Opportunity out of adversity for Telstra
Key statistics: ASX: TLS
Closing share price 06.12.16: $4.920
52-week high: $5.860
52-week low: $4.700
Most recent dividend: 15.5c
Annual dividend yield: 6.3%
Telstra's share price has underperformed the broader market by around 12.5% over the past 12 months, with the bulk of the damage having been done since the release of the company's 2016 financial year results in August.
However, to management's credit, the recent hosting of Telstra's second investor day in six months appears to have done enough to allay investor concerns, with the share price having responded in kind.
The main reason for the increase in Telstra's investor communications of late has been management's realisation that, on completion of the transition to the NBN, which is currently expected to occur between 2020 and 2022, Telstra's recurring EBITDA (earnings before interest, tax, depreciation and amortisation) will decline by $2 billion-$3 billion.
While Telstra has been compensated for this in advance and has time to invest ahead of the curve to fill the earnings hole, it will not be without its challenges.
There are three key mediums through which Telstra intends to do this: first, by investing in productivity initiatives that are expected to deliver at least $800 million in core fixed-cost reductions over the next five years; second, by seeking to generate at least a $500 million return (two-thirds revenue, one third costs) on its recently announced $3 billion of strategic investments by FY21; and third, by increasing organic and acquired earnings growth.
The fact that Telstra is not venturing too far from its core competency is comforting, in our view. This was confirmed at its recent investor day, with management stating that "we are faced with unprecedented demand on our network and a world of opportunity to deliver new experiences. Network traffic over our fixed and mobile networks will grow five times over the next five years and the capacity to support this is not yet built."
While Telstra's share price performance since the FY16 results suggests to us that the market is taking a glass-half-empty approach to the company's earnings prospects over the next several years, it does not take much of a leap of faith to picture a more positive outcome.
Key in this regard will be Telstra's ability to generate a sufficient return on its recent investments.
With the Australian telecommunications market having become increasingly competitive and the NBN set to ratchet this up even further over the next several years, we believe it makes sense for Telstra to leverage its strong cash flow and balance sheet to differentiate itself from its peers and ultimately preserve its market-leading position.
While not without its risks, the investments announced thus far will go a long way to filling the earnings gap post NBN.
Based on the current consensus estimates, Telstra is trading at 14 times consensus earnings for FY17, a price-to-book value of 3.9 times with a return on equity of 27.1%, and a dividend yield of 6.5% (9.3% grossed up).
This is, in our view, supported by a positive technical set-up, with the relative strength index (RSI) having recently ventured into oversold territory (which is indicative of an exhaustion of short-term selling pressure).
While Telstra has time on its side, there is no question that there is a lot of work to be done before the company can say that the migration to the NBN has had a neutral (or even positive) impact on sustainable earnings.
However, as was reiterated at Telstra's recent investor day, management is not shying away from the challenges ahead, and appears to have struck a balance between near-term capital management and investing for medium-term growth.