Calling the next move for telstra

• Telstra Corporation (TLS:ASX)
• Market capitalisation: $46.3 billion
• 12-month total return: 50.2%
• FY20 projected dividend yield: 4.1%, fully franked
• FY20 projected grossed-up yield: 5.9%
• Analysts’ consensus target price: $3.78 (Thomson Reuters), $3.49 (FNArena)

If you bought Telstra when we recommended it as a “contrarian play” about a year ago, you did well – the stock has moved from $2.76 to $3.89, for a nice capital gain of 41%. Telstra has surprised a lot of people – the analysts’’ consensus price targets at the time were $3.18 at Thomson Reuters and $3.15 at FNArena – and it definitely was a contrarian play.

On top of the capital gain, a shareholder who bought at $2.76 will earn a 5.8% dividend yield if Telstra, as expected, reports a 16 cent dividend for FY19 – representing a grossed-up yield of 8.3%. In a low-interest-rate environment, that is worth its weight in gold.

In hindsight, it would have been even better – and even more contrarian – to have picked up the stock at $2.62, a few weeks earlier, at an all-time low. But nobody picks bottoms exactly.

Telstra: one-year price performance

Source: nabtrade

What took Telstra so low was a combination of factors. There were market concerns over a $3 billion earnings “hole” that was going to be left in Telstra’s profit by FY22, as parts of its business were effectively transferred to the NBN, and what would replace that. Downgraded FY19 earnings guidance in June 2018 had shown that current earnings were unsustainable. Even worse, for yield-oriented investors, was the company’s admission that a dividend of 22 cents – which many such investors had come to consider virtually sacrosanct – was no longer achievable, largely because mobile competition had increased significantly, and the company’s mobile margins could not be sustained. The announcement in 2017 of rival TPG’s ambitious plans to become Australia’s fourth mobile network provider had also weighed heavily on Telstra’s share price.

Telstra has been forced to transform its business, such that mobile becomes the most important area. It was helped by the decision in January by TPG not to build its own mobile network and to continue along the merger path with another rival, Vodafone, but the intense competition is still being felt.

The slide of TLS to $2.62 demonstrated the risk of relying on stocks for yield, because the dividend was not much good to an investor who bought the stock all the way down from levels above $6.50 in February 2015 – many investors copped a hefty capital loss while picking up TLS dividends. (Let’s not even talk about the subscribers in “T2,” the second tranche of the Telstra privatisation, in 1999, who paid $7.40 a share in what was effectively a different telecommunications era.)

But where to for TLS, from here?

A 50% total return in 12 months for a company of Telstra’s size and market stature is an exceptionally fortuitous return. It would be unwise to think that there is much further in the way of capital gain to be milked from TLS in the short term. Analysts’ consensus price targets – which, admittedly, were not optimistic enough a year ago – have turned pessimistic on the stock.

There is quite a bit to like about Telstra. As the company’s advertising blitz tells you, Telstra has first-mover status in the 5G market. Telstra backed the correct horse in terms of its infrastructure partner, working with Ericsson to build its network, while rivals Optus and Vodafone got caught up in the Australian government’s ban on Chinese telecommunications giant Huawei, which was the main technology partner for Optus and Vodafone’s mobile networks. Telstra is arguably much better-placed to take advantage of 5G opportunity, which could be a profound market transition. Analysts believe 5G will be a big boost to Telstra’s mobile business’ revenue and subscriber growth.

The company is also doing good work in the less-sexy area of restructuring its business, running ahead of schedule on its plan to cut its costs by up to $2.5 billion as part of its T22 strategy. In an update in May, Telstra said it would bring forward redundancies into FY19, and an extra $200 million in restructuring costs, up to $800 million. The company will also write down the carrying value of its legacy IT systems by $500 million as they are retired as part of the T22 strategy. Further out, there could be quite a bit of value created by Telstra’s infrastructure division – called InfraCo – which the company created last year (this was talked about in the market as a potential buyer of the NBN, but Australian Competition & Consumer Commission [ACCC] chairman Rod Sims was quick to douse such talk, saying it would be inappropriate to sell the NBN to any of the telco retailers, Telstra included.)

In the short term, Telstra’s earnings are still being affected by severe mobile competition, but eventually, this should improve. Thomson Reuters’ analysts’ collation (derived from 12 analysts) sees a one-third fall in earnings per share (EPS) in FY19, from 31.41 cents to 20.9 cents, while FNArena’s collation (drawn from seven broking firms) sees a deeper FY19 plunge, to 18.5 cents,

Thomson Reuters projects a rise to 24 cents in FY20, but FNArena is less bullish, looking for EPS of 20.4 cents in FY20.

Thomson Reuters’ sample expects a dividend of 16 cents for the soon-to-be-released FY19 result, and the same in FY20. FNArena also expects 16 cents in FY19, but falling to 15.7 cents in FY20.

At 16 cents, Telstra is priced on a prospective FY19 and FY20 yield of 4.1%, which grosses-up to 5.9%. If the FY20 dividend does come in at 15.7 cents, the FY20 prospective yield falls to 4%, or 5.8% grossed-up.

There are brokers who are still bullish on Telstra: Morgans, for example, has a price target of $4.47 on the stock, while UBS sees it reaching $4. But for investors who missed the 40% lift in the share price over the past 12 months, it is probably wisest to accept that the market was smarter (and braver) than you, and has pushed the share price closer to fair value – which still offers an attractive yield on the projected FY20 numbers.