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Telstra – Blind Men and the Elephant

A $1.5 billion capital management program beginning in 1H17 is the outcome of a fantastically profitable venture into the Chinese website Autohome. This will be in addition to Telstra’s normal dividend which it still expects to fully frank and seek to increase over time.

Telstra today reminds me of the old parable about the blind men touching an elephant in different parts and disagreeing about its overall description.

Some investors view the company as a mature business that is ex growth. The legacy telecommunications business indeed fits this description but like all technology businesses, this is an everyday fact of life. New technology is a constant evolution that is especially prevalent in the telecommunications industry.

Others say that Telstra, as the incumbent, can only lose market share to nimble new competitors. That has certainly happened in consumer broadband and mobile where alternative networks and retail suppliers have built viable models that can and do compete with Telstra.

Yet more investors will argue that Telstra’s raison d’etre is under threat from the National Broadband Network. The NBN was undoubtedly borne out of the confrontational times between an apparently arrogant Telstra and a stubborn Labor government which seemed intent on destroying Telstra’s dominance. But an air of commercial reality has emerged that allows both to exist and Telstra has accepted and even embraced the NBN future to its advantage.

Financial Fortress

If there is one feature of Telstra that is elephantine it is the strength of its balance sheet. A single-A credit rating, gearing ratio at 48.7% (1H16), 15x interest cover and 1.3x debt servicing ratio – all well within or exceeding the ‘comfort’ parameters set by the company.

As a consequence of the balance sheet strength, the cumulative excess free cash flow after allowing for investments, capital expenditure, dividends and operating cash flow continues to pile up. Telstra estimates its cumulative excess free cash flow at $2.2 billion as at 31 December 2015.

This gives it enough head room to reaffirm that it will seek to increase its ordinary dividend over time. Based on current market expectations for FY16e the dividend of 31.5cps puts Telstra on a gross yield of 8.3% (share price $5.43). Further, Telstra says it will not borrow to pay the dividend or to fund capital returns which answers the critics who remember the bad old days when such behaviour was normal.

Details of the capital management program will be revealed when the company announces its full year result on 11 August.

Mobile Network Questions

The recent failures of the mobile network in February and March were discussed at length in today’s company briefing.

Since Telstra launched its Next G mobile network nearly 10 years ago (October 2006), it has held an unassailable lead in terms of the quality of its mobile network. Little wonder then that when 16.7 million devices across Australia couldn’t get any service on two separate occasions, there was widespread consternation and uproar. And yet, ask any customer when this sort of disruption last occurred and they will struggle to answer unless they cite similar issues when Vodafone went on the blink – a different network of course.

Kate McKenzie, Telstra’s Chief Operating Officer, put David Williams on the stage to help answer some of the questions on the company’s network. Mr Williams is an independent consultant and expert on global mobile networks. He noted that there were three elements that make a mobile network ‘world class’ including:

  • The best and most efficient spectrum
  • Rigorous supplier partnerships; and
  • In-house capability

Mr Williams unequivocally stated that Telstra had all these factors in abundance and that its consistent focus on quality investment is what categorised Telstra’s network as being world class.

Telstra is planning an additional spend of $50 million on more real-time monitoring of its network and for better recovery capability if and when outages occur. The emphasis seemed to be on the realisation that no network could be perfect but it was how a business responded to critical issues like this that really counted.

Telstra noted that it had spent $5 billion on its network over the last three years.

As any vaguely aware mobile consumer knows, 5G technology is on the horizon and Telstra is already underway with planning and preparation. It intends to run a 5G trial at the 2018 Commonwealth Games on the Gold Coast.

Capital expenditure as a percentage of revenue will settle at around 14% (excluding spectrum acquisition) over the longer term as the mix of business changes towards lower margin but less capital intensive business. The transition of legacy business to the NBN will also support this shift.

Hang Up?

If you’re a ‘tight five’ investor (banks plus Telstra) then the half year results from the banks will not be instilling your portfolio with a great deal of confidence at the moment. So the message from Telstra is a welcome one with a solid profile of dividend sustainability and capital management on the way.

Investors searching for growth will be tempted to hunt elsewhere so a good long look at Vocus Communications and/or TPG Telecom in this sector is warranted.

The bottom line for Telstra investors is that the company is financially robust and that concerns over its recent mobile network underperformance have been addressed.

This stock can stay put in your portfolio without losing any sleep.

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