Will telstra cut its dividend?

Will Telstra be forced to cut its dividend next year? That was the key question that emerged from Telstra’s full year profit report last Thursday, and fears that it may was one of the drivers behind the sell-off in Telstra shares late last week.

While Telstra provides forward guidance (a range) on expected income, earnings, capex and free cash flow, it doesn’t provide dividend guidance, saying that “it is a matter for the Board”. Because Telstra has a unique way of determining dividends, future dividend payments are open to more than the normal level of conjecture.

Telstra’s current policy is pay a dividend comprising two components – an ordinary dividend representing a return of underlying earnings, and a special dividend representing a return of the net ‘one-off’ payments received from the NBN. The latter are made as customers are migrated from the Telstra backbone to the NBN and are now declining as the rollout of the NBN comes to an end.

Two dividends, an interim and a final of 8c per share will be paid, making a total dividend of 16c per share (fully franked).

In FY20, the ordinary dividend is 10c per share (5c in each of the interim and final dividend). It represents 99% of underlying earnings, up from 60% in FY19 and above Telstra’s current “target range” of 70% to 90%.

The special dividend is 6c per share (3c in each half). It represents 66% of the net one-off NBN receipts, in line with Telstra’s guidance to return around 65% to shareholders.

But next year, net NBN one-off payments are forecast to decline from $1.5bn in FY20 to $0.7bn to $1.0bn, and they will decline again to almost nothing in FY22.

Telstra’s pre-tax, pre-amortisation, pre-interest earnings (EBITDA) are also forecast to decline. Telstra has guided from the underlying $7.4bn achieved in FY20 to a range of $6.5bn to $7.0bn in FY21. This was lower than the analysts had expected and is driven by higher COVID-19 related costs ($400m in FY21 vs $200m in FY20) and NBN headwinds of around $0.7bn, as Telstra’s fixed, data and IP assets are crunched.

Telstra has a targeted cost and productivity program and has so far delivered savings of $1.8bn against a target of $2.5bn by FY22. But it hasn’t been able to increase revenue, with the key mobiles division seeing revenue fall in FY20 by 4.4% or $400m to $10.1bn.

CFO Vicki Brady said at the results presentation: “we remain clear that our EBITDA, post the NBN, needs to be in the order of $7.5bn to $8.5bn to pay a dividend around 16c under the 70 to 90% payout ratio”.

Given Telstra’s track record of delivery, this statement puts at risk the 16c dividend in FY21, but even more so in FY22 when the NBN receipts tail right off.

There are upsides, however. Firstly, depreciation and amortisation charges and net interest expenses are forecast to be lower in FY21. This won’t have any impact on EBITDA, but will improve the bottom line (NPAT), increasing the scope to pay the ordinary dividend component.

Next, with the NBN special dividend pressured, the payout policy of “65%” could readily be changed.

More likely is that Telstra abandons its current dividend policy and replaces it with a policy related to free cash flow. Telstra defines this as operating cash flow less capex (excluding spectrum and acquisitions) less net finance costs. Some analysts and institutional investors argue that this is a more logical go-forward position for Telstra, and on this measure, Telstra does not look so bad. In FY20, the 16c dividend represented a 73% payout ratio of free cash flow.

Of course, Telstra could just do better on earnings and grow revenue. The mobiles division probably holds the key, as this will potentially be the biggest beneficiary of the 5G rollout. The ‘internet of things’ is another hope. Disappointingly, ARPU (average revenue per user) fell in FY20, and while Telstra expects this to stabilise in FY21 given a recent price increase, it has been some years since Telstra was able to show a decent uplift in ARPU, despite the ever increasing use of mobile devices.

On track record, you would have to say Telstra is at long odds to do this.

What do the brokers say?

On consensus, the brokers forecast a dividend of 14.8c for FY21 and 14.5c for FY22. Some are at 16c, some at 15c and others are at 14c. Bell Potter is an outlier at 12c per share.

On target prices, they are still as a group optimistic (they have essentially been wrong on this for the last 12 to 18 months). According to FNArena, the consensus target price is now $3.57 (it was $3.79 before Telstra’s result). In fairness to the brokers, most ascribe considerable value to the ‘Telstra Infrastructure Company’, which may yet be divested or spun out.

Bottom line

Listening to CEO Andrew Penn, I have no doubt that he and his Board are incredibly determined to keep paying the 16c dividend. They recognise the importance of the dividend to the more than 1 million Telstra shareholders.

If they can’t substantiate the 16c payment in FY21 under the current framework, I think there is a better than ever chance that they will change policy and move to a ‘free cash flow’ basis (provided the payout is not too high), as this won’t cause any real grief with analysts or institutional shareholders.

While I am tipping 16c to be maintained in FY21, investors should probably factor in 14c. At Friday’s closing price of $3.11, the yield is still half reasonable – 4.5%, which grosses up to