Two and a half years ago, Telstra was on top of the world. It had an entrenched, monopolistic position in both mobile and fixed line telecom and a rock-solid yield during a period when investors have been desperate for reliable high income. Its share price soared above $6.00 for the first time in more than a decade and it appeared as though NBN payments would be a boon and that Telstra would be able to manoeuvre any resulting structural changes. Less than three years later and following a major cut to its dividends, Telstra continues to face major headwinds. It is still dominant in terms of its market share, capital base and network, but the NBN and new entrants into the mobile market, such as TPG, are steadily eroding its competitive advantage.
The stock still offers a >6% fully franked yield and many investors, still searching for high income among the market’s largest companies, are evaluating Telstra’s prospects. However, margin pressure is still mounting and Telstra is expecting the NBN roll out to eventually cost it $3 billion of earnings (pre-tax), 85% of which will be incurred within 2 years. Its high historical return on equity is also declining as a result and there is a possibility that dividends will be cut further in the future. In its recent AGM, Telstra’s chairman, John Mullen confirmed the group was still facing ‘intense competition in both the fixed and mobile marketplaces’ as it continued to grapple with an exponential rate of change in technology and connectivity. Illustrating this, consider that Telstra, despite its 52% market share, is just one of 180 NBN resellers.
That is to say nothing of NBN Co. itself, which by all accounts has been very poorly structured from the beginning. Prime Minister Malcolm Turnbull himself claimed earlier this week that NBN Co. was not commercially viable as a standalone entity and lamented that at its inception a strategy more similar to New Zealand had not been adopted. Obviously, there is a political aspect to such an argument but regardless; it may imply that the government views NBN Co. as a more natural fit controlled by Telstra. Depending on the terms of such an agreement, there may be substantial upside in Telstra’s longer-term outlook but right now, it is probably premature to prognosticate NBN Co.’s future. In the meantime, Telstra’s ability to leverage its size and superior capital base to pivot into higher growth areas, as it has attempted to in e-health, could be some of the only sources of upside.
Outside of such scenarios, there is not much to get excited about in Telstra’s medium-term outlook and the share price certainly reflects this. Often the market overreacts to the prospect of structurally declining industries, which may lead to undervaluation and hence investment opportunities. We have witnessed it with traditional media for years as advertisers have fled ink filled pages for their digital counterparts. In Telstra’s case however, it may simply just have too many challenges to be attractive.
First and foremost, there is significant risk that the $3 billion total earnings headwind discussed above proves to be optimistic. Not only is Telstra contending with the direct costs of the NBN, but also stands to lose $1.3 billion annually in wholesale revenues to the likes of TPG, Optus and Vocus. This is to say nothing of NBN connection costs, margin compression in fixed line services and any future restructuring costs.
Looking out further than that, the outlook may still grow more challenging, with TPG investing heavily into building a viable fourth competitor in the mobile market. Contrasting comments from TPG and Telstra highlight this is a credible threat to both margins and market share in mobile. Once again, where Telstra once enjoyed a far superior network with better coverage and service, its position has been steadily eroded by competitors upgrading their own networks. TPG’s entry into the market further erodes its legacy position.
Telstra is trading in line with our base case valuation of $3.56 but this assumes no further dividend cuts over the next three years, and no more than $3 billion in total NBN-related earnings headwinds, both of which carry significant risk. In that sense, the stock may indeed be a yield trap even at these depressed levels. Telstra remains one of the most recognisable names in the market, but there are other places to find 6% yields with far fewer headwinds and far less risk to the dividend.
Originally published in The Australian, October 28 2017.