Summary: Telstra’s first half was broadly in line with expectations, with growth in mobile, network applications and services (NAS), NBN Infrastructure Services, health, global connectivity and China digital media more than offsetting revenue declines from fixed and data & IP segments. The focus on differentiation from mobile, NBN revenues and the Asian expansion gives us confidence in Telstra maintaining strong profitability. In the ultra-low interest rate environment the share price has been pushed up by yield hunters. It is currently trading above our FY15 valuation of $6.06.
Key take-out: We hold a positive outlook for earnings and dividends due to infrastructure advantages in mobile, growth in Asia and NBN compensation payments. Below $5.50 Telstra is excellent value. Above $7.60 the stock would be demonstrably overvalued.
Key beneficiaries: General investors.
Category: Blue-chips
Recommendations:
| Stock | Company | Call | Price< | Projected price |
|---|---|---|---|---|
| TLS | Telstra Corporation Limited | Out of value | $6.63 | $6.06 |
Telstra has rallied strongly in recent times, with yield hunters attracted to its secure dividend.
First-half results for FY15 show momentum in mobile, network applications & services (NAS) and international divisions offsetting structural decline of legacy assets in the fixed products business.
By 2020 Telstra aims to source one third of revenues internationally, mainly through expansion of NAS in Asia. At this stage we see the transition from David Thodey to new chief executive Andy Penn as neutral for value.
We think Telstra is worth $6.06 excluding NBN payments, which have a present value (PV) of around 90 cents per share, and $6.90 including the PV of NBN payments.
Excluding NBN payments our valuation range is $5.50 to $6.70. Including NBN payments the range is $6.40 to $7.60. Therefore Telstra would be excellent value below $5.50, and demonstrably overvalued above $7.60.
Image may be NSFW.
Clik here to view.
Figure 1. TLS adopted valuation metrics and future value
Source: StocksInValue
We recently reduced our adopted profitability as measured by normalised return on equity (NROE – includes franking) to 43 per cent from 45 per cent, partly due to reintroduction of the dividend reinvestment plan (DRP), where we expect takeup of 25 per cent. The NROE is in line with consensus earnings estimates over the next five years.
More broadly, we think Telstra will continue to achieve the same level of future profitability as it has in the last five years (of around 44 per cent) despite declining revenues and profitability from fixed products (fixed voice, fixed data, etc.), which contributed just 28 per cent of total product sales due to earnings growth in Mobile (42 per cent), NAS (8 per cent) and international, as well as NBN cash payments.
We also reduced our required return to 10.5 per cent from 11 per cent previously due to historically low risk-free rates with the Australian 10-year government bond yield currently at 2.6 per cent, having fallen from 4.19 per cent a year ago. At 10.5 percent the RR is very low, reflecting strong cash generation, large market capitalisation at approximately $81 billion, and competitive advantages in mobile and fixed-line infrastructure and services.
Gearing as measured by net debt to equity increased from 75 per cent on 30 June to 105 per cent because net debt rose $3.7 billion to $14 billion and equity reduced $470 million, largely due to the $1 billion share buyback. Gearing is high but financial risk is mitigated by strong and consistent cashflows and the coming NBN compensation payments with a present value of $11 billion.
Our dividend (D)-reinvestment (RI) split is skewed to D (38 per cent D to 5 per cent RI), reflecting an assumed payout ratio of 88 per cent. Telstra’s high dividend payout ratio reflects its large market shares, resulting competition constraints and the maturity of much of the business.
We derive an equity multiple of 5.6 times and a pre-NBN FY15 valuation of $6.06, rising to $6.67 in FY16. TLS shares are currently trading above the FY15 valuation but after adding 90 cents per share of NBN payments to our valuation, the stock looks inexpensive.
Sensitivities to changes in adopted metrics, assuming a constant payout ratio, are shown in Figure 2 below. As shown, valuations vary between $5.50 and $6.70 based on a range of plausible assumptions for required return and profitability. Accounting for the present value of NBN income at $0.90 per share, the range is $6.40 to $7.60. The lower and upper limits of this range represent cheap and expensive valuations. Below $5.50 represents excellent value. A price above $7.60 would be stretched.
Image may be NSFW.
Clik here to view.
Figure 2. TLS FY15 valuation matrix (excludes PV of NBN payments at $0.90 per share)
Source: StocksInValue
In the prevailing ultra-low real interest rate environment yield hunters are treating Telstra as a proxy for fixed interest given its secure dividend payments, especially after the renegotiated NBN payments.
Investors are factoring in lower required return to lock in yield, pushing up the share price. Further lowering of RRs for equities could push Telstra well above $7. In doing so investors could be risking capital loss for yield because long-term RRs will change by less than risk-free rates will in the near term.
Following Telstra’s recent rally, FY15 dividend yield fell from well over 6 per cent to 4.6 per cent now, so the yield has become somewhat less attractive.
Image may be NSFW.
Clik here to view.
Figure 3. TLS price and valuation history
Source: StocksInValue
Telstra’s 1H15 result was broadly in line with expectations with sales revenue up 2 per cent to $12.6 billion and net income 22 per cent higher at $2.08 billion (consensus was $2.05 billion).
Telstra declared an interim dividend of $0.15, up 3.6 per cent on the previous corresponding period but at the lower end of expectations.
Guidance for FY15 was confirmed at $25.7 billion of revenue and operating earnings of $10.6 billion, flat on FY14 with single-digit income growth offsetting the absence of CSL revenues, which were $630 millio in FY14. TLS divested CSL, a Hong Kong mobile business, in May 2014.
Outlook
Telstra is highly profitable with NROE averaging 44 per cent over the last five years, largely generated from the monopoly national copper network and strong growth in mobile.
The NBN rollout and increasing mobile use mean these assets have contracting revenues and are a declining source of competitive advantage. However, TLS is creating infrastructure advantages in mobile and NAS (cloud computing), offsetting the structural decline in the fixed network and the data and IP businesses.
With over 80 per cent smartphone penetration, Australia is a mature market. Consumers are using more data, however, and Telstra is developing infrastructure and services to meet increasing demand. Competitors Optus and Vodafone cannot match its mobile infrastructure investment, so Telstra’s mobile network becomes more attractive as data usage increases with higher data speeds.
A major part of the long-term strategy is to increase overseas revenue, mainly from Asia. Last year management stated its goal of a third of revenue from international sources by FY20. Significant progress was made in 1H15 with the Pacnet acquisition, a provider of telecommunications and data centre services to carriers, multinationals and governments in the Asia-Pacific and China.
Pacnet owns the world’s largest submarine cable network stretching across Asia and the US. The acquisition will accelerate international connectivity and NAS growth but further acquisitions will be necessary to achieve one-third international revenues.
Annual company cashflow of more than $5 billion over the last five years, and $7.5 billion most recently in FY14, provide a powerful capability to maintain the network’s technological edge and for expansion.
Growth in mobile and network applications and services revenue, NBN revenues and the Asian expansion focused on differentiation give us confidence in Telstra maintaining strong profitability.
The post Robust earnings for Telstra appeared first on StocksInValue.