Telstra at $2.85?

Telstra’s profit downgrade on Monday 14 May, which saw the shares lose 10.9% over the week and touch seven-year lows, probably wasn’t a shock for many people. Telstra said that the lowering of earnings (EBITDA) guidance for FY18 from a “range of $10.1 billion to $10.6 billion” to “the bottom end of the range” was caused by two main factors.

Firstly, an intensely competitive mobiles market, where revenue is under pressure. The key ARPU measure (average revenue per user) for post-paid customers declined from an average of $65.92 in the first half to $65.35 in the third quarter, and is down by 3.6% on the corresponding quarter in FY17. Secondly, not only is the NBN impacting fixed line customers (which is expected), the ARPU Telstra is receiving on its NBN connections is under pressure.

The speed of the decline is also worrying some analysts, with one analyst suggesting that the fall in core earnings, which excludes net ‘one-off’ NBN receipts, is closer to $1.0 billion.

I said that the downgrade “wasn’t a shock” for some because the factors aren’t new. Competition in mobiles – Optus and Vodafone have lifted their game and TPG is coming; NBN – Telstra is one of more than 100 retailers offering NBN services; and the NBN earnings hole, where Telstra has struggled to articulate a plan to address the $3 billion impact it will have on EBITDA from FY22.

Five weeks ago, with Telstra trading at $3.10, I concluded my article When will Telstra be a bargain? with:

“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.”

I am sorry to say that I have been right about Telstra (“not a buy”) since management fessed up and told the market about the extent of the NBN earnings hole. I’m also sorry to say that I didn’t recommend a sell.

Now, as it bounces around $2.85, is it a bargain yet?

The metrics

Going by the numbers, Telstra looks cheap. The brokers have it trading on a multiple of 10.6 times FY18 earnings and 10.0 times FY19 earnings (although there now may be a little more risk on FY19 earnings).

The dividend of 22c for FY18 is secure, giving it a nominal yield of 7.71% (plus franking credits). But there is increasing risk about FY19 and later years. Whereas a month ago most brokers thought the dividend was secure for at least the next three years, dividend cuts are now being discussed. Macquarie, for example, forecasts a cut from $0.22 to $0.20 in FY19, while Ord Minnett considers a dividend cut by FY21 “almost inevitable”.

The earnings/dividend problem really comes into play in FY20 and FY21 when the impact of the NBN bites hard. It is a double impact – less upfront receipts for Telstra as the rollout comes towards an end, greater impact on recurring revenue as customers stop using Telstra’s broadband and telephony services. In regard to the dividend, the current 22c per share 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).

To maintain the dividend at 22c, Telstra has to replace the special dividend with an increased ordinary dividend. This means higher earnings – more revenue, lower costs.

While Telstra has implemented a program to take out cost through productivity savings and invest in the business to drive revenue, many analysts fear that Telstra’s not going hard enough or deep enough on the cost front. They want the razor out to slash costs.

What do the brokers say now about Telstra?

Following the announcement, brokers cut their target prices by around 30c (Citi and UBS the highest at 40c, Morgans the lowest with a 13c cut). The consensus target price, according to FN Arena, is $3.39 – some 18.9% higher than Friday’s closing price. Morgan’s target price is the highest at $3.99, while Citi is the lowest at $2.70.

There are three buy, three neutral and two sell recommendations.

Source: FN Arena. *Last updated 16/2/18

Citi, who have been the most bearish of the major brokers on Telstra (and most accurate) say (paraphrasing):

Telstra’s guidance downgrade highlights the acceleration of the decline in core earnings and hence quick and drastic action needs to be taken. With limited scope for core growth, aggressive cost cutting and asset sales should be considered.

5G will be cheaper to deliver than 4G but will lead to data limit increases rather than greater profitability. Intense competition among NBN provider’s means any wholesale price cuts will be simply completed away.

My view

Trying to pick the bottom is a dangerous investment pastime. But even at $2.85, I just can’t get that excited about Telstra.

There is no doubt that it is cheap on the metrics, and if you factor in a dividend cut to 15c per share, it will still yield a relatively attractive 5.25% (plus franking). But it is the apparent lack of urgency by CEO Andy Penn and his team to cut costs and address the earnings issue that leads me to think that Telstra is just going to meander along.

Shareholders are becoming uneasy with Penn and don’t be surprised if the board acts. This could be a buying cue, as could a credible announcement about how 5G might enable Telstra to deliver revenue growth.

But in the absence of these actions or executable plans to boost earnings, I think it is unlikely that the market will rush to re-rate Telstra. Bargain hunters can afford to remain patient.