Back in April, we published an article from Switzer Super Report expert Charlie Aitken headed ‘Telstra: Dividend Certainty in an Uncertain World’. Charlie went on to say that: “To me, TLS is all about the dividend and the dividend appears secure. As investors and analysts come around to this view, I would expect TLS to experience a P/E re-rating driven by dividend yield compression. My first price target is the 200-day moving average at $5.57 and if that hurdle is jumped, it is not outrageous to forecast TLS to recover to $6.00, which would represent a 5.25% fully franked, FY17 dividend yield.”
Clearly, this rerating hasn’t happened. A couple of readers took me to task for admitting that “we got it wrong”, so I thought I should look at what has changed since April. More importantly, where to now for Telstra.
In regard to this question, fortunately Telstra held an Investor Day last Thursday and updated the market about their biggest challenge – closing the NBN earnings hole. They also reconfirmed profit guidance.
What has changed since April?
There are four drivers behind the recent underperformance of Telstra. Firstly and most importantly, the hole in Telstra’s earnings post the full roll-out of the NBN in December 2020. This earning’s hole is material, and comes as customers switch from using the Telstra infrastructure to that provided by the NBN. Telstra has now quantified this and estimates a negative impact on EBITDA of $2bn to $3bn annually.
For comparison, Telstra’s total EBITDA in FY17 is forecast to be around $10.8bn. Its dividend payment of 31c per share in FY16 cost $3.8bn – so if EBITA is impacted by $2bn, you could in a worse case situation see the dividend cut in half in FY22.
Telstra Share Price 2016
Source: Yahoo!7 Finance
Telstra’s network also suffered several outages, forcing the company to commit to investing $250 million from its existing capital program over the next six to 12 months to provide a higher degree of network resilience and improved network performance in the mobile and ADSL broadband networks. The important point here was that prior to these outages, Telstra’s key competitive differentiator in the mobile and broadband areas was considered to be its network resilience.
Full year results met profit guidance, but were somewhat disappointing as they were at the lower end of the range. Total income in FY16 grew by 6.3% compared to FY15, while EBITDA growth slipped to just 2.6%. Then there has been the impact of the sell off in the bond market, which has seen 10-year US treasury bonds jump by 0.59% over the last month to 2.33%. In Australia, the 10-year bond has added 0.39%, closing Friday at 2.72%. Given Telstra’s high dividends and annuity style characteristics, higher interest rates make Telstra less attractive.
The NBN hole
Telstra’s plan to address its NBN hole is summarised in the slide below. Firstly, it has a productivity program under the stewardship of CFO Warwick Bray to find $800m of cost savings. This will focus on four key themes – improving the end-to-end customer experience; product and process simplification; reducing complexity in Telstra’s organisational structures; and supplier partnerships to reduce costs.
Independent of this program is a strategic investment of $3bn over the next three years into the core businesses. This will take the capex to sales ratio to 18%. The investment is targeting run rate benefits in excess of $500m annually, which they expect to fully realise by FY2021, with two thirds coming from revenue and one third from cost improvements. Of the $3bn, $1.5bn is earmarked for networks and re-enforcing network differentiation, $1.0bn for digitisation to cover all forms of interaction between Telstra and its customers, and $0.5bn for projects improving the customer experience. Telstra says that it will be targeting a ROIC (return on invested capital) of over 14%.
Assuming that these initiatives deliver a$1.3bn improvement in EBITDA, the balance of approximately $0.7bn to $1.7bn will be covered by growth from Telstra’s four main products – mobile, fixed (including reselling NBN access), data and NAS (Networks, Applications & Services) and new business.
While the roll-out of the NBN has a long term impact on Telstra’s earnings, it also has a short term impact through one off payments that Telstra receives during the migration. The balance of one-off payments that Telstra expects to receive over the next four to five years will generate approximately $5bn post tax free cash flow. For shareholders, this means that capital initiatives such as further share buybacks could be on the cards in the next couple of years. Telstra says that it will consult with the market over the next six to 12 months regarding its capital strategy, which will include its dividends policy.
And despite this windfall, it doesn’t look like Telstra is keen to rush offshore with acquisitions, such as the proposal it considered earlier this year to buy a mobile carrier in the Philippines, or invest further in ehealth. At the Investor Day, it detailed some refinements to its strategy, which mean new businesses must be “close to the core”.
The brokers
While the brokers are supportive of Telstra’s actions to plug the hole, they are not yet convinced that they are going to be sufficient. While all expect Telstra to hold or marginally improve its dividend in FY17 and FY18, and a number point to further buybacks or other actions to return capital, many are still worried about FY22 and haven’t ruled out changes to make Telstra’s dividend more sustainable.
According to FNArena, sentiment is negative with three sells and five holds, and Telstra is seen as pretty close to fully valued. These are the latest recommendations and target prices:
Broker Recommendations and Target Prices
The brokers have Telstra trading on a multiple of 14.3 times FY17 earnings, and 13.7 times FY18 earnings. They forecast a dividend of 31.5c fully franked in FY17, and 32.0c in FY18. At a price of $4.93, this puts Telstra on a forecast dividend yield of 6.4% pa (9.1% pa grossed up).
My view
I think it is unlikely that the market will re-rate Telstra upwards until there is more clarity on its capital strategy and evidence that its productivity/capital investment agenda is working. A steadier bond market will also provide support. While Telstra will be supported by income investors, particularly in any market sell off, growth investors will continue to look elsewhere.
Sure, the dividend yield is attractive, and given that Telstra has yet to conduct an earlier announced on-market buyback, there is going to be buying support. So, I can’t recommend a sell. Buy more? I am not convinced there is any real hurry, so in weakness, targeting $4.50 to $4.75 range.
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