Telstra rings changes as risks loom

In this year's results presentation, the Telstra chief executive, David Thodey, did something one cannot imagine his predecessor Sol Trujillo doing. Midway through his speech, he paused and thanked his staff.

In this year's results presentation, the Telstra chief executive, David Thodey, did something one cannot imagine his predecessor Sol Trujillo doing. Midway through his speech, he paused and thanked his staff.

The only time Trujillo engaged with his staff was when he sacked them. It was a simple yet revealing gesture, emblematic of Thodey's desire to drive a deep cultural shift.

There was a time when Telstra could carry poor management; profits from its fixed line business insured against ineptitude.

No longer. Margins are falling, competitive pressures are rising and Telstra's monopoly power, already dwindling, will disappear with the NBN. Telstra has to change.

In its favour are three factors that strengthen its chances of success.

Valuable brand

The first is that communication is part of what makes us tick. That gives the telecommunications industry a tailwind unlike any other.

Since 1985 spending on telcos has increased at 7.7 per cent year on year, over twice the rate of inflation, and a rate unlikely to slow.

Telstra's second quality relates to the fact that it was once the country's only carrier. It now faces prolific competition but, according to Interbrand, it remains Australia's most valuable brand. None of its competitors even make the top 20.

That and a huge fixed line customer base means it controls 70 per cent of the fixed line business, 42 per cent of the mobile business and 43 per cent of broadband. These are monopoly-like figures.

In an industry with high fixed costs, this leads to fatter margins.

Third, there are early signs of cultural change. Services now appear on one bill and call centre staff are being retrained. The company is actively competing for business, expressed in the acquisition of 1.6 million new mobile customers in the past year.

Finally, Telstra is on the right track. And yet there are three barriers that might derail Thodey's plans.

Structural shift

The current NBN deal may yet be scuttled and confusion remains, aided by Telstra's 306-page structural separation undertaking submission to the Australian Competition and Consumer Commission.

Regulatory risk isn't limited to the NBN, either. Telstra could be forced to open its Next G mobile network to competitors, as the ACCC discussed in 2006. With BHP and Rio Tinto forced to grant access to their Pilbara rail networks, precedents already exist for legislating open access to private assets.

Even if the NBN doesn't proceed, the decline in Telstra's fixed line business is terminal.

This is a decisive, structural shift.

Mobile margins are half those of fixed line, which means Telstra needs to add $2 of revenue for every $1 from fixed line just to maintain profits. In a growing industry, this explains why Telstra's cash flow is falling.

NBN or not, competition in Telstra's remaining businesses is increasing, placing more pressure on margins.

Telstra's business model is changing from being a utility-like supplier to a retailer in a highly competitive market. It is being forced to adapt.

What's it worth?

Let's for a moment imagine Telstra makes a flawless transition to the new industry dynamics, that the company is milking cash from its dying fixed line business and is switching customers to its NBN products. Let's also assume it has won an even larger share of the growing mobile market and T-Boxes are as common as fridges.

What would Telstra be worth then? According to our research, about $4 - still much less than the T2 float price of $7.40. But if things go badly, a share price of less than $2 is quite conceivable.

It's an even-money bet. And one that investors can choose to avoid with superior opportunities available following the recent market falls.

If you're an income investor hooked on Telstra's 9.2 per cent dividend yield, Spark Infrastructure on a yield of 7.4 per cent or MAp Group at 6.4 per cent offer more stable returns over the long term without the risks.

Growth investors attracted to Telstra's turnaround potential might sleep more easily with CSL or Computershare.

And if you're hanging on to Telstra for its defensive qualities, you're living in the past. Genuine defensive stocks like Woolworths and Metcash will serve you better.

Nathan Bell is the research director at The Intelligent Investor, This article contains general investment advice only (under AFSL 282288).

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