Hold The Phone Company

In a six-hour presentation on November 15, Telstra (ASX code: TLS) provided one of the most detailed financial outlooks I have ever witnessed. Stockmarket companies normally only provide guidance for the following year; Telstra gave detailed forecasts for the next five years. Management explained that a strategy that simply maintained status quo implied a decline in EBITDA (earnings before interest tax and depreciation) of 5–6% a year over the next five years, a staggering decline in net profit after tax of 18–20% a year. Clearly, if true, such an outcome is completely unsustainable.

One of the biggest issues confronting Telstra is its myriad and overlapping legacy systems. The problem is highlighted in the diagram included on Page 4 of the pdf file attached to this document.

Telstra has embarked on a multi-pronged strategy to redress the current adverse trends. The strategy consists of:

• A capital expenditure (capex) upgrade funded partly by reduced capital management initiatives; that is, lower dividends.

• Continued ramp-up of Sensis. Telstra believes its directory business is world’s best practice. Sensis is aiming to raise revenue by 75% over the next five years (12% a year compound versus 18.5% in 2004-05). Sensis expects to maintain its margins, implying EBIT of $1.4 billion by 2010 (2004-05 was $800 million).

• Leveraging its Hong Kong business CSL via the announced merger with New World (currently at the memorandum of understanding stage). The synergistic benefits of this merger could see an earnings uplift of 15–25%.

• Maintenance of other important assets such as Foxtel, Clear (NZ) and Reach (HK).

Simplification of Telstra’s systems was the key message delivered. Among other initiatives Telstra intends reducing the current 334 network platforms by more than 60% over three years and more than 65% over five years. Telstra also expects to reduce the current 1,252 IT systems by 75% over three years and 80% over five years. The company also announced it would construct a super-fast national 3G mobile service (replacing its three existing mobile services, including the six-year-old CDMA network) and upgrading its public switched telephone network (PSTN). The PSTN upgrade will see Telstra replace 116 old PSTN switches with only 10 new voice soft switches and boost capacity by 77 times.

To achieve these upgrades, Telstra intends to lift capital expenditure from about its $3.7 billion a year average over the past three years, to $4.4–4.7 billion a year over the next two years. As part of this initiative, the company announced the initial appointment (more to follow) of equipment suppliers Alcatel, Cisco, Ericsson, Siebel and Accenture to help it re-equip. Following completion, Telstra should be able to reduce its full-time equivalent head count (including contractors) by an initial 6,000–8,000 (in 2007-08) and 10,000–12,000 by 2009-10.

The market has plenty of benchmarks upon which to judge how well Telstra management perform over the next five years. Telstra provided detailed financial targets out to 2010. These targets included revenue and cost growth projections, operating profit (ebitda) growth and margins projections, net profit after tax (NPAT) growth projections, depreciation and capex forecasts, free cashflow forecasts, yearly net debt changes, balance sheet forecasts as well as detailed guidance on 2005-06 earnings. The following table summarises the main financial benchmarks provided by Telstra.

KEY TELSTRA FINANCIAL BENCHMARKS
	2005	2006e	2006e	2008e	2008e	2010e	2010e
		low	high	low	high	low	high
Sales growth (CAGR)	6.90%	1.00%	2.00%	1.00%	2.00%	2%	2.50%
Cost growth (CAGR)	8.60%	5.00%	7.00%	2.00%	3.00%	1%	2%
Ebitda growth (CAGR)	5.10%	-3.20%	-3.30%	2.00%	3.00%	3%	4%
Ebitda margin	49%	47%	46%	47%	47%	51%	52%
Ebit growth (CAGR)	-31.70%	-9%*	-6%*	-1.00%	0.00%	3%	4%
Ebitda cover	14.6 x	10.6 x	10.6 x	9.7 x	10.0 x	12.9 x	13.5 x
Tax rate	29%	30%	30%	26%	31%	32%	34%
NPAT growth (CAGR)	8.00%	-15.10%	-11.80%	-2.00%	-3.00%	3.00%	4.00%
Change to net debt $m		-2600		0	0	2500	3500
* Adjusted for $80m ebit benefit from new initiatives

I have never seen a company provide such detailed long range forecasts. Although it left open some wiggle room by pronouncing all forecasts dependent on regulatory outcomes, I was very impressed management was prepared to be so candid with its shareholders.

Of course, benchmarks are one thing, execution is something else. Shareholders will need to comfort themselves these benchmarks are achievable. I’m prepared to give Telstra management the benefit of the doubt. The detail provided and the enthusiasm of management presentations suggests they are committed to achieving their goals. In addition, the benchmarks are not particularly onerous. For example, NPAT growth of 3–4% out to 2009-10. While some investors may be concerned about the magnitude of the capital expenditure, Telstra highlighted that net additional spending over the five years is only $2–3 billion above what would otherwise have spent under prior plans.

Even at its weakest point (2006-07–2007-08), Telstra should be still able to maintain very comfortable debt ratios such as six times ebit cover and 1.5 times net debt to ebitda in 2007-08. I value Telstra using a number of methodologies including:

Dividend yield. Telstra intends maintaining its special dividend in 2005-06. After the payment of $5 billion in dividends in 2005-06, it expects its net debt to rise by $2.6 billion. To help fund its capex program, Telstra therefore intends dropping its special dividend from 2006-07. Even so, it expects net debt to rise a further $1.8 billion to about $16.2 billion. Thereafter, Telstra expects no further increase in net debt. By 2010, net debt should be no more than 2004-05 levels: $12 billion or less. At $4, Telstra is yielding 8.4% fully franked in 2005-06, falling to 6.9% fully franked thereafter (after the cancellation of the special dividend). This represents the highest yield among the Top 300 stocks on the Australian market.

Price/earnings multiple. Telstra is trading on about 13 times 2005-06 earnings, a slight discount to the current market. Based on Telstra's forecasts, by 2009-10 the P/E should have declined to about 10 times, which is probably a small premium to the market. I think this is an attractive earnings multiple for one of Australia’s largest and, I would think, most defensive stocks.

Enterprise multiple. Here I compare total capitalisation (market cap plus net debt less hidden assets like Foxtel) to ebitda. I calculate Telstra is trading on about six times 2005-06 ebitda, declining to about 4.5–5 times by 2009-10. This would represent one of the lowest multiples in the market.

Free cashflow multiple. Pre dividends, I calculate Telstra is trading on a very high 21 times 2005-06 free cashflow. However, based on the company's expectations, this should drop to 7–8 times by 2009-10.

The following table summarises my estimate of the key valuation parameters.

KEY VALUATION PARAMETERS
	2005 act	2006 est	2008 est	2010 est	2010 est
		low	low	low	high
EPS (pre significants)	36c	30c	33c	39c	40c
PE at $4	11.3 x	13.3 x	12.0 x	10.4 x	10.1 x
Premium/discount to market	–31%	–3%	0%	4%	1%
DPS	40c	34c	28c	28c	28c
Yield at $4	9.90%	8.40%	6.90%	6.90%	6.90%
Ebitda multiple	5.7 x	6.1 x	6.1 x	5.0 x	4.5 x
Free cashflow per share	35c	19c	28c	48c	56c
Free cashflow multiple	11.6 x	21.0 x	14.4 x	8.4 x	7.2 x

While short-term share price prospects remain questionable, I continue to think Telstra represents excellent long-term value. Its yield is very defendable (6.9% fully franked beyond 2005-06) and can shield shareholders during a transition period. Although most of today’s announcements were well flagged, some shareholders were clearly disappointed. Although Telstra lifted its pre significant ebit guidance by $80 million (or 1%) based on the benefits of the new restructuring, some were expecting an even greater lift. This lift excludes restructuring charges of $1.3–2.1 billion (pre tax), the size of which may have surprised some. The special dividend will eventually be cancelled (but I would argue this has been in the price for some months). Regardless, some disappointed shareholders are likely to leave the register in the short term.

On other valuation metrics as discussed above, Telstra represents good value. Some might scoff at an underlying growth rate of 3–4% a year in NPAT over the next five years, but I think this ignores any leveraging of important international assets. Evidence for this potential came with the CSL/New World merger announced today and the potential synergies that may arise from that.

The drop in the share price following Tuesday's annoucements also places additional pressure on the Federal Government to be sympathetic to Telstra’s regulatory problems. I continue to think there is a better than even chance Telstra will achieve many of the regulatory concessions it has been advocating. The current share price, of course, assumes the opposite is likely.