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If pressed, most would agree that Telstra's best business is mobile. It boasts over 18m mobile customers - more than Optus and Vodafone combined - and it generates the best average revenue per user (ARPU) and the highest margins in the industry.
Yet despite advantages of scale and network quality, mobile returns have withered. Operating margins have fallen from 45% to 35% and earnings are lower now than they were five years ago. All this from Telstra's crown jewel.
The rest of the business has fared worse. The broadband business has had its wholesale monopoly torn away and replaced by NBN. Margins and profitability have been shredded to reflect the business's turn as a mere reseller. Tesltra still accounts for one in two of every retail broadband connection but profitability has suffered and won't be restored.
Efforts at filling the earnings hole left by mobile and broadband has been mixed and desperate.
Telstra has bought a bewildering array of businesses - from cybersecurity firms and IT consultancies to Chinese internet portals and an American streaming service. Attempts at finding a new crown jewel have failed. Until now.
A savage restructure announced last year involved the usual cost cuts, job losses and corporate-speak, but it also resulted in Telstra splitting its infrastructure assets into a separate business segment.
Dubbed InfraCo, these assets still remain within Telstra but now operate and a standalone segment, charging other business units for their use. We can now see what was hidden in the past: that Telstra owns a ripper infrastructure business.
Originally consisting of Tesltra's exchanges, ducts, data centres and subsea cables worth over $11bn in asset value, management have announced that even more fixed assets will now be rolled into InfraCo after July this year.
The fibre backhaul that supports the mobile business and the network of 8,000 towers and masts that host Tesltra's networking gear will soon be part of InfraCo. This is a huge development.
We speculated in Telstra: the invisible bull case that Telstra's tower assets alone could be worth billions if they were free to pursue new revenue. That now appears more likely.
Towers, backhaul and other parts of InfraCo currently generate revenue from servicing Telstra alone. If liberated, these assets could increase revenue by servicing new customers and, because they are largely fixed costs, additional revenue could translate to profit at exceptional margin. InfraCo, as attractive as it is today, is underearning. Only a split of the business will allow it to reach its potential.
While Telstra hasn't confirmed that a split of InfraCo will happen, we think it is inevitable. Telstra has just found its new crown jewel and, like in a Meg Ryan film, everything it was looking for was under its nose the whole time.
We won't know the asset value of the towers and backhaul until they are rolled into InfraCo in July and we don't know whether Telstra would allow them to be financially independent. Backhaul and towers are a key part of what makes the mobile network better than peers.
Even without those assets, we think InfraCo is potentially worth up to $15bn. The new assets will increase that sum mightily. It's likely that the infrastructure business is worth at least half of Telstra's current $44bn market capitalisation and, while a path to realising that value hasn't been confirmed yet, we think it will be.
InfraCo will generate wonderful annuity income and there are plenty of ways to grow. We've noted previously that tower businesses in the US, separated from their telco owners, have morphed into some of the best businesses in the land. American Tower alone has a market cap of US$110bn.
A split of InfraCo, if it happens at all, is still years away and, for now, the market is still myopically obsessed with traditional telco stats. There is a potential opportunity brewing here.
We aren't excited by Telstra's operating businesses. Mobile is a decent business but faces substantial competition and heavy capital expenditure to establish 5G networks.
Telstra is also stifled by a ludicrous dividend policy that pays 50-70% of underlying profit to shareholders.
This is a capital-intensive business about to undergo a major spending cycle. Dividends ought to be cut. Paying such huge dividends while also paying for its vast network while competition erodes margins will prove tough.
We've long had a Sell on Telstra. We've been unimpressed by its complexity, lethargy and anticipated falls in its margins.
We argued two years ago (see Telstra: a mobile target) that margins would fall to 30% from 45%. They are now at 35% and the savage restructure being undertaken means they might stay there. We don't think the company's other businesses will grow meaningfully.
The new crown jewel, however, InfraCo, is interesting and we don't think its potential is being adequately considered by the market.
Using rough numbers, let's say old InfaCo is worth $15bn - 1.3 times its net asset value. Add another $8bn for fibre and towers and InfraCo could be worth over $20bn.
This implies that the rest of Telstra is worth just over $20bn. The traditional business should still generate $6bn-8bn in operating profits. Add in $15bn of debt and those assets are potentially being valued at 4-6 times earnings before interest, tax, depreciation and amortisation (EBITDA).
That sounds reasonable, perhaps mildly cheap. Yet if InfraCo can succeed Telstra and generate new revenue streams, the group is cheap today.
A split should relinquish Telstra of its onerous dividend obligation and it would have more cash to reinvest into the business and compete with an aggressive TPG-Vodafone. With a full split still an uncertainty, risks to this investment case are still high and we'd need a cheaper price before acting.
After a long period with a Sell on Telstra, the option value of InfraCo changes everything. Recognising this, we're raising our Buy price from $2.50 to $3.20 and our Sell from $3.50 to $4.50.
For the first time in a while, Telstra could be the source of opportunity. HOLD.
Gaurav Sodhi is the Deputy Head of Research at Intelligent Investor. For more share research from Intelligent Investor, start a 15-day free trial.