Is it time to buy Telstra?

Telstra shares are down 34% over the last 12 months. It’s been a painful period for many investors, especially when accompanied by a dividend cut. The problems for the company are now well-known: falling revenues from fixed line disconnections (partially offset by payments from the NBN) and margin pressure in their lucrative mobile division. But despite the headwinds, there is a price for everything. To find out if all the bad news has been priced in, we asked four experts for their view on the current investment case for (or against) Telstra. Responses come from Neil Margolis, Merlon Capital Partners; Tim Kelley, Montgomery Investment Management; Aaron Binsted, Lazard Australian Equity Team; and Hugh Dive, Atlas Funds Management.

More dividend cuts ahead

Neil Margolis, Lead Portfolio Manager, Merlon Capital Partners 

On the positive side, earnings expectations have been rebased and the strategic emphasis is shifting to cost-out.

However, even with the recent rebase, Telstra’s mobile business is amongst the most profitable in the world and its retail prices high relative to competitors.

This poses further downside risk, especially with TPG’s imminent entry as a fourth network operator.

Our downside scenario assumes mobile revenues converge towards peers and capex remains at historic levels, in-line with current guidance.

Our upside scenario assumes the current mobile pricing premium can be retained and capex is reduced as Telstra transitions to the NBN network and simplifies the business.  We also note that our assumptions require significant cost-out, which is yet to be delivered with a starting point of poor earnings quality.

Dividends ultimately need to be backed by sustainable cash flow and if the 2019 guidance is representative, the dividend will need to be cut significantly further.

We value TLS at between $1.70 and $4.30 per share based on its sustainable free cash flow under a range of sensible scenarios. The stock is currently trading in the middle of this range, or simplistically at 20x recently guided free cash flow, which excludes NBN disconnection payments and restructuring charges.

We do not own Telstra.

What the market's underappreciating about Telstra

Tim Kelley, Head of Research & Portfolio Manager, Montgomery Investment Management

The much anticipated Telstra2022 strategy has recently been announced. We like the new direction, and sense that TLS’s share price plunge may be coming to an end. Having recently acquired a position in TLS we were very interested to understand the direction the company intends to take over the coming years.

We recently bought TLS shares because we thought that, while the various headwinds facing the company were well-understood, the market may have under-appreciated some longer-term sources of potential upside.

The possible sources of upside we had identified were:

• Scope for greater-than-anticipated cost reductions;
• An improvement over time to NBN economics, possibly through reduced NBN wholesale charges or through fixed wireless substitution; and
• Scope for significant growth in services in operation flowing from the introduction of 5G.

Overall, our assessment is that the strategy TLS has set out is very much in line with where it should be, and we gained comfort in the longer-term prospects for growth in earnings and value.

There was, however, a sting in the tail, in the form of underlying FY2019 EBITDA guidance that fell below the market’s expectations and prompted further declines in the TLS share price. In looking at this downgrade, however, we are reasonably sanguine.

Part of the near-term headwinds reflects an expectation that markets will continue to be highly competitive into FY2019, and that revenue will suffer as a result. Related to this, TLS is surrendering a pool of revenue over the next few years as it simplifies its customer experience and eliminates things like excess data charges. While this introduces some short-term earnings pain, we see it as part of creating a stronger business beyond that. Our hope for TLS is to see it become a highly efficient market leader that enjoys superior economics to its competitors by virtue of market position and scale advantages. Driving productivity gains is an important part of this.

When we bought into TLS earlier in the year, we expected that we may well be too early with the investment, and that the share price could continue to decline. Our response to this was to take a small initial position with a view to adding to it as opportunity presented.

Our view in this regard is unchanged, but we now feel that the end of TLS’s long and painful price decline is getting closer, and that the key investment question has now changed. The question as to whether TLS is able to identify the correct strategic path has been substantially answered.

The question that matters now is whether TLS management is able to execute that plan in the years to come.

A balanced equation

Aaron Binsted, Portfolio Manager/Analyst, Lazard Australian Equity Team

Telstra’s operating earnings are likely to fall for the next two to three years. This means that ongoing dividends are also likely to fall in proportion (excluding the one-off payments from NBN disconnections.) Exactly when and at what level Telstra’s dividend per share will bottom is very hard to determine at present. Any investor holding Telstra for dividends needs to be aware of this context.

Telstra’s prospects as a total return investment at current valuation levels is a much more balanced equation.

To earn an acceptable return, Telstra must be successful in achieving the recently upgraded productivity target of $2.5 billion.  If that is not achieved, the market pessimism is warranted. 

Yet in our view, there are two areas of potential upside that are not currently in the market's estimates: 

1. Possible lowering of access costs for the NBN or the ability of 5G technology to enable subscribers to go mobile-only, which will drive better margins for Telstra.
2. How the competitors behave in the next 24 months will be another key determinant of Telstra’s fortune. While everyone is watching TPG and is very cognisant of the lowering of mobile revenue per user and loss of subscribers, other industry participants like Vodafone and Optus have suffered very large reductions in profits. How this impacts the ability of these players to compete and invest remains to be seen but is a medium-term issue worth watching. Telstra could conceivably emerge in a stronger competitive position overall. 

Still too early to buy

Hugh Dive, Chief Investment Officer, Atlas Funds Management

Despite our focus on delivering high fully franked distributions, we have historically avoided Telstra, as our investment process focuses on dividend sustainability and preclude investing in companies that may pay a high current dividend but have a probability that this will be reduced in the medium term. This is based on the view that a company’s share price gets punished excessively by vengeful yield investors when they cut the dividend.

Whilst we are looking at Telstra as at some stage it may represent good value, it still looks too early.

Telstra 2022 will be a complicated process with high execution risk and Telstra as a company has a poor long-term record of executing on complex projects.

In 2018, Telstra is expected to pay a dividend of 22 cents per share but falling earnings from increased competition and restructuring charges may necessitate further cuts in 2019. Additionally, from 2020, NBN payments which are being used to support the dividend begin to taper off.  Given this environment, we see that there are other companies that will offer safer and more stable returns for investors seeking income from Australian equities.