Telstra - Better Than Cash

Last week, Telstra (TLS) reported a record full year profit of $4.45 billion, slightly above market expectations. But, judging by the market reaction (Telstra shares down 5 per cent in the two days after the release), the result was a shocker.

My approach to TLS is relatively simple. OK, it has problems. That is why it is trading at $4.75. The problems are well known and reasonably well quantified. But, within a very difficult competitive and regulatory environment, TLS is, as the latest result reveals, still scoring runs.

What attracts me is the dividend policy. On top of a normal 14 cents half-year dividend, TLS has committed to paying a special dividend of 6 cents in October and another 6 cents next April. This means, at its present share price of $4.75, TLS is yielding a whopping fully franked 8.4 per cent a year. Grossed up for franking, it means one of Australia's biggest companies is yielding 12 per cent.

Another way to look at TLS is that, over the next 15 months, it is likely to pay out 60 cents in dividends, a return of 12.6 per cent even before franking credits. When grossed up for franking credits, that's a huge 18 per cent.

And there's more. The sharemarket is starting to look frothy, particularly within resources. With rising US interest rates and oil prices, it is only a question of time before the party ends. When it does, defensive stocks such as Telstra are going to look very attractive indeed.

I'm not going to rely on getting much capital appreciation any time soon, but the best I can get from a bank deposit is 5.5 per cent a year, which makes a switch from cash to Telstra a no-brainer. Who knows, maybe we'll get lucky and Trujillo will negotiate a subsidy deal for rural Australia that doesn't cost the company too much.

As for last week's result, I think there was plenty to like about it. Despite declining revenue in segments representing more than 20 per cent of total revenue (categories such as local, national and international calls), overall sales grew nearly 7 per cent and underlying sales 3.7 per cent. TLS has reduced its cost base by $600 million in the past two years and another $200 million cut is planned in the next year.

Consider the following highlights:

So why the 5 per cent share price fall? No one likes declines, least of all stockbrokers and institutions. They are primarily growth animals so, when Telstra predicted an (unquantified) earnings decline in 2005-06, profit forecasts for that year were promptly lowered about 10 per cent. What's more, it was extrapolated into the future, indefinitely. Within 36 hours, the institutions had dropped more than 250 million shares on the market.

CEO Sol Trujillo may be a very smart political operator. Since joining, Telstra, he has been confronted by a cacophony about rising regulatory constraints and demands for increased telco services (read higher costs) in rural Australia. On the surface, he doesn't have a great hand.

But he does have one big card: the Howard Government wants to sell its half share in Telstra, and at a reasonable price. Since Trujillo told the market last Thursday that earnings would be lower this financial year, the value of the Government's TLS shares have fallen more than $1.6 billion. No doubt Trujillo is letting the relevant ministers know it could get worse before it gets better. The Government has previously said that, in the T3 sale, it wants at least $5.25 a share, not $4.75.

So his suggestion that increased bush services should be, at the very least, subsidised by government (and perhaps even other telcos) could get a sympathetic hearing. There could well be an element of gamesmanship in Telstra's downbeat forecasts.

Yes, Telstra has challenges. Its core revenue streams (20 per cent of total) are in decline. Its second-half effort was way below the first half. Operating costs are rising at 4 per cent a year. Hence, TLS is likely to have more than 1000 redundancies this financial year. It will spend $4 billion on capital expenditure (capex) this year, more than the market expected. But it produced more than $8 billion in operating cashflow last year, another record. So Telstra can afford to improve its competitiveness by spending half its cashflow on capex, and still have more than $4 billion left to pay a 40-cents annual dividend. Importantly, this still leaves its gearing ratio below a target range of 45-55 per cent.

Leading stockmarket analys Mike Mangan previously worked for Deutsche Bank. He has lifted his Telstra shareholding since the 2004-05 results were released.