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Telstra – Filling in the NBN hole

The Conroy/Rudd table napkin plan for the National Broadband Network was hatched in early 2008, and it has taken since then for Telstra to devise a plan to refill the estimated $2-3 billion earnings hole created by the NBN.

The NBN itself has taken on a few variations in design and cost along the way, but Telstra’s latest and best estimate for the completion of the NBN rollout is sometime around 2020. So far, the NBN has passed 3.4 million premises (no physical infrastructure passes the premises, but coverage is available through a retail service provider) and has activated 1.5 million of these. The NBN’s goal is to activate 8 million homes and businesses by 2020.

Telstra’s deal with the NBN provides for one-off type payments worth approximately $5 billion (balance outstanding) over the next 4-5 years plus long term payments for access and use of Telstra’s infrastructure (pipes and ducts etc) worth around $1 billion before tax each year.

But even that is insufficient to compensate Telstra for the significant change to the telecommunications landscape now that NBN has moved into the neighbourhood.

If a trading multiple of around 7x is applied to the $2-3 billion of recurring EBITDA that Telstra calculates it will lose, then that equates to a lost value of $1.17-$1.76 per Telstra share if not replaced.

Looking back at Telstra’s network history, it launched the $1.5 billion Next IP platform in 2006, alongside the Next G mobile platform. At the time, this put Telstra’s network far ahead of its competition and enabled the company to stay well ahead in terms of its technology.

But it seems father time caught up with the mobile network earlier this year when several major outages upset a few customers. Telstra has always continued to invest in its network but this series of embarrassing failures may have been the catalyst for a major rethink of its network capabilities.

At the FY16 result in August, Telstra announced it would spend an extra $3 billion over three years into its networks and digitisation program. This was a major strategic shift for the company designed not only to rectify the brand damage from the outages but to push the company well ahead on the technology curve once again, as it had done back in 2006.

The thrust of the spending program will be towards software defined networks, digitisation and improving customer service as a consequence. This one sentence probably undersells the scope of what Telstra is doing.

The excitement of Telstra’s network people who presented the details of the plan to the company’s industry briefing day this week was palpable. They were rabbiting on about doubling the speed of a standard 4G connection to 87% of the population by FY19 and providing peak network speeds of 1Gbps in CBD areas.

They were also talking about the additional benefits of being able to progressively shut down older systems that carry high costs. The 2G network will officially shut down this December, for example. The SDN will allow nearly half of exchanges to be closed and the legacy PSTN systems can also be gradually deconstructed, as they put it.

For the $3 billion investment, Telstra is expecting a return of around $500 million per annum by 2021 attributing about two-thirds to revenue gains and one-third to cost savings.

That is step one to filling the NBN hole.

Step two is about productivity improvements. Telstra says it will target more than $1 billion of net underlying core fixed costs over the next 5 years, equating to around 2% annual reduction of costs.

Step three will require growth in the company’s core businesses: mobile, fixed, Data & IP/NAS and new business.

This is the first time I have seen a coherent and strategically sound plan from Telstra that combats the NBN earnings broadside.

The extra spending boosts the capex to sales ratio to 18% over the next three years before returning to a more normal 14% ratio.

But Telstra is doing this from a financially solid starting point. Its balance sheet is in good shape and CEO Andy Penn believes the single A credit rating can be maintained.

This is all in addition to the $1.5 billion share buyback announcement made at the FY16 result.

Telstra reaffirmed its FY17 guidance at the briefing which expects revenue growth of mid-to-high single digits and EBITDA growth of low-to-mid single digits from its $10.7 billion FY16 base.

One additional piece of information that caught my attention was from the retail presentation by Kevin Russell, who has spent the last 8 years working for Telstra’s competitors. Apparently, some 40% of Telstra’s customers, who have just one product with the company, spend $4.2 billion of revenue with other providers. In the context of Telstra group revenue of $27 billion, that is a revenue opportunity of some significance, one would think.

Telecommunications seems to be one of the few industries where customers already know what the future looks like – video, mobility, anytime/anywhere/any device. The challenge for the telco providers is to build the network platforms and products that can deliver the expected five-fold growth in video traffic in the next five years.

Telstra’s earnings profile is obviously changing as the NBN begins to scale up, but it appears that technology and a good balance sheet are the key factors that will fill the earnings hole.

The stock hasn’t been this cheap for over two years and now offers a gross dividend yield of 9.1%.

Many investors will already own this stock, but it is once again offering some real value.

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