The bottom line on Telstra's cash flow

One of my roles is to represent our company on the board of Jasco Holdings, a private trading company that imports, distributes and retails arts and crafts.

My role as a director gives me a refreshing look at the real world away from the frantic pace of the stockmarket, and it also gives me a commercial grounding when I look at the financial reports of listed companies.

This background is particularly useful in allowing me to review the interim financial result of Telstra (TLS) and to help you understand the significance of the report. When looking at TLS, I will not fall into the trap of looking at the last six months in isolation but will consider the whole of calendar 2012. I will look at the important balance-sheet moves and put them into context in the current dynamic telecommunications market.

In particular, when TLS management noted confidently that cash flow of the business will lift in the second half from a 17% decline in the first half; I will try to help you determine whether this is a reasonable forecast. If it is, then my confidence level in valuing TLS shares will be enhanced.  

Let me explain the relevance of a small unlisted trading company to understanding business cash flows generally, and specifically those of TLS. In particular, how kerbside or “snapshot reviews” of financial performance, without context, can lead to potentially spurious analysis.

Jasco manages its business through yearly seasonal cycles. A significant part of its business is its “back to school” offer in January and February. To meet this demand, it must be fully in stock in October to ship to retailers in December. It will get then get paid over the next three months depending on trading terms. So each year the company goes into negative cash flow in the months up to November, and then heavily into positive cash flow from March onwards. A passing analyst looking at the cash flow in the three months to November may conclude that the company is going broke. The conclusion would be absolutely wrong, for a mere three months later cash from sales comes flowing in, debt repaid and cash actually sits on the balance sheet.

Why is this significant for TLS? Well, there has been much commentary by financial analysts in recent days regarding the decline in Telstra’s cash flow in the December half. Remember that TLS did not hide this fact, and suggested that the second half cash flow would be significantly better. The analysts who have jumped on the reported decline did not find it hidden in the small print.

So why is TLS so confident about the second half, and why should you be as well? Simply because the rollout of 4G or the Long Term Evolution (LTE) network involves substantial cash out for TLS before cash comes in from phone sales, pre-paid and monthly contracts. Indeed, it must be the most well publicised mobile telecommunications development of recent times – barring of course the National Broadband Network (NBN). In the months leading up to Christmas, Apple launched the Iphone 5 and Samsung upgraded its Android product. So Telstra would clearly anticipate a surge in product and service demand from these product developments and its own network rollout. Further, there would be a surge in pre Christmas sales and the holiday sales in January. To meet this demand, TLS did increase its investment in working capital and this is clearly seen in the accounts.

Specifically we can see this from some key movements in the balance sheet and through the cash flow over the last 12 months. I have identified cash out movements with brackets.

Over calendar 2012, TLS produced some fairly impressive numbers. For instance, look at net debt. Despite cash dividends being paid of $3.5 billion (cash out) the company reduced net debt from $14.1 billion to $13.6 billion. In simplistic terms it is clear that TLS generated $4 billion of after-tax free cash flow over the 12 months. Comments that cash flow was constrained are wide of the mark.

Further, there were significant business cash outlays and investments made over the 12 months that did not stop net debt reducing. These included:

1. $4.13 billion of capital expenditure. This amount was actually lower than depreciation expense; and
2. There was a net outflow of $0.48 billion to fund movements in net working capital and this is explainable by the market shares gains reported by TLS (see below).

When I specifically look at the last six months I see timing movements in working capital that consumed cash. These were increased trade receivables ($0.4 billion), increased inventories ($0.18 billion) and reduced trade creditors ($0.5 billion). All up net working capital investment was about $1.0 billion and yet net debt only rose by $0.3 billion. Analysts who think this is bad news need to go back to school and do their basic accounting course again.

Also, if you are wondering like me about the NBN, I can report that virtually nothing of the $11 billion of net present value cash came to TLS in the last six months. TLS has funded its build-up for the 4G rollout from its own operating cash flow. This is important for shareholders to understand. Rather than paying back debt that costs about 5% (pre-tax), TLS invested in working capital that will generate double-digit returns in profitability and cash flow.

Other highlights

Key statements by TLS management that supported capital investment and therefore caught my eye were:

1. Reported higher operating margins across the business streams;
2. Signed up 670,000 new mobile customers;
3. Signed up 85,000 new fixed broad band customers;
4. Sold about 500,000 Apple iphones;
5. Forecast 66% 4G coverage across Australian population by 30 June 2013; and
6. Upgraded 2,000 sites to 480,000 customers to access ADSL 2.

Intrinsic value of TLS

Intrinsic value (IV) is derived from the forecast “normalised return on equity” (or profitability) and adjusted for risk as defined by “required return”. The valuation can be thought of in terms of “multiple of equity” rather than “multiple of earnings”. The higher the level of actual and forecast profitability the higher the derived multiple of equity. The valuation thus considers the income and the growth prospects of a company.

In TLS’s balance sheet I note an apparent low equity value. This is because the historical investment in land lines and home connections has been heavily depreciated. Further, these copper lines will be effectively transferred to the NBN for a NPV of $11 billion. Noteworthy is that the TLS balance sheet does not have an asset (receivable) entry called “NBN proceeds”. If it did then this would represent a 90 cent per share increment to equity.

To derive value for June 2013 and 2014 I have used forecast market consensus earnings growth of circa 5% p.a. I have chosen a rate of return of 10%, which is low but acknowledges the bond characteristics of TLS. So my valuation is $4.90 and my preferred accumulation price is below $4.50.

Click to enlarge

Finally, should I add 90 cents per share to the valuation for the NBN proceeds? Probably not at this stage but it is worth considering when you may be thinking of a price to lighten your TLS.

In the meantime I am a happy holder in my Income Portfolio.

John Abernethy is the chief investment officer at Clime Investment Management. Clime is a top performing Australian Equity fund manager. Utilise MyClime, to identify companies with attractive dividends and yield. Click here for a free two-week trial.

Clime Income Model Portfolio

Return since June 30, 2012: 20.64%

Returns since Inception (April 24, 2012): 19.42%

Average Yield: 7.76%

Start Value: $118,757.19

Current Value: $143,266.32