Company Overview: Telstra Corporation Limited (Telstra) is a telecommunications and technology company. Its principal activity is to provide telecommunications and information services for domestic and international customers. The Company operates through four segments. The Telstra Retail segment provides telecommunication products, services and solutions across mobiles, fixed and mobile broadband, telephony and Pay television/Internet Protocol television and digital content. The Global Enterprise and Services segment provides sales and contract management for business and government customers. The Telstra Operations segment offers overall planning, design, engineering and architecture and construction of Telstra networks, technology and information technology solution. The Telstra Wholesale segment provides a range of telecommunication products and services delivered over Telstra networks and associated support systems to other carriers, carriage service providers and Internet service providers.


TLS Details

Near-term headwinds persist but long-term growth catalysts can be envisioned -

Telstra Corporation Limited (ASX: TLS) is a leading telecommunication company in Australia with the main activity of providing mobile phones, mobile devices, home phones and broadband internet services in Australia market. The top line has grown at CAGR of 0.9% over the period of FY14-18 whereas EBITDA declined at CAGR of 2.4% over the same period. Resultantly, the group has recorded NPAT degrowth at CAGR of 4.5 per cent over the five years. TLS posted a decent flat total revenue of $26,011 million for FY18 compared to $26,013 million for FY 2017. Profit attributable to the equity shareholders of Telstra was down by 8.4% to $3,563 million against $3,891 million in FY17. The bottom line was primarily impacted by further nbn rollout and lower Average Revenue per User (ARPU). Resultantly, it posted low earnings per share for the FY18 at 30.0 cents per share compared to 32.5 cents per share in FY17. Despite the challenges such as rise in competition for mobile customers and the impact of NBN rollout, TLS’ long-term growth drivers can now be envisioned along with credentials of being one of the leading players in telco industry with decent financials, as it is trading at 15.57x of FY19E EPS. We value the stock level to be providing an interesting opportunity ascribing a valuation of 1-standard deviation to five-year average P/E of 14.16x for FY20E with EPS of $0.22.


Key Financial Metrics (Source: Company Reports, Thomson Reuters)

Risks Telstra Might Encounter in Future -

1. Impact of nbn network: As per the management of Telstra, the robust momentum in the technological innovation as well as competition has, in turn, led to the substantial increase in the challenges for the telecom providers globally as well as in Australia. Apart from these challenges, the company is exposed to the negative effect of the rollout of nbn network as it would dash the company’s status of “predominantly fixed line provider (wholesale)” having operations in Australia. For the times to come, this could impact the company’s top line number. However, this could also impact the company’s cost base i.e. the costs would be at the elevated levels.

2. Data security risks: Telstra believes that the prevention of the customers’ data, as well as the corporate data, is the key priority. Any breach in this regard, could, in turn, lead to the loss of reputation as well as the brand name. As a result, the company needs to protect the data from unauthorized disclosure, loss, misuse, and damages. However, moving forward, the company might encounter a temporary failure of the information technology or IT systems which could lead to the breach of the confidential data. Keeping this in mind, the company is gearing up in terms of various strategies that will support to manage and handle the cybersecurity as well as privacy risks.

3. Regulatory challenges: Telstra is exposed to the risks related to the regulatory changes as any unfavorable change could have a direct impact on the company’s revenues as well as the business model. These changes have the potential to make the business more complex and could also end up increasing the costs for Telstra. The telecom industry is highly regulated and therefore the company’s services, and product offerings along with the delivery criteria of these services and products, are under the radar of the scrutiny process of the agencies as well as several regulators.

Needle on Key Indicators-

1. In-line Key Metrics with Industry Median: EBITDA margin and NPAT margin stood at 41.1% and 16.9%, respectively on a 5-year average basis (FY14-18). However, in FY18, NPAT margin was down by 130 bps to 13.6% from 14.9% over the prior year but still it is above the industry median of 8.3%. Apart from effective cost management, the group has also generated decent returns for the shareholders consistently with ROE marked at 24.1% for FY18 against the industry return of 13.50%. As of now, the group is on track to improve its key metrics from the current level on the back of several strategies such as Telstra 2022 strategy which will support to lead the Australian market by simplifying its operations and product set, improving customer experience and reducing its cost base. Furthermore, TLS’s trailing 5-year average EPS and DPS came in at 36 cps and 29 cps, respectively.



2. Decent Operating and Free cash flow: During the last 2-3 years, the company has seen disproportionately high capex with over $4.0 Bn and therefore a significant investment is taken care. Moreover, Free cash flow from continuing and discontinued operations came in at $4,695 Mn in FY18 despite the higher capital spending of $4,717 Mn. It indicates that that the company has generated decent cash flow from its operations after spending the money required to maintain or expand its asset base. Moreover, the management expects that the company is likely to maintain its free cash flow in the range of $3.1 Bn to $3.6 Bn after capital spending of approximately 16% to 18% of sales or between $3.9 Bn to $4.4 Bn.


Operating and Free cash flow (Source: Company Reports)

3. Expecting Higher Operating Expense: We are expecting higher operating expenses in years ahead due to rise in NBN access payments, mobile hardware, NAS growth and cost to connect expenses. However, FY 18, total operating expense increased by 7.6% to $18,899 million against FY17.

Operating Expenses (Source: Company Reports)

4. Decent Dividend Payout Policy: The total dividend for the 2018 financial year was 22 cents per share. This was a reduction from the earlier provided amount given the reduction in profit for the year and included an ordinary dividend of 15 cents and a special dividend of 7 cents, relating to the one-off receipts from the transition of fixed customers to the NBN. The group has paid $2.6 billion in dividends to about 1.3 million Telstra shareholders in 2018 while it is one of the largest contributors to corporate tax in Australia. The group has a key challenge relating to NBN which has significantly eaten into Telstra’s profit and thus dividends. There is a possibility of a further hit in near to medium term while the group is aiming to settle for bringing the business back on track. However, the long-term perspective seems to be maintained with many catalysts taking charge. Over the years, the company has consistently distributed stable dividends with healthy payout ratios in the range of 65% to 95%. We expect that the company is likely to continue to have a decent dividend payout policy in long term and years to come and reward dividends to its shareholder under regular circumstances.


Total Dividend Paid and Pay-outs (Source: Company Reports)

Drivers for Future–
The top management of Telstra is having an optimistic outlook despite several challenges as well as risks it is entitled to. The management believes that the company has a significant opportunity which is yet to get tapped. True, that the company might witness some reduction in its profitable services as well as products, the company’s fresh products have witnessed robust momentum in the demand. On the long-term basis, the company’s assets, networks, people as well as balance sheet would be helping it to face the headwinds which it might encounter moving forward.

In the time-span of the next 5 years, Telstra is expected to witness a fivefold increase in regard to the traffic on the mobile networks. The group is intending to reinvent Telstra into a new, digitally enabled business. Further, the new Telstra2022 (T22) has been launched to simplify the operations and deliver better customer experience with reduced cost base. Primarily, the group intends to bring a simple menu of 20 plans that can be activated at the click of a button instead of over 1800 complicated services and products. The other key aspect is to have $2.5 billion of cost reduction.

Additionally, the consumers are increasingly getting inclined towards the use of digital tools. As a result, the streaming of the HD video over the smartphones, increasing numbers with respect to the connected devices which include air-conditioners, cars, watches as well as cloud computing devices would be primary tailwinds which could help in the growth of traffic on the mobile networks.


Historical P/E Band (Source: Company Reports)

Sustainable Outlook and Stock Recommendation–

Telstra shares are down about 11.96% over the last 12 months but are gaining momentum with 12.1% positive movement seen in last three months. The stock has witnessed a challenging period given the dividend cut at the back of margin pressure in mobile division and lesser revenues from fixed line segment. Lately, the shareholders and proxy advisers have questioned the company’s decision to give bonuses given the overall soft scenario and have been noted for preparing for a revolt over the executive pay. The group still stood strong against these allegations. The prevailing stock levels indicate that many of the above-discussed shortcomings have been priced in to a good extent while earnings have found a new base (although lower) and group is focusing on cost management. The key aspect would be the sustainability in cash flow to manage dividend going forward. The direction of the group in terms of Telstra2022 strategy looks positive; and digitization, cost reductions, any possible improvement in NBN economics (wholesale charge reduction, or fixed wireless substitution) and operation based out of 5G are expected to play a key role. The challenging telco sector scenario may prevail in FY19, TLS is still continually working on mitigating the challenges to emerge better and stronger in long term. It is also trying to tactically manage pricing for instance in postpaid service when it comes to competition with Optus and Vodafone. TLS stock now finds support at $ 3.040 and has moved over the resistance seen around $ 3.1. Despite certain key challenges, TLS is having the credentials of staying as one of the leading players in telecommunication industry with sound financials, and it currently trades around 15.57x of FY19E EPS. By looking at long-term growth catalyst and near-term headwinds, we give a “Buy” recommendation on the stock at the current price of $3.16, as we expect a marginal upside from the current level in terms of sustainability and averaging out earlier high levels, while ascribing a valuation of 1-standard deviation to five-year average P/E 14.16x and FY20E EPS of $0.22.
 

TLS Daily Chart (Source: Thomson Reuters)

 
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