Telstra's cash conundrum

Get used to hearing the words 'capital management' in relation to Telstra over the next nine months as the market tries to work out how the company will spend an extra $1.6 billion in free cashflow.

Chief executive David Thodey last week committed to lifting Telstra's free cashflow by 36 per cent to $6 billion in 2010 by slashing capital expenditure, improving working capital, paying less tax and improving earnings before interest, tax, depreciation and amortisation.

Leading broking analysts have already started to float different scenarios as to how the additional cash will be spent. The speculation could help boost Telstra shares.

The most obvious option is for the Telstra board to declare a higher dividend. Telstra's dividend yield is currently about 8 per cent or 12 per cent after being grossed up for tax paid.

With that in mind, is it realistic to expect a company with one of the highest fully franked dividends in Australia to pay out even more cash? Certainly some expect just that.

UBS analyst Richard Eary thinks a higher dividend is highly likely. He says Telstra now has a forecast dividend yield of 13.3 per cent based on his forecast that the dividend will be lifted by 14 per cent in 2010 from 28 cents a share to 32 cents a share.

Christian Guerra, analyst at Goldman Sachs JBWere, also says a higher dividend is on the cards. However, he cautioned that any return of capital to shareholders would depend on three factors: the outcome of the NBN negotiations, the completion of the Sol Trujillo transformation, and acquisitions.

Guerra says the two most likely options are either an increase in the ordinary dividend from 28 cents a share to 30 cents a share or on-market buybacks of Telstra shares.

Ian Martin at RBS, Alice Bennett at Merrill Lynch and Daniel Blair at Southern Cross Equities are tipping a dividend of 30 cents a share in 2010 rising to 32 cents a share in 2011.

Sameer Chopra at Deutsche Bank last week upgraded Telstra to a buy partly because of its sustainable 8 per cent dividend yield. He is forecasting an increase in the dividend to 30 cents a share in 2010 and 31 cents a share in 2011.

He estimates Telstra will have about $1.2 billion in 2010 to fund further growth opportunities or return capital to share or debt holders. That could be a sign to buy Telstra's bonds.

Over at JPMorgan, Laurent Horrut says that instead of being used for higher dividends, the additional free cashflow will simply relieve Telstra of the burden of borrowing to pay its dividends.

Over the past few years Telstra has borrowed about $3.7 billion to pay its dividends. It probably should have cut the dividend in 2007, but that was not an option after the T3 share float.

According to Horrut, the importance of the higher free cashflow in 2010 is that it removes the uncertainty over the sustainability of the existing dividend.

However, he did note that there would be about $1.4 billion of excess free cash after payment of a 28 cents a share dividend in 2010.

Andrew Levy at Macquarie Equities says the dividend might rise by a measly 1 cent to 29 cents a share.

Phil Campbell at Citi Investment Research is equally cautious with a 29 cents a share dividend forecast for 2010, though he says the dividend will jump to 32 cents a share in 2011.

The Telstra board will probably sound out institutional shareholders about any capital management initiatives before they go ahead.

Retail shareholders would probably regard a higher dividend or special dividend as a more equitable outcome than an on market buyback of shares.