Markets: Profiling Telstra's potential

The end of Telstra's dividend guarantee has put the focus on the stock's income stream. But it's the telco's growth profile that should be the main issue for investors.

Telstra Corporation Limited (TLS) had committed to paying a full year distribution of 28 cents since the 2006 financial year. The financial year just gone was the last year of that dividend commitment.

Now Telstra’s dividend will be at the discretion of the board each year. Investors can loosely rest assured it will maintain the dividend at worst, knowing full well dividend cutting is a signal you are in poor health financially.

Numbers

Certainty around dividend payments essentially turned Telstra into a bond, allowing investors to buy a stock and have a similar confidence over the income stream. This has helped the share price climb from a low of $2.56 on November 17, 2010 to highs of more than $5.

At its low, Telstra was offering an unfranked yield of just over 10 per cent. The dividend factor has seen Telstra gain around 101 per cent since this time. If we were to smooth this out to make it an annual figure, we come in at around 28 per cent per annum measured over 34 months.

Over the same time, the same gains cannot be said for Telstra’s growth. If we look at a longer time-frame, say over five years, the numbers don’t really indicate that Telstra has been growing.

Looking at the numbers since 2009 Telstra’s free cash flow, the money that’s left over to pay dividends, has only grown at an annual compounded rate of 2.85 per cent.

Until this year, dividends have been paid using all of the generated free cash flow (meaning they aren’t ‘saving’ any profits) and debt. Although it is pleasing Telstra have funded this year’s dividend out of their free cash flows, that should be the norm for companies of Telstra’s size and calibre noting it is unsustainable to use debt to fund dividend payments on an ongoing basis.

This year, profit came in at $3865 million and dividends paid out were $3480 million. In total, Telstra paid out 90 per cent of its profit to shareholders.

Growth

The question for Telstra is now focused on growth. When we combine potential dividends and future growth prospects it could be said that Telstra’s share price overcompensates investors for what may lie ahead.

At a price of around $5.07, the current yield is just on 5.5 per cent, unfranked. This comfortably beats the dividend yield of 4.26 per cent available on the ASX 200. But the future growth profile of Telstra means, after accounting for inflation, income alone doesn’t offer you the return you are probably after.

With strong fundamentals to support further share price appreciation, investors should be looking at the real return achievable from Telstra over the longer term. Sure, you will probably continue to get a 28 cent dividend per annum, at a minimum, but how much further appreciation is left in the share price?

Industry

Mobiles made up 36 per cent of Telstra’s gross revenues this financial year. This is great, but the only way to substantially increase this year-on-year is to gain market share from competitors or increase the profit margins. Given we have a matured mobile market, things look difficult on this front.

In addition to this, the telecommunications industry is becoming more competitive and iiNet Limited (IIN) and TPG Telecom Limited (TPM) are snapping up market share where they can. 

From 2009 through to 2012, iiNet grew its profit by 44 per cent, at an annualised rate of 9.6 per cent. TPG grew even faster at 415 per cent, or just over 50 per cent annually. Both iiNet and TPG report later this year.

In a note to investors this morning, Morgan Stanley rightly questions whether Telstra’s current share price is justifiable. The investment bank base this on its view the multiple no longer supports Telstra’s growth. Essentially, it is implying that Telstra’s current price does not match up with valuation metrics and its growth outlook.

We know from having looked at the numbers over the longer term that Telstra hasn’t been growing, rather just reporting the same headline numbers year after year. This isn’t something a company of Telstra’s size can change in an instant. 

Acquisitions could be a way for Telstra to grow but the ACCC has shown it is not inclined to support this path after it stepped in to squash Telstra’s planned takeover of internet service provider Adam Internet, which iiNet later swooped on.

Telstra is similar to the banks in that not only must it please shareholders and customers but also regulators, which can be the most difficult of all.

On the flip side, the NBN is set to benefit Telstra regardless of who is in power