Telstra Plans Meet With Some Scepticism

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Telstra is planning to extend its network and devices business via services delivery and apps to create more value. The extent to which this can plug the earnings hole created by the NBN is debated among brokers.

-NBN net additions are growing but momentum has eased back
-Desire to leverage verticals to provide additional earnings streams considered a positive
-Yet, proposals are in their infancy and questions regarding the size of investment remain
 

By Eva Brocklehurst

Brokers agree tough competitive times continue for Telstra ((TLS)) but they diverge as to the extent they believe the company is grappling with the problems. Telstra is planning to extend its current focus on networks and devices, expanding into the delivery of services and apps to create more value.

Citi believes this is likely to require significant investment, either both organically or in terms of acquisitions, as Telstra moves beyond its core strengths. Meanwhile, the NBN is continuing to experience significant downward pressure on pricing and, while net additions are growing, the broker observes momentum has eased back.

Management revealed some soft operating trends in the September quarter including a slight decline in mobile services-in-operation (SIO) revenue and a slower rate of post-paid as well as ARPU (average revenue per user) growth. Demand for the iPhone 8 has been below previous iPhone launches although demand for the iPhone X has been strong and ahead of previous launches.

Telstra has indicated that phone re-contracting could be delayed because of the launches of new phones which is a possible explanation, Deutsche Bank points out, for the slowing rate of post-paid SIO growth in the quarter.

Telstra's monopoly returns are fading and there is no avoiding this conclusion, Morgan Stanley asserts. Competition will continue to intensify as the roll-out of the NBN accelerates. Moreover, TPG Telecom ((TPM)) is launching a fourth Australian mobile network in 2018.

Morgan Stanley highlights evidence that competition in mobiles and broadband is having an impact on the business and considers the strategy for earnings growth beyond one-off NBN payments remains unclear.

The company's approach to mobile pricing, offering more data while getting customers to pay more, is a difficult sell in Citi's view. Most customers expect increased data for the same price, or lower, and this expectation is being met by competitors. Citi expects that ARPU will remain under pressure even before the market moves to four operators.

Beyond NBN Roll Out

At the investor briefing management highlighted long-term opportunities in 5G, Internet of Things (IoT) and Big Data. Collectively, the addressable market for these represents around $20bn in new revenue streams by 2026, Morgan Stanley calculates.

While chasing new revenue in these high-growth areas is a logical step, the broker questions the ability to monetise the opportunity when competing with globalised technology operators such as Amazon, Google and Facebook. These operate on a lower cost curve with global expertise and huge advantages in economies of scale. If Telstra is unable to replicate these earnings the broker considers the current distribution of $0.22 per share is unsustainable.

Citi acknowledges the scope to boost IoT earnings and a multi-brand approach to capture a share of a growing price-sensitive segment, such as Belong mobile, as opportunities but suggests the move into the delivery of services requires significant investment, either organically or via acquisitions. The broker retains a Sell rating.

Macquarie takes a more moderate position, believing the company's strategies were more clearly defined at the briefing, although not a reason to alter expectations. The start of FY18 has been modestly below expectations for mobiles but the broker notes management is optimistic the trends will improve in the second quarter.

Macquarie is also supportive of the desire to leverage Telstra's network and expertise to deliver solutions across a range of verticals. Countering this, the broker agrees there is little visibility as to how much is being invested, when some of the projects will be monetised and whether they will collectively evolve to provide a meaningful offset to the NBN earnings gap.

Ord Minnett was disappointed with the update, not only because of the lack of concrete revenue targets for some of the potential new revenue streams but also fearing that this focus on services and apps could be just an evolution of telecoms and displace existing revenues.

Earnings Gap, Upside Or Downside?

Morgans is upbeat and suggests positives were overlooked from the briefing, including the fact that SIO continues to grow and the services accruing from Telstra's challenger brand Belong are coming from competitors and, therefore adding, not destroying, value.

The broker agrees NBN economics are not sustainable but believes the market is pricing in the earnings hole without considering that it may not be as large as suggested previously, if NBN prices are lowered.

On a medium-term view the broker finds a number of options to reduce the NBN challenges including network convergence, security services, IoT and, as yet unquantifiable, revenue-adding opportunities around 5G. Mobile is unlikely to be an outright replacement for fixed line, given the volumes of data traversing the fixed network, but Morgans considers the two remain complimentary.

On the other side of the equation UBS questions whether the market is underestimating the potential downside to the NBN "earnings gap". The broker envisages risks to total data and IP operating earnings pools, given NBN plans to compete in the wholesale business market and the re-pricing risk that is inherent Telstra's enterprise front book.

Moreover, the broker also asks whether there is really upside to capital management stemming from long-term free cash flow exceeding accounting operating earnings per share. UBS suspects Telstra may yet deploy future free cash flow to de-gear, depending on the amount of leverage it takes on for upcoming spectrum auctions and the extent of future productivity gains.

Non-Core Exchanges

Value could also be realised for around 2500 non-core exchanges which are on the balance sheet at a cost of $1bn, Morgans suggests. This land has not been revalued for decades and the broker suggests it could be worth substantially more if revalued today.

The main operating risks, the broker envisages, relate to the ability to offset the negative impacts from the NBN and competition while there are upside risks with better growth in services. Morgans retains a Add rating. Citi also mentions the potential to rationalise exchange sites and the book value that could be realised as one of the key positives in the briefing.

There are three Buy ratings, two Hold and two Sell on FNArena's database. The consensus target is $3.79, signalling 8.8% upside to the last share price. The dividend yield on FY18 and FY19 forecasts is 6.3% and 6.4% respectively.

This stock is not covered in-house by Ord Minnett. Instead, the broker whitelabels research by JP Morgan.
 

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