Telstra: Hot Air Rises

After the Telstra strategic announcement this week an investment banker, who declines to be named, said: "Overall, I think the market will react warmly."

I suspect he hoped for his own sake that the market would react warmly, so he could flog T3 to the masses. Unfortunately, the market thought the long-awaited Telstra strategic review raised more questions than it delivered answers.

Many investors I spoke to also couldn't believe the contrived nature of the presentation, which involved "21st Birthday" style video messages from other global telco CEOs supporting the strategy. Cheerios from abroad: now that's a first in corporate Australia.

So what was at the heart of the presentation?

1: Telstra expects fixed-line rental revenue to decline 9.2% in 2005-06, and by 10% in 2006-07, a hastening of this year’s 3.4% decline. This leads to earnings falling by 30% this year.

2: Telstra committed to $10 billion capital-expenditure program, or 17¢ a share, over the next five years. The strategy is to rollout a broadband service to offset decline in fixed-line revenue. Apparently we are all going to watch movies on our mobile phones.

3: The company has committed to paying a dividend of 28¢ a share for the next three years.

4: Considering the company earns 30¢ a share, and they are committed to paying out 45¢ in dividends and capital expenditure, the arithmetic is flawed.

5: To balance the ledger, the company is cutting costs by reducing the workforce by between 10,000 and 12,000 jobs and, hopefully, winning concessions by the Government on broadband pricing (which I regard as unlikely).

6: The company is obviously trying to balance yield with growth to appease the shareholder base. However, will the dividend yield be enough to offset the earnings and cash flow risk?

The Telstra strategic review, for all its hype, was clearly a disaster in the market’s eyes. The market correctly questioned the company's commitment to 28¢ dividends, and a large capital expenditure program that added up to significantly more than forecast earnings per share. Dividends will need to be party paid out of retained earnings, or party funded by further borrowing.

EBIT growth forecasts in the outer years of the five-year plan are an anaemic 2–3%, and we have to cope with negative EBIT growth this financial year. The eventual payday for all this pain is forecast to be 2008-09 or 2009-10, and by then the great bull run in equities may be over!

So we are left with a fully franked yield play, yet after capital expenditure is accounted for that yield can't be entirely funded out of earnings. This clearly requires Telstra’s dividend stream to attract a higher risk rating than other comparable large-cap industrials. Telstra’s dividend cover ratio will be the worst of any Top 50 company (ex infrastructure), and that should mean the market applies a lower "yield multiple" to the stock.

Make no mistake: Telstra trades on a fully franked yield multiple, yet that yield multiple must be risk-adjusted to reflect the unsustainable nature of the dividends. This yield multiple pricing, at the expense of earnings based pricing, has been the trap in Telstra shares.

The 2005-06 prospective price/earnings (p/e) multiple of 14 is simply too high relative to the risks to both the dividends and the earnings, and doesn't reflect rising debt levels, falling interest cover, falling free cash generation, and falling dividend cover.

Let me repeat that: "Risks to both dividends and earnings, rising debt, falling interest cover, falling free cash generation, and falling dividend cover." Yet that glosses over clear "regulatory risks", and a 51% share overhang.

When you add up all those negatives, it's pretty easy to come to the conclusion that Telstra is getting special treatment by the market because it's Telstra. If this was any other stock it would be on a p/e multiple of 10 and trading at $3, and nobody would be paying for the unsustainable dividend yield forecasts.

I also believe that the continued attack on regulation by Telstra’s management and board is misguided at best. Chairman Donald McGauchie should phone his counterpart at Qantas, Margaret Jackson, and take some lessons on the nuances of political and competition commission lobbying.

So who is the more effective?

I'm pretty sure the best way to get concessions from regulators isn't to attack them personally at every opportunity. I'd be certain that's the way to make sure you get no concessions. Telstra’s public strategy of attacking regulators is misguided, and I'd be pretty sure that at this level threats don't work.

Qantas plays the ball, and not the man. It regularly publishes well-researched press releases aimed at their competition, not at the regulator or the Government. Competitors' anti-competitive arguments are countered with facts.

Yet here we are today, and Qantas is trading on the same forward dividend yield as Telstra, but with all dividends paid out of earnings, yet commanding a five-point p/e discount to Telstra. Qantas has falling debt, rising interest cover, rising dividend cover, and rising free cash generation. That either makes Telstra look expensive or Qantas look cheap or, most likely, both.

This brings me to a much larger point, and that is why is it that well-run, strong companies such as Qantas and BHP Billiton, for example, still command solid p/e discounts to companies such as the growthless Telstra?

It's a complete joke, and it will not continue. I can name 40 large-cap stocks with proven management, and improving overall returns, with the vast bulk of them trading on lower multiples than Telstra. Just remember, a stock isn't good value because it once traded $7 and now it's $4.

I think these Telstra developments will prove a pivotal development for p/e ratings of leading Australian companies. From this point investors will have to consider what is the appropriate risk-adjusted p/e for many Australian companies, especially those world-leading global cyclicals who are the all but debt-free, yet growing earnings per share at more than 50% a year and spitting out cash everywhere.

These developments must make investors consider who is really going to lead this market for the next decade, and the answer is big-cap global cyclicals with pricing power. It ain't growthless domestic yield plays. That's last decade’s story, when interest rates were falling.

What was previously "defensive" has proved "offensive" in many cases, and I want to again reiterate that the highest degree of visibility of earnings lies in the big-cap resource sector. In big-cap resources you have contracted prices, visible spot prices, visible currencies, and detailed quarterly production reports. You get all this visibility and transparency for a 50% p/e discount to the market. That won't last.

Our biggest strategic call remains that large-cap resource stocks will move to a market multiple (a p/e rating higher than the average p/e rating for the wider market). Nobody believes that call; everyone thinks it’s madness. Even resource bulls think it’s madness.

Well, I can remember when everyone said building materials "would never command a market multiple", now we see Rinker and James Hardie commanding p/e premiums. I'm happy to be shot down by building materials analysts, yet I can't see any real differences in risk profile between cyclical building materials companies and heavyweight resource stocks.

I can also remember when transport stocks "would never command a market multiple", yet here we are with Patrick Corporation and Toll Holdings commanding 25% p/e premiums to the market.

What do the four companies I mention above all have in common? A track record of strong and consistent EPS growth and cash flow generation, a focus on shareholder returns, strong management, and pricing power due to product innovation. They have also concentrated on building higher barriers to entry in their core businesses, which should reduce cyclicality. They have also all introduced internal capital allocation discipline, which has driven strongly rising return on expenditure. They have also all been consolidators of their industry, which has also driven pricing power.

Major diversified resource stocks have all these characteristics, all they are missing is the market p/e rating. It's coming, and you know it's coming because nobody believes it is.

There is only one heavyweight sector left to be re-priced by the influential pool of compulsory superannuation money, and that is large-cap resources. It may not happen overnight, but it will happen.

These companies simply aren't the high-risk, high-volatility, companies that they are currently priced as. This is a historic p/e rating, and history is to be taken advantage of.