A fresh start for Telstra?

Summary: Telstra's plan to spin off $11 billion in infrastructure assets could mark a true fresh start for the telco.

Key take-out: Investors shouldn't be in a state of despair over Telstra. There could be a silver lining, even in depreciating shareholdings, revealed through case studies around the world.

A great many Australians combined a major investment in banking stocks with Telstra to achieve high yields to offset the fall in rates on interest-bearing securities. 

We have discussed banks before but today I want to focus on Telstra, which has been truly a disastrous stock for those looking for income. Not only are Telstra dividend payments set to be reduced, but the stock has been hammered, resulting in substantial capital losses for most people. 

But don't totally despair. It's true, Telstra will never return to being the sort of company that pays out the bulk of its earnings in dividends. You now have a very different investment. 

The first leg of this new investment is Telstra's plan to spin off $11 billion in infrastructure assets including data centres, domestic fibres, international subsea cables, exchanges, poles, ducts and pipes. 

This new infrastructure company will provide Telstra with access to these assets through commercial arrangements. It will also continue to provide services to the NBN. This will be a substantial Australian infrastructure company. Telstra will pay a fee to rent use of the assets. 

We don't know the details of the arrangements and what sort of growth will be involved, but Telstra has revealed that annual revenues will be about $5.5 billion and earnings before interest, tax, depreciation and amortisation (EBITDA) will be about $3 billion. Without the finer details, it's impossible to value that stock, but the Chinese are bidding 14.8 times the EBITDA for APA Group . The Telstra infrastructure company will certainly not be valued on that basis, but if it was, then its market capitalisation would be greater than the existing Telstra company. 

Gas infrastructure companies around the world typically sell on an EBITDA ratio of between 8 and 17. If the Telstra infrastructure operation was valued at 8 times EBITDA, then it would be worth $24 billion — compare that to Telstra's market value of some $32 billion. I emphasise, again, I have no idea what would be an appropriate EBITDA ratio for the Telstra infrastructure company, but infrastructure assets carry a much higher value than trading assets in most situations. Australian companies are reluctant to spin off infrastructure because it commits the parent company to substantial payments so, inevitably, that tends to depreciate the value of the parent. 

However, that discount has already been taken into account by the market, with Telstra shares having been hammered heavily as of late. The infrastructure company will have a very high payout ratio, although, just how high will depend on how much it needs to spend on upgrading and maintaining the infrastructure it has purchased.  

Telstra chairman John Mullen is a global expert on infrastructure. He was a former CEO of Asciano, which was taken over by the Toronto-based Brookfield Infrastructure and its partners.

Brookfield, a global infrastructure provider, thought so highly of Mullen that it appointed him a director in the process. Mullen has a unique understanding of global infrastructure and I am sure he has been a key driver in the decision to spin off Telstra infrastructure. 

So, first and foremost, if you are a Telstra shareholder, you are set to become a shareholder of a significant infrastructure company. No doubt Mullen will leverage this company given its secure income stream. 

The infrastructure company will not include the very valuable mobile infrastructure, which Telstra says must be incorporated into its base operation. And this is the second part of your Telstra investment. 

Telstra was basically going to turn its mobile operation upside down and simplify its offerings to customers, complete with lower prices and a reduction in staff. The company believes the looming 5G network will emerge as a major growth industry for Australia, because it will enable internet control of a vast number of domestic household and industrial applications. Not only does it transform households, but it makes more efficient a whole series of activities conducted by industrial, service and mining companies. 

Telstra hopes to ride a substantial growth path on the back of 5G. There will be an auction for 5G spectrum, and given that Telstra intends to make that the linchpin of its future activities, it will have to bid high enough to get a substantial amount of spectrum. This sudden understanding that telecommunications is a growth industry is being grasped in many countries, particularly in the US, where share indices have been changed dramatically to set up a telecommunications sector which will include companies like Google and Amazon. Telstra is not in that league. 

Will Telstra CEO Andy Penn be able to pull all of this off? The institutions and many shareholders hate him because they yearn for the continuation of the old-style Telstra. That is simply impossible. We have just seen with Optus how things can go dramatically wrong if your systems are not in top order. We have seen Telstra suffering from previous lack of investment as its systems failed. If Telstra ‘does an Optus' and fails to deliver the services it promises in this reorganised state, it will be smashed by the market and lose further market share. First and foremost, the new Telstra has to be right on top of its technology game.

If Penn can deliver on the technology, and given that Optus has fallen over on the soccer, there is no reason why Telstra marketers can't do extremely well promoting the new and simplified products. But none of this happens quickly, so it will be in the next decade before benefits start to be realised. It's important that Mullen does not succumb to institutional pressure and sack his CEO simply because the shares have fallen. 

The disastrous decisions to pay out too much money in dividends is the responsibility of the previous CEO and chairman. Of course, if Penn can't deliver on his promise, naturally, he must be replaced. But right now, Mullen's job is to make sure the CEO feels secure and gets on with the job of implementing the new Telstra structure. 

One of the factors that will affect the share price of the infrastructure company is the success of the Telstra operating company. If Telstra operations encounter turbulence and the market starts to worry about payments, clearly it will discount the value of the infrastructure company. Conversely, if Telstra does well, the infrastructure company will get a higher rating.