A household name that most investors are familiar with, Telstra is Australia’s largest telecommunication provider. Telstra is held by many retail shareholders who were lured and encouraged at the time by the Federal Government to the idea of owning a significant piece of national infrastructure. As a listed entity it tried to reinvent itself several times, never really succeeding in doing much other than consistently paying a dividend. A dividend that long-term holders came to value dearly to the point of fanaticism.
It was this unwavering commitment to a stable fully franked dividend that made Telstra a Star Income Stock. That was until early 2017 when we decided to remove the company’s Star rating and sell it from our Lincoln Australian Income Fund. The looming revenue hole created by the re-nationalisation of Australia’s telecommunication network, as well as the rising threat of competition in the mobile space squeezing margins and subsequent capital expenditure bill meant that there were real risks to the future dividends, and therefore the call was made.
Following a significant price decline and three dividend cuts, investors may now be thinking is it the right time to dip the toe back into the water once more, or will Telstra continue to be the dividend trap it has been for the last few years?
Positive investment thesis
The current investment thesis for Telstra rests on three key factors;
- It is the largest telco provider in the space supported by strong economies of scale.
- Improving cost efficiencies and first-mover advantage in 5G network capabilities backed by strategic partnerships with Qualcomm and Ericsson.
- Mobile and Fixed connections represent a significant portion of Telstra’s revenue (~70% of underlying earnings).
The current Financial Health for Telstra is Strong, highlighted by a Net Debt to EBITDA of 1.9x and Interest Coverage of 6.6x, enough to cover any future debt obligations. Leverage (calculated as Net Debt/Invested Capital) currently sits at 52.2%, within the target range of 50-70%, and could further improve on the potential demerger/sale of Telstra’s infrastructure assets – Telstra InfraCo.
The recent 1H19 interim results came broadly in-line with expectations driven by continued weakness in top-line revenue which was offset by cost reductions. As expected, margins also declined on the back of stiff competition and unwinding of legacy products. Dividends fell by 27.3% pcp due to delays in the NBN rollout, a revision of the company’s dividend policy and lower operating income. In terms of earnings outlook, management provided guidance for EBITDA to fall by 10.5% (mid-point on guidance) to $9.05b on the back of continued competition in the sector and further margin compression.
The dividend landscape has improved
However, while growth in the immediate term remains a real challenge, there are some excellent points for Income-seeking investors to consider. Moreover, we believe the recent significant cut in dividends has allowed distributions to be rebased to more sustainable levels. Based on Telstra’s now stated dividend policy of 70-90% of underlying earnings, FY19 dividends are expected to come in at 16cps – representing a current forecast gross dividend yield of 7%. We believe this level is achievable especially given that the free cash flow generated by the company is currently well above dividend payments. Furthermore, investors will enjoy the bonus of additional fully franked special dividends from now until 2021, when the NBN receipts for the copper network Telstra once owned dries up.
In the short term, Telstra will continue to implement the Telstra 2022 strategy, and while competition remains strong, we believe that much of the negativity has now been appropriately priced into the share price. As Telstra has been investing heavily into its 5G network with spectrum acquisition and infrastructure builds over the past 12-24 months, 5G is expected to be vital to Telstra’s future profitability as margin expansions flow through with a likely strong initial uptake from consumers.
From a management perspective, Andy Penn has been at the helm since 2015 and is faced with the challenge of executing the 2022 strategy and keeping Telstra relevant in the ever-evolving landscape. Recent appointments within the business are Roy Chestnutt (ex-Verizon) and Niek Janm van Damme (ex- Deutsche Telekom) both of whom have strong credentials from much larger telco markets in terms of managing disruptions.
So, while Telstra’s growth challenges mirror that of the sector and are not expected to be resolved anytime soon, we feel from an Income perspective that there is enough justification at current prices to take an exposure in the business once more. While the risks around the execution of the future strategy, regulatory environment, and rising competition are real, we feel that on a balance of probabilities the time is right to re-instate their Star Income Stock status as investors should be able to rely on their clockwork-like dividend distribution once more.
* All figured are annualised
** Source: Lincoln Indicators
TLS 3-year-price chart
Lincoln Financial Group Pty Ltd, its employees and/or associates of these entities hold interests in Telstra (TLS) which is the subject of our advice. This position could change at any time without notice.
ELIO D’AMATO (@Elio_DAmato)
Elio D’Amato is the Executive Director at Lincoln indicators, a leading boutique fund manager and creator of Stock Doctor the complete share market research platform. www.lincolnindicators.com.au