Australia | Nov 18 2016
This story features TELSTRA CORPORATION LIMITED. For more info SHARE ANALYSIS: TLS
Telstra has sparked speculation among brokers as to what it intends with its capital allocation strategy review.
-Will the new strategy support the current dividend or involve a re-basing of the dividend lower?
-Strategic shift away from new growth businesses and a re-focus on domestic
-NBN earnings gap remains the key issue for most brokers
By Eva Brocklehurst
Telstra ((TLS)) will undertake a review of its capital allocation strategy over the next 6-12 months and expects to update the market at the first half result in February. The announcement, at an otherwise steady-as-she-goes AGM, provoked keen interest from brokers as they mull just what the outcome of the review might contain.
The company has also announced a strategic shift away from new growth businesses, meaning it will not, for the time being, make large-scale consumer investments in Asia. Part of the company's review of its capital allocation will include obtaining feedback from debt and equity stakeholders.
Telstra has previously identified that the National Broadband Network (NBN) will affect recurring earnings by $2-3bn between FY15 and FY22. FY22 is a key year because this is the first year which excludes one-off NBN payments and could likely be used as the base for the company's dividend policy. Telstra expects $3bn in strategic investments will drive a $500m improvement to earnings by FY21.
Deutsche Bank suggests investors will appreciate the company's willingness to canvass various options surrounding capital allocation. Yet, while the uplift from the $3bn investment sounds good in principle, the broker is cautious about the revenue benefits, given the telecommunications sector has not been successful at monetising increased data consumption and new services. The broker cites evidence in the relatively stable average revenue per unit (ARPU) in mobile and fixed data.
UBS forecasts recurring earnings to fall to $9.8m post the NBN completion, although assumes a one-year delay and that FY23 will be the first year which excludes any one-off NBN payments. The earnings improvement expected, combined with around $800m in productivity gains, fills around $1.3bn of the $2-3bn gap, in the broker's calculations.
Based on the broker's projected earnings profile and capital expenditure forecasts, Telstra could better sustain its earnings per share of around 31c if it deployed up to $2bn in excess cash flow for additional share buy-backs. UBS estimates the buy-backs could also reduce the annual dividend burden by $125m. The broker's current mobile forecasts assume capital expenditure normalises in FY24 to 14% of sales. However, if assumptions are increased to 16%, UBS estimates that only a 29c dividend would be sustainable.
Several brokers raise the hypothetical scenario of Telstra securitising recurring NBN payments, crystallising the value of long-term receipts in return for a lump sum payment. Telstra is entitled to recurring payments for leasing its infrastructure to NBN for 35 years from the date of the initial deal. Given these payments are also guaranteed by the federal government they could be viewed by some investors as a government backed annuity, UBS suggests.
Telstra could also deploy the proceeds for buy-backs which would reduce its nominal dividend load. UBS also suggests, hypothetically, if Telstra were to divest its recurring NBN payments, it could exacerbate issues around the NBN earnings gap and place pressure on the dividend profile. The broker wonders whether investors might, in that instance, de-rate the remainder of the stock.
Credit Suisse is of the opinion that the review will lead to fundamental changes to the company's capital management strategy. The main issue is to address the gap between the current 31c dividend and recurring earnings per share and the broker highlights the risk that the review leads to a re-basing of the dividend to a lower, more sustainable, level.
The broker concurs that Telstra could consider a relatively radical capital management strategy which involves securitising, effectively pulling forward future NBN infrastructure receipts. Telstra could then use the proceeds to either support the dividend or make a large one-off capital return, in order to smooth the transition to a lower underlying dividend.
At present, Credit Suisse maintains its dividend forecast for FY17-19 but looks to revise the longer-term forecast upon receiving clarity on the outcome of the review. The broker retains a Underperform rating, believing the key operating risk relates to high levels of competitive intensity across all the company's product lines.
Macquarie notes a retraction of the Asian consumer growth strategy is consistent with increased investment in the domestic business. Telstra will continue to pursue international expansion through global enterprise services and network applications and continue to expand its Asia-Pacific submarine cable network. The broker suspects the capital review may unlock some value to shareholders, but is sceptical it will transform the underlying earnings challenge for Telstra.
Macquarie agrees a key component could involve options to realise value from the NBN payments stream, in particular the $1bn in annual receipts, and possible solutions may involve the sale of some of the revenues contracted under the infrastructure services agreement, securitisation, and/or an in-specie distribution.
Macquarie envisages Telstra will be able to sustain its dividend, albeit with little margin for error given the challenges of the NBN earnings gap. The $1bn targeted for cost reductions will be spread out across the entire group and the broker expects this to be particularly important, allowing Telstra to defend its profitability in the low-margin NBN business.
Macquarie acknowledges filling the NBN earnings gap will require good execution in the number of areas, including mobile and productivity/cost reductions as well as turning around the negative contribution from new business ventures. The broker still envisages Telstra will offset most of the NBN impact, although underlying earnings could still fall to around $9.5bn by FY22.
On the other hand, the AGM commentary has underscored Citi's view that the NBN earnings gap is too big and will require the company to pull back on its dividends as it earnings fall. Citi retains a Sell rating alongside a $4.50 target.
Goldman Sachs welcomes the greater clarity around the capital expenditure program and, in continuing to view this as a largely defensive investment, believes there is less scope to drive incremental market share gains compared with previous investment programs.
The broker also notes a significant cost component and an increased focus on generating returns from existing subscribers by up-selling to higher price points and cross-selling. Goldman Sachs, not one of the eight brokers monitored daily on the FNArena database, retains a Neutral rating and $5.50 target.
The database contains five Hold ratings and three Sell. The consensus target is $5.03, suggesting 2.0% upside to the last share price. Targets range from $4.50 (Citi) to $5.55 (Ord Minnett). The dividend yield on FY17 and FY18 consensus forecasts is 6.4% and 6.5% respectively.
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