The most important piece of information in this report is this: Telstra’s mobile business is under pressure. Postpaid ARPU (including mobile repayment options) decreased 3.6% due to higher data inclusions. This is the 5^th consecutive half of postpaid ARPU decline with an acceleration in the rate of decline.

Competition is heating up. Optus recently reported a cracking postpaid mobile result with 202,000 net adds for the December half, compared to 130,000 for Telstra. Industry growth is being fuelled by heavy promotions and higher data inclusions. This is a sound strategy for adding subscribers but hurts the bottom line. Indeed Telstra’s mobile EBITDA margin declined by 1 percentage point to 40% on PCP.

Why are we so focused on Telstra’s mobile business?

Because it has been the jewel in the crown, in the face of rapidly crumbling fixed margins due to NBN.

Telstra’s fixed data EBITDA margin halved from 34% to 17%, while fixed voice dropped from 50% to 38%. Telstra needs its mobile business to fire on all cylinders to offset declining fixed EBITDA. This is why declining postpaid mobile ARPUs are a major concern.

No clear plan to fix Telstra's earnings hole

Telstra faces a lot of challenges over the next 5 years. This includes a $3 billion earnings hole post ‘peak’ NBN payments in FY19, mobile competition from TPG entering as the 4th player and elevated capex until FY19 (18% of sales).

There are some potential positives in the medium term. Telstra’s elevated capex over the next few years should make it well placed to roll out its 5G network. This means there shouldn’t be a capex spike for 5G post FY19. And with 5G speeds faster than NBN, fixed to mobile substitution should accelerate, enabling Telstra to shift customers from low margin fixed plans (10-20%) to high margin mobile (40%).

And while management may not admit it, we believe the primary reason for last August’s dividend cut was to pay down net debt, which has blown out by $500m in each of the last two halves. This will ensure the company is prudently geared for the future, when its sustainable earnings (and hence ability to service interest payments) are materially lower.

However, at this stage, we view 5G and de-gearing as mitigating factors for a company facing a material earnings hole with a management team that has provided little detail as to how they intend to fill it.

What the market is missing about Telstra

Telstra is not cheap. But the market can’t seem to look much beyond FY19, when consensus forecasts have Telstra earnings 34 cents per share. This puts the stock on a PE of just over 10 times, which on the surface looks appealing. But it also represents peak earnings.

Peering into the looking glass in five years’ time, we see that NBN one-off payments have ended and core business EBITDA is $3 billion lower, largely attributable to the loss of the fixed line earnings. There’s nothing heroic about these forecasts – management has guided to these earnings declines. Sliding down this glide path, EPS is estimated to be around 22 cents per share, which is effectively the company’s sustainable earnings. This places Telstra on a far less attractive PE of 16 times in 5 years’ time.

The last time Telstra was on 16 times, was at $6 back in 2015. This was based on 1-year forward earnings.

Are you willing to wait 5 years to realise you are holding onto a 16x PE stock..?

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