Unbundling Telstra’s hidden value

After a decade of industry headwinds, we think the tide has turned for Telstra (ASX: TLS) as the telecommunications (telco) industry outlook is now becoming increasingly attractive.

In our view the industry outlook is now positive, given:

• The NBN roll out is complete, marking an end to its drag on TLS’s earnings ($3.6bn p.a. recurring cost to EBITDA).
• The industry has consolidated, most notably with the merger of Vodafone and TPG, which has created a more attractive industry structure with 3 major players.
• Significant investments into 5G have acted as a competitive reset for the sector, lessening the competitive focus on pricing.
• The inflationary backdrop has disincentivised telcos from competing on price.
• After several years of price wars triggered by Optus in 2017, the competitive environment is becoming increasingly rational.

Figure 1: TLS looks attractive compared to other large cap defensives, offering reasonable growth at a compelling valuation

Higher mobile prices a tailwind for earnings

Figure 2: Mobile is the key driver of TLS’s earnings

The increasingly rational industry backdrop is supportive of TLS’s earnings outlook, as the company is now able to raise its (already premium) mobile plan prices for customers without sacrificing market share.

TLS has explicitly committed to lifting its plan prices annually in line with CPI at least, while its largest competitors Optus and Vodafone have also been raising their prices.

This is being reflected in industry ARPUs (Average Revenues Per User) which are now rising again after being on a downward trajectory for a number of years.

We expect TLS to keep increasing its ARPU over the medium-term as the 5G upgrade cycle continues to build momentum, which should translate to continued growth in earnings, driven by both top-line growth and margin expansion. This will drive a higher ROIC over time making TLS a higher ‘quality’ investment in our view.

Figure 3: Increases to Telstra’s average pricing is expected to translate to EPS growth over the medium-term

Buoyant demand should underpin resilience in a weaker growth environment

We are attracted to TLS’s ‘quality defensive’ attributes at this point in the cycle as the economic outlook softens.

Telcos are subject to their own cycle which dictates industry profitability, although we believe TLS benefits from relatively resilient user demand which should see earnings hold up well relative to other consumer-facing sectors in the event of an economic slowdown or recession. As the leading player with the #1 mobile network, we think TLS is best placed to weather a slowdown.

We could see a degree of customer churn as individuals ‘trade down’ to lower value plans in response to the major telcos raising their prices. Still, on balance we view digital connectivity as a relatively non-discretionary expenditure item which should underpin a degree of resilience through the cycle.

In this vein, despite softening consumer sentiment, TLS is expected to grow its SIO (services in operation) over the medium-term – buoyed by the return of overseas migration – which should underpin earnings growth over the coming years.

Meanwhile, TLS’s infrastructure assets, which represent ~25% of its earnings, provide highly defensive, annuity-like cash flows indexed to CPI that are underpinned by long-term agreements with users.

Figure 4: Telstra is expected to grow its services in operation even as it raises prices for consumers

Further cost outs to enhance profitability

TLS’s margins are poised to benefit from a continued focus on cost discipline across the business.

Telstra recently wrapped up a successful ‘T22’ strategy, which saw it deliver $2.7bn in annual cost savings, helping to plug the ~$3.6bn p.a. EBITDA gap caused by the NBN’s rollout and the subsequent decommissioning of TLS’s legacy copper wire network.

TLS's most recent strategy, ‘T25,’ promises to deliver further operational improvements including $500m of additional cost outs by FY25 while still investing for growth, including in 5G where ~95% population coverage is targeted by FY25.

If successful, T25 will deliver more incremental improvements to profitability, supporting EPS growth and an improving ROIC over the medium-term, while also strengthening the company’s dominance in 5G.

Figure 5: TLS is targeting mid-single digit underlying EBITDA growth to FY25

Telstra’s infrastructure has significant hidden value

We are attracted to TLS’s ‘hidden value’ attributes, which we believe can help deliver attractive and relatively uncorrelated returns as implied valuation inefficiencies close.

One of TLS’s top strategic priorities is to unlock the significant intrinsic value of its infrastructure assets, which we believe is not being reflected in the company’s current market valuation as a combined entity.

This process was kicked off with the 2021 sale of a 49% minority stake in TLS’s mobile tower assets (Amplitel) for a consideration of $2.8bn representing an EV/EBITDA multiple of 28x.

InfraCo Is The Next Logical Candidate for Monetisation

TLS has recently completed a restructure of its assets to allow for the infrastructure owned by its InfraCo Fixed (‘InfraCo’) business to be monetised.

InfraCo owns a range of unique assets including ducts, fibre, and fixed network facilities including data centres, although ducts are the key driver of its earnings and value. Ducts are very high quality, difficult to replace assets with low ongoing CAPEX requirements.

These assets have a predictable long-term earnings profile, which is underpinned by the recurring, CPI-linked fees the business earns from the NBN and other wholesale customers for ongoing access to this critical infrastructure. TLS’s agreement with the NBN for access to its pits, ducts and exchanges is worth ~$1bn per annum in rental payments over 30 years.

We suspect InfraCo’s investment attributes will be highly attractive to institutional investors (e.g. super funds) which have been actively acquiring infrastructure and infrastructure-like assets in recent years.

There is significant upside to TLS’s share price implied by a sum-of-the-parts valuation of InfraCo

We think InfraCo should be valued on an EV/EBITDA multiple of ~15x in line with global telco infrastructure comparables and recent market transactions, which typically range from ~13x to ~17x.

To assess TLS’s value as a whole using a ‘sum-of-the-parts’ analysis (detailed in figure 6), we have applied an EV/EBITDA multiple of 15x to InfraCo, while putting Amplitel on an EV/EBITDA of 28x (in line with its 2021 transaction multiple), and applying an EV/EBITDA multiple of 7x to the core TLS business (i.e. excluding infrastructure assets) in line with global telco peers.

In combination, using relatively conservative assumptions, our analysis implies the combined TLS business is worth an equity value of $64bn, or ~$5.50 per share, representing material upside to the current share price.

Figure 6: ‘Sum of the parts’ valuation implies meaningful upside to Telstra’s share price

Figure 7: Implied enterprise value by segment

Asset sale could trigger share re-rate and fund significant capital management

Our sum of the parts analysis suggests that TLS’s assets should be valued on combined EV/EBITDA multiple of ~9.1x, which represents a meaningful premium to its current implied market multiple of ~7.4x for FY24.

We think management’s efforts to ‘monetise’ InfraCo, if successful, could be a key catalyst for a re-rate of TLS’s valuation multiple as its underlying infrastructure is valued more fairly by the market.

We think TLS will follow a similar structure to the Amplitel deal (i.e. the sale of a minority stake) with InfraCo, which would likely fund sizeable capital management initiatives such as large special dividends or share buybacks, noting the significant size of InfraCo relative to TLS’s overall market value (i.e. at >40% of TLS’s current enterprise value).

Alternatively, TLS may opt to spin-off InfraCo into a separately listed entity, similar to Spark New Zealand’s (SPK) demerger of Chorus (CNU) in 2014.

As figure 8 illustrates, we estimate that a 49% sale of InfraCo could raise ~$12.6bn (ignoring taxes and transaction costs for simplicity) which could be used to fund large capital management initiatives. The potential capital raised could translate to a hypothetical special dividend of 109 cps, representing a ~25% special dividend yield on the current TLS share price. On the other hand, TLS could use the capital raised to buyback shares which would be highly accretive to both EPS and DPS and therefore could trigger upgrades to consensus forecasts.

Figure 8: InfraCo: hypothetical special dividend under a 49% sale scenario*

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