Our model portfolio exited Telstra at $5.50 in August last year on the view intensifying competition in mobile would undermine wide legacy profit margins. This thesis has now suddenly played out with TPG Telecom’s successful bid for its own mobile spectrum and plans to build Australia’s fourth mobile network. The market is pricing in lost market share and margins in Telstra’s mobile business even before TPG gets access to its new spectrum and starts building its network, which will take three years.
The share prices of Telstra and TPG have however fallen so far that value investors should go to work to see if the panic selling has created any buyable value. The surprising conclusion about a sector pricing in so much carnage is both Telstra and TPG deserve places in the portfolio depending on price – and, crucially, the investor’s time horizon.
To start with Telstra, we think the stock is worth around $4.50 based on long-term structural decline in margins and market share, which will also depress earnings growth to sub-GDP rates of around two per cent. Because this valuation is bearish a decent discount to the valuation, say 10% for an implied entry price of $4.00, should hold the stock – especially since the dividend yield at this price would be nearly eight per cent. Telstra will have to cut its dividend from 31 cents eventually due to earnings pressure and the 90 per cent payout ratio, but not for another two years. The most likely catalyst for a rerating from $4.00 to value would be an earnings result which demonstrated the worst pressure on earnings is still over two years away and the stock is oversold. In short Telstra is a short-term trade at the right price rather than a long-term investment.
Investor strategy on TPG should be entirely different. Whereas Telstra is trying to defend legacy market shares and margins, TPG is building a new business from the ground up on a 10-20 year view. While the stock will no doubt be overbought and oversold at times along the way, serious shareholders of TPG should align their time horizon with the board’s. This will be confronting for some investors. A 10-20 year strategy is culturally normal in Asian business but strange in an Australian market typically focused on the next half-yearly earnings result and dividend.
The other reason a long-term view on TPG is essential is the heavy cost to earnings in coming years of the huge $1.3 billion price TPG paid for mobile spectrum and the planned $600 million of capital expenditure. The respective amortisation and depreciation of these amounts will subdue earnings before the mobile network has had time to break even, let alone reach peak profitability.
The execution risks for TPG are also high as the ambitious business attempts to simultaneously construct an Australian mobile business, construct a Singapore mobile business, compete for NBN customers during the rollout, take share in the corporate market and grow a fibre-to-the-basement business. The $400 million rights issue and future dividend reinvestment plans will weigh on profitability. We can value TPG anywhere between $6.00 and $8.00 by 2019 depending on profitability and growth.
Investors in TPG also must be comfortable with control of the company by Executive Chair David Teoh, who owns 34.4 per cent and has the full backing of Washington H Soul Pattinson and Co., which owns 25.2 per cent. This is not a standard ASX company with a diverse share register and an independent board. To own this stock an investor needs to be a true believer in David Teoh and be “all in” for what will be one of the longest journeys of any major ASX company.
But there’s also a unique appeal here. In a market swept by investor short-termism, the same by CEOs with average tenures of only a few years and short-selling/manipulation by hedge funds, TPG shapes up as one of the most interesting stocks for investors whose drawdown phase is at least 10 years away. Accumulation funds and SMSFs with long-dated liabilities, take note.
Originally published in The Australian, Tuesday 25th April 2017.