As Telstra gets ready to announce the outcome of its capital review, pressure for a cut to its dividend is increasing. Last week, Citi joined the fray, forecasting Telstra would cut its dividend from 31c to 25c in the next financial year and arguing that slashing it to 17c would be more appropriate.
Citi isn’t the only major broker to forecast a cut. Credit Suisse reduced its forecast to 25c per share for FY18 back in May, with the cut to be offset by share buybacks in FY18 and FY19 to maintain the overall dollar value of returns to shareholders and help ease the transition to the lower dividend.
Telstra is set to announce its full year results on Thursday 17 August. Accompanying this is expected to be long awaited capital review, which should reveal Telstra’s go forward position on the dividend.
Back on 24 April, I wrote:
“My guess is that the noise for a cut in the dividend from institutional shareholders and analysts will grow louder. Many will point to the BHP example, where the abandonment of its crazy progressive dividend policy was virtually the turning point in its share price decline.” (see here [1])
One month to go, I think we are going to see more words written about this subject. But before turning to just how likely a cut is, let’s re-cap why some believe a cut is necessary.
Why does Telstra need to cut its dividend?
The argument for cutting Telstra’s dividend is pretty simple. It is barely generating sufficient free cash flow to cover it, and the outlook isn’t looking that good.
It has an NBN (National Broadband Network) earnings hole to plug as customers switch from using the Telstra infrastructure to that provided by the NBN. In the long term, this is material and has been quantified by Telstra as having a negative impact on EBITDA in FY22 of $2bn to $3bn (total Telstra EBITDA in FY17 is forecast to be circa $10.7bn).
To address the NBN hole, Telstra has initiated a productivity program, is increasing capex to drive long run revenue and cost benefits, and says that it will grow revenue in its core and new businesses.
The productivity program is under the stewardship of CFO Warwick Bray and aims to find $800m of cost savings. It focuses on four key themes – improving the end-to-end customer experience; product and process simplification; reducing complexity in Telstra’s organizational 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 by FY21, with two thirds coming from revenue and one third from cost improvements. Of the $3bn, $1.5bn is earmarked for networks and re-inforcing network differentiation, $1.0bn for digitization to cover all forms of interaction between Telstra and its customers, and $0.5bn for projects improving the customer experience.
Assuming that these initiatives deliver a $1.3bn improvement in EBITDA, the balance of approximately $0.7bn to $1.7bn will need to be covered by revenue growth from Telstra’s four main products – mobile, fixed (including reselling NBN access), data and NAS (Networks, Applications & Services), and new business.
But that leads to the second problem – revenue is not growing. In fact, revenue fell in the first half of FY17 by 0.7% to $13.7bn. While there were some one offs due to regulatory pricing decisions, recurring core revenue fell by 0.4% compared to the same half in FY16.
Critically, revenue in the mobiles division, which accounts for 39% of Telstra’s sales revenue, fell on a recurring basis by 2.4%. This came despite Telstra adding 200,000 retail customers in the first half, taking the subscriber base to 17.4 million.
Telstra has reaffirmed guidance for FY17 (as per the table below), but for both revenue and EBITDA, it is low single digit growth.
Will the dividend be cut?
Telstra’s current dividend of 31c per share costs around $3.7bn. Add in interest of $0.5bn, and Telstra needs free cash flow (which is the cash generated from operations less capital expenditure, but before payment of the dividend) of around $4.2bn. However, free cash flow in the first half fell to $1.4bn, and while it is expected to improve in the second half, Telstra has only guided for full year free cash flow in the range of $3.5bn to $4.0bn.
To improve free cash flow, Telstra could reduce its capex, but it has said that it plans to increase this as part of the efforts to plug the NBN hole. Another option to sustain the dividend is to increase borrowings, however, this appears unlikely as the overriding feedback from shareholders in the Company’s ongoing capital review has been the importance of retaining a strong balance sheet. Telstra says that it is committed to retaining balance sheet settings consistent with an A band credit rating.
From a cash flow perspective, the real problem for Telstra is not FY17 or FY18 but in the later years when the NBN earnings hole grows deeper, and the impact of any new competitor such as TPG on its mobiles business is going to be felt. The issue for Telstra is whether to cut the dividend now, or continue to pay out at the same rate and work on its plan to address the earnings hole.
Cutting the dividend now would allow Telstra to potentially further increase capital expenditure, reduce debt and strengthen its balance sheet, or apply some of the excess funds into share buybacks, thereby reducing the number of shares on issue and increase earnings per share.
My guess is that the finalization of the capital allocation review is likely to be accompanied by an announcement that the dividend is being cut on an ongoing basis. I don’t think we are going to see Citi’s 17c per share, but a cut to around 25c (which would take the annual cost to $3bn) seems possible.
What do the brokers say?
Two of the 8 major brokers that cover the stock are forecasting dividend cuts in FY18. The other six brokers see no change.
Sentiment for the stock remains marginally negative, with 2 buys, 3 neutrals and 3 sells. The consensus target price (according to FN Arena) of $4.41 is 2.7% higher than Friday’s closing price. Individual recommendations are as follows:
Broker Recommendations and Target Prices
The Brokers have Telstra trading on a multiple of 13.9 times forecast FY17 earnings and 13.3 times FY18 earnings.
Bottom Line
Since the ACCC’s decision not to declare roaming, Telstra has traded in a very narrow band between $4.25 and $4.45. As talk about a dividend cut has intensified, it has traded down towards the bottom of the range. The likelihood is that with a month before the expected capital review is announcement and Telstra details its full year results, Telstra’s share price will remain under pressure. It is hard to envisage the market re-rating Telstra in this period.
The table below sets out various dividend scenarios (from Citi’s 17c call to an unchanged 31c) and various share prices, and shows the purchaser’s yield.
Telstra Yield
As I said back in April, I haven’t changed my view that growth focused investors should look elsewhere. Income investors who are filling up on Telstra can afford to be patient, perhaps targeting the next buy level around $4.00 or just shortly before the Telstra results announcement. At $4.00 and with a 25c dividend, Telstra would yield a handy 6.3% fully franked (or 8.9% grossed up).
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