Is the downside priced in for Telstra?

The list of problems facing Telstra is well known: falling revenues as the NBN rolls out, and declining market share in mobile. As the payments from the NBN begin to roll-off, some have questioned whether Telstra can even maintain its reduced dividend. But it’s precisely this negativity that caught the attention of Allan Gray, explains Dr Justin Koonin, Investment Analyst.

“When we look at a stock like Telstra, we assume there’s a significant impact on NBN-related earnings and ask, ‘how bad does it actually get?’ In our view, it doesn’t get worse than $3B-$3.5B in free cash flow.”

In this short video, he assesses the potential impact of the TPG/Vodafone merger on the Australian mobile market. 

Key points:

• Telstra’s challenges are well understood by investors.
• When looking at the worst-case scenario, Telstra still ends up producing $3B-$3.5B in free cash flow. At current prices, even this doesn’t look too bad, which leaves plenty of room for upside in the share price. 
• The Vodafone/TPG merger reduces potential competition and may help to keep TPG rational upon entering the mobile market.

Further insights

Going against human instinct and taking a contrarian approach to investing is not for everyone, however there can be great rewards for the patient investor who embraces Allan Gray’s approach. Find out more 

Edited transcript

So everyone knows that Telstra's facing challenges with the NBN. It has a dominant mobile segment, but that may not continue forever. So those challenges are well known. The way we look at a stock like Telstra is to ask, "Okay what happens if we back out of the NBN earnings," you know, if we assume that there's some significant impact to NBN and ask how bad does it actually get for Telstra? 

In our view, probably it doesn't really get worse than $3 billion to $3.5 billion of free cashflow. At that level, the price you're paying for Telstra is a bit more expensive than the market, but it's not that bad. On the other hand, there's potential upside, because maybe mobile doesn't go backwards as fast as we're expecting. Maybe they can do better on their cost out than our conservative assumptions. 

So, if we look at the downside, and if we think the downside is actually not too bad and there's a potential for upside, it's probably a pretty good place to invest. And so, that's why we're investing in Telstra. 

In terms of what's happened with TPG and Vodafone, well, I think TPG had made it known to the market that they were interested in entering the mobile arena one way or the other. They bought spectrum, it was likely they were going to do it. Compared with the alternative, which is a fourth independent player undercutting others on price and a company which doesn't have customer base to protect them, can be a bit more reckless. Actually, I think the outcome with Vodafone and TPG is net probably slightly positive for Telstra. 

Telstra is one of these stocks that you're a bit embarrassed to admit owning at a dinner party. Those are the stocks we like, the stocks that everyone can see has problems. But as I said, in our case, our view is that the downside we can live with. The upside is considerably better than that. So we're willing to give it a go. 

Ends...