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I wrote eight weeks ago, when Telstra (TLS) was trading at $3.43: “A market underperform – well supported by income buyers in dips, a laggard when the market moves higher. Growth investors should look elsewhere. Income investors can afford to be patient and buy in dips. Telstra is no bargain – yet.”
On Friday, Telstra closed at $3.10. Over the last eight weeks, it has produced a return of -6.4% (capital loss of 31c offset by a dividend of 11c). The market, as measured by the S&P/ASX 200 Accumulation Index, is down by 0.4% over this period.
Apart from the prevailing negative sentiment about it and the Telco sector in general, Telstra has also been hit by Bill Shorten’s proposal to abolish cash refunds of excess imputation credits. For those eligible, including most SMSFs in pension phase, the effective yield on Telstra shares (based on $3.10 share price and 22c fully franked dividend) will, if ever implemented, drop from 10.1% to 7.1%. While only some investors are potentially impacted and it won’t apply (at the earliest) until the start of the 19/20 financial year, it could still put some downward pressure on the price.
So, around $3.10, is Telstra a bargain yet?
The case that Telstra is a bargain is as follows.
Firstly, over its 20-year period as a listed ASX security, Telstra has traded in a range of $2.52 to $9.11. The last time it was under $3.00 was in 2010 when the Future Fund was selling down its holding. Over the 20 years, the time spent under $3.00 has been fleeting (see chart below).
By most pricing metrics, Telstra is cheap. It’s trading on multiple of 11.1 times FY18 earnings and 10.4 times FY19 earnings. The dividend of 22c, which looks secure for the next two years, puts it on a yield of 7.1% fully franked (grossed up, 10.1%).
The problem for earnings and dividends comes into play when we start talking about FY20 and FY21, when the impact of the NBN really bites. It’s a double impact – less upfront receipts for Telstra from switching customers, bigger impact on recurring revenue as customers stop using Telstra’s broadband and telephone services. In regard to the dividend, the current 22c is a combination of an ordinary dividend and a special dividend – the latter being paid from the upfront receipts which will cease. The 11c interim dividend paid in February comprised an ordinary dividend of 7.5c (71% payout ratio of underlying earnings) and special dividend of 3.5c (58% payout of net one-off NBN receipts).
Thirdly, Telstra is viewed as being well positioned to leverage the 5G opportunity. Proponents of 5G technology say that it delivers more than 100 times the speed of 4G, and that in due course, wireless technology could make fixed cable infrastructure services like the NBN “white elephants” Others say that mobile services won’t have the reliability of fixed cable services and see a 5G mobile style service complementing fibre optic cable.
5G is still a little way away, with the best case for Telstra to begin a commercial service in the second half of CY2019. The Government recently announced plans to auction the first spectrum in October.
Finally, there is the opportunity to reduce costs. Some of the analysts and fund managers who are bullish on Telstra talk about the opportunity to take out costs. This isn’t new talk – it has been around for most of the last two decades. As part of Telstra’s project to close its NBN earnings hole of $3.0bn by FY22, Telstra has a $1.5bn productivity program underway. At its half-year update in February, it reported that it had delivered a cumulative reduction of $0.5bn in core fixed costs and was ahead on a run-rate basis on the target to reach the $1.5bn reduction.
Telstra’s challenges are essentially two-fold. Firstly, there’s the impact of the NBN, which is estimated to leave an earnings hole of $3.0bn pa when fully implemented. If Telstra took no action, EBITDA would fall from around $10.5bn to $7.5bn.
Telstra has a high level plan to address this, which includes productivity, capex and revenue goals. It says that it has so far delivered around $870m of benefits, mainly from productivity and cost initiatives. However details on how it aims to address the balance are sketchy. In particular, it has yet to articulate the “new” revenue sources.
The second is that its existing businesses are largely growthless. While it’s the dominant player in the key mobiles market and demand for data is soaring, revenue is flat as competition intensifies. Despite adding a net 235,000 new customers in the December half, revenue fell by 1.2%. It will shortly face the prospect of a new network from TPG. There are some bright spots for Telstra with its NAS or network application services business and global connectivity, but earnings have been under pressure as costs mount.
According to FN Arena, there has been no movement in the broker target prices over the last two months (apart from a very small reduction by Deutsche Bank). The consensus target price is still $3.65 – some 17.7% higher than Friday’s closing price. Morgan’s is the highest at $4.12, while Citi is the lowest at $3.10. There are 3 buy, 3 neutral and 2 sell recommendations.
Credit Suisse believes the dividend of 22c is sustainable for at least the next four years and has an outperform rating on the stock. On the other hand, Citi says that Telstra would need to double its productivity target to maintain its dividend and doubts whether this is practical.
There is no doubt that Telstra is cheap. But probably like many investors, I am already fully invested in Telstra. As a value investor, I don’t see the benefits on a risk/reward basis of being underweight a stock like this.
Am I ready to buy more? Not yet. I really want to see Telstra outline a more convincing plan about addressing its earnings hole.
In the meantime, I expect that Telstra will be an underperformer. It will continue to be well supported by income buyers, but a laggard when the market moves higher. I think bargain hunters can afford to be patient.