Friday 10th February 2017
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A mispriced gem or structurally challenged?
While Telstra’s share price performance since the FY16 result suggests to us that the market is taking a glass-half-empty approach to the company’s earnings prospects over the coming years, it does not require much of a leap of faith to picture a more positive outcome. Key in this regard will be Telstra’s ability to generate a sufficient return on the investment in its telecommunications network and the associated digitalisation of its customer proposition.
This is something that management attempted to address at Telstra’s recent Investor Day. The problem for investors, and one of the likely reasons why the stock has underperformed the broader market over the last 12 months, is that it remains unclear what Telstra’s capital allocation strategy will ultimately look like. It is this lack of certainty that the market is taking a dim view of.
While we have been impressed to date with how Telstra intends to fill the earnings hole left by the migration to NBN (i.e. increase productivity, return on investments and organic growth), it is fair to say that a lot of the details are yet to be confirmed, or at least communicated to the public. This is not unusual or surprising given the competitive nature of the telecommunications industry and the timeframes involved, with the NBN payments not expected to cease until FY21 at the earliest.
The second reason, in our view, that Telstra’s shares have lagged the broader market over the last 12 months is the market’s increasing appetite for growth or cyclical stocks. Having moved in sync with the S&P/ASX 200 for the majority of the first half of CY16, Telstra’s share price significantly underperformed through the second half of CY16 as investors became more concerned about the company’s lack of earnings growth and relative yield appeal.
Of course, while these concerns have played out across the broader market, they have arguably been most acute for Telstra given its defensive qualities and reputation as an income stock. With the election of Donald Trump having prompted investors to switch out of bonds and defensive equities into growth stocks on the expectation that inflationary pressures will rise, it is perhaps no surprise that Telstra’s share price has come under some pressure.
This is not to say that it is all doom and gloom for Telstra from this point forward. For starters, there is no guarantee that Donald Trump’s key economic policies will get enacted, and even if they do, how quickly they will put upward pressure on global bonds and interest rates remains uncertain. It is more than likely that inflationary pressures stemming from Donald Trump’s various economic initiatives will become evident over the medium-to-longer-term.
In the meantime, we expect Telstra to continue to reward its shareholders with various capital management initiatives that will be underpinned by the (i) NBN payments, and (ii) the resilient nature, albeit currently low growth, of the company’s earnings base and strong cash conversion. While not unlike our investment thesis for the Australian banks over the next 12 months, we expect yield to remain a key drawcard for investors, and to underpin the share price.
While it is difficult to have the same level of confidence about Telstra’s ability to replace the circa $2-3 billion in annual EBITDA that is expected to be lost once the NBN migration is complete in FY22, we note two key points. The first is Telstra’s track record, albeit under previous management, of generating positive returns, on average, from most of its investments. The second is our view that the Telstra’s current plan to replace the lost earnings to NBN is relatively low risk.
In terms of the latter, the reason we consider it ‘relatively low risk’ is because at least one-third of the targeted EBITDA replacement is expected to come from productivity gains, the bulk of which are internal and thus within the company’s control. In addition to the targeted productivity gains of circa $1.3-plus billion, management is also expecting some of the replacement EBITDA to come from organic growth, with the balance likely to come from acquisitions.
With the Australian telecommunications market becoming increasingly competitive, and the NBN set to ratchet this up even further over the coming years, we believe it makes sense for Telstra to leverage its strong cash flow and balance sheet to differentiate itself from its peers and ultimately preserve its market leading position. While not without its risks, we believe that the investments announced thus far will go a long way to filling the earnings gap post NBN.
Telstra is trading around 14.9 times prospective earnings, a price to book value of 4.13 times with a return on equity of 27.1 percent, and a dividend yield of 6.2 percent (8.8 percent grossed up). While the latter underpins our positive view on the stock, it is worth noting that Telstra’s technical set-up is also reasonably positive, with a definitive break above resistance at $5.15 being a key near-term trigger.
While Telstra has time on its side, there is no question that there is a lot of work to be done before the company can comfortably say that the migration to NBN had a neutral (or even a positive) impact on sustainable earnings. However, as is evident from Telstra’s recent investor day and FY16 results, management is not shying away from the challenges ahead, and appears to have struck a balance between near-term capital management and investing for medium-term growth.
As has been the case for some time now, Telstra’s scale and solid competitive position is generating strong cash flows. While some of this capital is being used to pay dividends, management is also reinvesting in the business. In our view, this will help ensure that Telstra can continue to grow its dividends over the medium to longer term by enabling the company to maintain its strong competitive position in what is a dynamic operating environment.
James Lennon is a senior analyst at investment research and funds management house Fat Prophets.
Disclosure: Telstra is held within the Fat Prophets Concentrated Australian Share and Australian Share Income Models.
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