Telstra – Trap or Treasure (Revisited)

Following their large earnings downgrade last year, I penned a wire titled 'Telstra – Trap or Treasure'. We bought Telstra around $2.77 shortly after and enjoyed a strong resurgence in the share price. At the time, the market universally hated them - another disappointment from a perennial underperformer and the barrage of competition hitting the Telco sector would continue to put pressure on the incumbent. 

A lot of water has now flowed under the bridge and I bet very few out there (me included) pegged the Telcos to be the No 1 performer from then until now having rallied 29% since May 2018. Telstra is obviously the biggest influence on that sector and has rallied an impressive ~40% to close on Friday at $3.84. 

Livewire recently reached out for some discussion around what the drivers have been, and what the road ahead may look like for this stock.  

Source: Bloomberg

In that wire, I wrote:

All up, short term holders of Telstra leading in to today will be disappointed by the earnings miss – a big one, howeverbuying weakness based on the FY19 earnings miss makes sense. The ‘new vision’ for TLS should prompt slower, but bigger more influential money off the sidelines given the plans unveiled this morning improve the sustainability of future earnings. We like this aggressive approach taken by TLS today – not just another band aid solution.

Looking back on the intervening 12 months, the resurgence of TLS has been driven by 3 key factors:

1. Telstra is effectively simplifying their business, and communicating that simplification process well to the market.
2. The competitive landscape has changed for the better. Their main rival TPG cancelled a planned 5G network rollout while the merger between TPG & HTA has been scuttled by the ACCC.
3.  Interest rates have continued to fall, making Telstra’s lower, but more sustainable dividend payout more attractive.

Telstra’s first half 2019 results released back in February was met with selling – the stock down 2.14% to $3.14 on the day of the release, however it’s clearly recovered strongly thereafter. At the time, the report showed net profit was $1.2b, down over 25% from the first half of 2018, while revenue saw a more muted fall of ~2% to $12.6b in the half. 

Despite the sizable fall on the previous year’s first half, the results were broadly in line with guidance, and with what the market was expecting, however for the first time in a while, dividend guidance was not given to the market.

Telstra (TLS) Chart

Upcoming results

Leading into the full year result scheduled for 15^th August, the market is expecting FY19 revenue of $27.3b dropping to a net profit of $2.43b, implying the second half is broadly in line with the first. 

A 5cps ordinary dividend plus a 3cps special will take the full year dividend to 16cps, with some risk on the upside in our view. Importantly, this equates to an 80% payout ratio on expected earnings per share (eps) of a tad over 20c, with the markets range being 15-25cps.

The main focus will once again be around mobiles given its got the highest ability to drive earnings momentum across the business. 

With competitive pressures starting to ease along with the launch of new mobile plan structures, the commentary here should be watched closely.

Conclusion

At $3.84 we think the market has now become too bullish on the Telco. On 19x expected FY19 earnings TLS has now become the most expensive it’s been since 2015. While the factors above are still in play, and they should continue to support TLS over time, we’ve now sold out – a touch too early in hindsight, but it’s now too rich for us leading into full year numbers.

We simply feel the market is pricing in too much optimism for a business that is still in a long transition period. We’d get interested again nearer ~$3.60.

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