Will Telstra Need To Cut Its Dividend?

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Will Telstra need to cut its dividend? Brokers have asked this question for some time now and several revisit the prospect.

-Pressure on investment capital in the industry as a whole
-Organic growth needs to offset the impact of Telstra's earnings loss from the NBN
-Dividend expected to hold steady in the near term but under increasing pressure
 

By Eva Brocklehurst

Will Telstra ((TLS)) need to cut its dividend in the near future? The question has been forming in broker views for some time, given the earnings gap from the rolling out of the National Broadband Network that the company needs to fill. The Australian telecommunications market has experienced challenging conditions of late, with mobile industry earnings declining by around -8% in the first half reporting season and fixed data industry earnings declining around -9%.

Meanwhile, the sector is entering a period of elevated capital expenditure, as companies invest in their core or expand networks, lay submarine cables and build, in the case of TPG Telecom ((TPM)), a mobile network in Singapore.

To Cut Or Not

Deutsche Bank, as a result, forecasts returns on investment capital in the industry declining in FY17-18 before recovering in FY19. In the case of Telstra's fixed data margins, these declined 6% in the first half because of the costs associated with the NBN.

Deutsche Bank expects Telstra's operating earnings (EBITDA) will decline to $10.2bn in FY22 and the main driver of this will be the impact of the NBN, offset by organic growth in core segments, productivity and benefits from the company's capital expenditure plan. Based on the broker's calculations, Telstra should be able to maintain a 31c dividend in FY17-25.

UBS believes the company should cut the dividend as a matter of prudence. There is the issue of the $2-3bn gap in earnings from the NBN and the company's desire to maintain an A credit rating band ahead of a sizeable upcoming refinancing obligation. There is also capital requirements to take into consideration, such as a $3bn strategic expenditure plan, spectrum and 5G. A fourth mobile entrant is a potential threat.

UBS concedes that whether Telstra will actually cut the dividend, given its high retail and income fund shareholder base, is another matter. Hence, with a capital allocation review still under way, the broker believes Telstra is likely to hold its dividend steady at 31c in the near term, i.e. in FY17 and potentially FY18.

UBS, however, aligns its FY19 dividend with a long-term forecast for earnings per share (EPS) of 29c. The broker considers this forecast already generous, as it assumes around $2bn of the earnings gap is filled by $1bn of net productivity gains, $600m of network application services (NAS) growth and a $400m swing in new business contributions.

This is predicated on the status quo in core businesses being maintained, such as flat mobile earnings. There are risks to all these factors, even without the potential entry of TPG Telecom as the fourth mobile operator.

In simple terms, the broker notes the NBN agreement is an asset sale and after the roll-out Telstra should bear less debt relative to the $16bn it holds today. Debt considerations could, therefore, constrain capital allocation outcomes. Even if recurring NBN payments are securitised, UBS suggests Telstra should earmark a portion of excess free cash flow – around $1.5-2bn – for debt repayment versus equity returns, contingent on how much of the earnings gap is filled.

Credit Suisse believes the sustainability of the dividend is at risk. Core recurring EPS is expected to fall significantly over the next 2-3 years, although reported EPS will remain high because of one-off NBN payments, which will support cash flow and probably prevent an immediate cut to the dividend.

The broker forecasts core recurring earnings to fall as low as 23.2c per share in FY19, before picking up as growth in mobile, NAS and fixed line cost savings start to fill the earnings gap.

Nevertheless, Credit Suisse expects it will take some time for core recurring EPS to rise above the 31c that is required to support the current dividend. This presents a problem for Telstra. If it sticks with the current policy, the broker expects the dividend to be cut in the outer years, as it will not be supported by sustainable earnings.

Yet, Telstra could change its policy and pay a dividend above EPS for a period, to give earnings from areas such as mobile and NAS time to grow and catch up with the pay-out. Regardless, even if the dividend is not reduced, the broker expects investors will start to worry about its sustainability.

Credit Suisse envisages dividend risk as the medium-term issue, with history revealing that the company's yield tends to rise, i.e. the share price declines, when there is concern about long term dividend sustainability. The latest corporate plan for the NBN shows completion by 2020.

FNArena's database shows five Hold ratings and three Sell. The consensus target is $4.79, suggesting 3.8% upside to the last share price. Targets range from $4.40 (Citi) to $5.35 (Ord Minnett). The dividend yield on FY17 and FY18 forecasts is 6.7%.
 

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