Australia | Jun 15 2016
This story features TELSTRA CORPORATION LIMITED, and other companies. For more info SHARE ANALYSIS: TLS
-Mobile outages influencing churn
-Is the yield play enough?
-More conservative on capital
-But is it sufficient?
By Eva Brocklehurst
Many headwinds batter Telstra Corp ((TLS)) as it progresses from a monopoly owner of infrastructure to a competitor for access to the NBN. Still more are being identified in the mobile network, where competition has raged for longer.
Several brokers consider Telstra is in a tough situation, facing increasing competition and declining returns. Morgan Stanley asks: should Telstra invest offshore for growth or invest domestically to retain market share? Either way, the broker envisages returns declining and considers this scenario is under-appreciated by the market.
While the fixed data business faces lower profitability and market share losses as the NBN is rolled out, increased competition and its own network outages are also affecting the company's mobile business. Deutsche Bank initiated a survey to gauge the propensity to switch providers among mobiles.
In view of the recent well publicised outages in Telstra's network, the survey found no change in the perception of network quality. Yet the results suggest mobile churn could rise to 19% from the current 11%. This could lead to a fall of 6% in FY17 mobile, hand-held subscribers, the broker maintains. Of significance, mobile outages also appear to be influencing the churn intentions of fixed data customers, with many indicating this was the reason to switch providers.
The frequency of the mobile outages in February and March this year caused the greatest concern, particularly as Telstra's services are priced at a premium to reflect a superior network. The broker estimates the implied churn rate could lead to a 4% reduction in fixed data subscribers in FY17 and a 1.6% reduction to FY17 earnings.
Deutsche Bank also enlists the experience of the Vodafone/Hutchison joint venture in its analysis. That JV experienced severe network outages in 2010-11, which considerably tarnished its image and resulted in the loss of 2.4m unique subscribers and 9% market share.
The broker revises forecasts to reflect a higher churn rate for Telstra in FY17, leading to reductions in earnings estimates of 5% in FY17 and 10-11% in FY18-20. Yet the attractive dividend yield and prospective capital management means the broker sticks with a Hold rating.
Morgan Stanley also recognises Telstra's yield is valuable in the global chase for yield but prefers Spark New Zealand ((SPK)) as its dividend yield play as that company is returning capital to shareholders in the form of special dividends. The broker envisages normalised returns on equity (ex NBN payments) for Telstra will decline to 23%, from 28%, by FY20. The stock is also noted to be trading at a 22% premium to its long-term average and Morgan Stanley retains an Underweight rating.
The broker bases its rating on the fact once almost guaranteed returns are fading amid increasing competition across 75% of its revenue base, and the company will struggle to fill a $2-3bn earnings hole while costs are growing. Telstra will need to reduce costs by 1.4% per year for the next five years to remove $1.1bn in costs by FY20 and this looks difficult to achieve, in the broker's view.
Morgan Stanley presents a detailed analysis of the company's iPhone business, which suggests, in the longer term, competition will erode any profit and add $40-50m per annum in costs to the mobile business. The situation is thus: the market envisages Telstra absorbing a $400 phone subsidy every time it sells a 24-month, post-paid plan on iPhone i.e. this is not evaluated as a profit centre or source.
This is not the case, Morgan Stanley maintains. The company is not absorbing the subsidy, rather it is actually generating a small profit on the lower-priced plans of around $4 per iPhone. Most other operators, in the US and NZ markets as well, do not use the iPhone as a profit centre. Therefore, competition on price will erode or erase any iPhone subsidy changes Telstra makes, the broker contends, and, on extrapolation, this will not fill the earnings hole.
Analysis suggests Optus is also using the iPhone as a profit centre but Morgan Stanley expects this competitor will move away from that position because, over the last two years, it has become increasingly competitive in the mobile segment. With the first steps towards lower prices being undertaken, the broker believes it would not be unreasonable to expect Optus to stop generating a profit from iPhones.
The broker acknowledges Telstra has adopted a conservative approach to capital to the near term, abandoning its Philippines investment and selling most of the stake in Autohome, as well as announcing a $1.5bn capital management program. Yet, the longer-term capital allocation strategy is intent on plugging the earnings hole, once NBN payments are finished ,which means a continued focus on growth and an Asian expansion strategy.
This introduces an elevated level of risk for Telstra and Morgan Stanley is mindful the company has had mixed experiences offshore. The broker would prefer that a forecast $5.2bn in excess capital over the next five years is returned to shareholders as a $1bn share buy-back per annum. This would shrink the equity base and stop the returns on equity falling by FY20.
The consensus target on the FNArena database is $5.38, signalling 1.4% in upside to the last share price. The dividend yield on FY16 and FY17 forecasts is 6.0% and 6.1% respectively. The one Buy rating – Morgans' Add recommendation – is predicated on the strength of the balance sheet and relative safety of the company's earnings. Otherwise, there are five Hold ratings and two Sell.
See also, Telstra Approaching A Crossroads on May 3 2016.
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