half were particularly strong, rising by 32% against a 16% increase in earnings on a full year basis.

The full year result was driven by an improvement in net margins, Credit Suisse seeing this as a reflection of improved utilisation and operational leverage. Macquarie agrees, noting utilisation rates for the full year were around 92%.

Operating conditions are also improving, this apparent in an increase in staff levels to 1,372 as at the end of June compared to 1,168 at the end of June last year. Despite this increase in staff levels, Macquarie notes overhead cost management was good as it remains a focus of management.

Cost pressures remain a major issue for the company according to UBS, particularly in relation to wage pressures. As SMS Management has a large base of project managers and consultants, wages are a risk as such services are not easily able to be outsourced offshore.

Major projects also appear to be picking up, Credit Suisse noting SMS had $280 million of bids being contested as at the end of the financial year. Given a sales to bill ratio of 1.2 times, the return to growth comments of management appear justified in the broker's view.

SMS Management should be able to comfortably finance the growth from new projects, Macquarie noting the company had net cash of $31 million on its balance sheet as at the end of June. This also offers scope for acquisitions, particularly in the managed services space where expansion attempts are underway.

Macquarie suggests the result shows strong demand across key vertical segments of the company's business is translating into a bounce back in top-line growth. In Macquarie's view this suggests SMS Management should continue to outperform the market over the medium-term, particularly given the solid earnings growth outlook.

This growth outlook is reflected in Macquarie's earnings per share (EPS) forecasts, which stand at 46.2c in FY11 and 53.2c in FY12, up from the 40c result in FY10. Credit Suisse is even more optimistic, forecasting EPS of 51.4c in FY11 and 56.9c in FY12.

UBS is not quite as aggressive in forecasting EPS of 47c and 50c respectively, while consensus EPS forecasts for SMS Management according to the FNArena database now stand at 48.3c in FY11 and 53.4c in FY12. Changes to earnings estimates post the result were relatively modest.

Credit Suisse's EPS forecasts imply earnings multiples of 11.1 times in FY11 and 9.7 times in FY12, while the broker suggests the earnings growth justifies a 30% premium to the Small Industrials Index. This implies respective earnings multiples of 12.1 and 17.8 times in FY10 and FY11, which underpins the broker's $8.10 price target for the stock.

This puts Credit Suisse ahead of the back with respect to price targets as the average target according to the FNArena database stands at $6.83, with BA Merrill Lynch the low marker with a target of $6.26. The average price target is unchanged from prior to the profit result. (Special note: BA-ML has just lifted its price target to $6.71 post the result).

Ratings for SMS Management remain positive, the stock scoring four Buys and one Hold rating. Shares in SMS Management today are stronger and as at 11.30am the stock was up 20c or 3.2% at $6.46. This compares to a range over the past year of $4.20 to $7.21 and implies upside of around 7.5% to the average price target in the database (uncorrected for the BA-ML update).