Telstra's high-speed yield connection

PORTFOLIO POINT: The dividend yield from Telstra is hard to beat, with its share growth having provided an added capital bonus.

This week the chase for yield was focused on Telstra, and the shares jumped to around $4.30 as investors put aside earnings considerations and concentrated on yield.

Telstra is a fascinating stock which delivers wonderful returns for shareholders, but if the shares go too high in the quest for yield it might even damage the company.

So let’s look at the simple figures. Last year Telstra earned around 28.4 cents a share and the brokers are expecting that in the current financial year those earnings will rise to around 31 cents a share. Obviously mobiles will be an important factor in the earnings rise, as will Telstra’s first full-year of NBN contribution, which should exceed $400 million. That means that at $4.30 Telstra is on a price earnings ratio of around 15 based on a 28.4 cents a share earning rate.

But in the next two financial years earnings per share are expected to hover around the 31 cent mark, which would bring the PE ratio down to 13.9 based on current price levels. However, apart from the jump in the current financial year, the market is expecting little profit growth. So, on the surface, a 13.9 times price earnings ratio looks too high given that subdued profit outlook.

But what the simple profit statement does not reveal is the amazing cash flow sums. Telstra’s operating cash flow in the next few years is expected to be around the 65 to 70 cents a share mark. Out of that cash flow, Telstra must pay capital expenditure and dividends. In normal years capex is expected to come in around 30 to 35 cents a share, leaving say 30 cents a share for dividends. But in the current financial year (2012-13) the Telstra group’s free cash flow will actually fall heavily and go below earnings per share because Telstra will have to pay about $1.5 billion (and the figure could be higher or lower) to buy much-needed spectrum from the government to maintain the growth outlook for its mobile operation. Optus and Vodaphone must do the same thing, but their outlays will be lower than Telstra. In total the government is expecting about $2.5 billion from the three companies in April/May, which will substantially boost its budget numbers.

That means that free cash flow will fall sharply from the normal 30 cents a share (in 2011-12 it was higher than normal) to around 23-24 cents a share. Telstra will have to borrow to pay its 28 cents a share dividend. But in the next financial year, 2013-14, the free cash flow is expected to jump above 30 cents a share and in subsequent years might reach 35 cents. Australian institutions look at those cash flow figures and drool. Accordingly some are predicting that Telstra will increase its dividends from 28 cents a share to at least 30 cents a share in 2013-14 and then go even higher. So if Telstra was to increase its dividend to say 30 cents a share, the yield on a market price of, say, $4.30 would rise from 6.5% (based on a 28 cents a share dividend) to 7%.

Of course the Telstra dividends are fully franked (tax paid), which means the real yield rises well above 9%. That looks a lot more attractive than the sub 5% rates that are offered on bank term deposits. And it is that differential that is driving Telstra shares upward and, of course, also driving bank shares upwards. But Telstra management has its own set of expansion priorities that may be higher than what the institutions expect. For example, the group has a substantial undersea operation in Asia and the time has come to increase the scope of that operation. In time it will yield good returns, but in the short term it might not equal the current earnings per share rate.

Telstra management has been delighted at the rise in the share price linked to the chase for yield. But as Telstra shares rise further so too does management realise that the market and the new shareholders will not take kindly to free cash flow being diverted to anything but dividends and /or capital return. Telstra, in the eyes of its new shareholders, is a dividend play. But you can’t run a telecommunications operation longer term on the basis that you simply distribute to shareholders all the free cash flow generated by the business.

For a few years it will work but longer-term it won’t. Telstra shares have not reached the level where the quest for free cash flow could affect the longer performance of the company. But that position is coming.

The fact that you can still get almost 7% fully franked (equivalent to about 9%) from a company that has very stable earnings means that Telstra has got to be an important part of any equity portfolio that is aimed at dividends.

But Telstra shares are now higher than broker forecasts of only a few months ago that were based on the high price earnings ratio given the lack of forecast profit growth. Yet if interest rates fall further, and that seems likely either in December or in later months, then the Telstra dividend yield will look more and more attractive. But the new Telstra shareholders should not forget how the company reached the current position. Former CEO Sol Trujillo committed substantial Telstra capital to the mobile network. The institutions did not like it but that capex is now driving profits, particularly given the Vodafone problems. If a similar decision was required of the current Telstra management, they would be under pressure not to invest and take a risk.

The push for yield is also going to affect the ability of Australian banks to reinvest profits. I must add that, at least on the basis of the 28 cents a share dividend, there are few more stable income stocks than Telstra.

But while quest for yield is driving many people, investors should realise that there are others with an entirely different strategy. I was at Christie Beach at the weekend, which is a resort town on the southern outskirts of Adelaide. It was a food and wine afternoon, which was most enjoyable. But right in the middle of the action were stalls offering low interest rate bank loans, and on another was a raffle where the prize was an entry to a property seminar. It was a reminder to me that just as the lower interest rates are driving investors to Telstra and banks to boost income, so they are also driving investors into borrowing for housing. I think the yield from Telstra shares will be hard to beat, even though the stock has risen sharply. Yet every time it goes up it makes it harder and harder for directors.