Trujillo's Winning Hand

A torrent of views have been aired in the market since Telstra's strategy meeting last week. Those views range from "the end is nigh” to “it will be a difficult execution, but it had to be done”. Amid the word fest, some aspects of the strategy appear to have been “lost in translation”.

There appears to be plenty of confusion about Telstra's future cash flow. The following table highlights Telstra's forecasts of its future cash flows as per slide 24 of the chief financial officer's presentation.

	2006 est $ mil	2007 est $ mil	2008 est $ mil	2009 est $ mil	2010 est $ mil
Free cash flow	2400	1700	3500	4600	5900
Dividends	5000	3500	3500	3500	3500
Change to net debt	–2600	–1800	0	1100	2400

After dividends, Telstra expects to increase debt by $4.4 billion in 2005-06 and 2006-07. Thereafter, it expects to almost repay these increased borrowings by 2009-10 (low case). It should be noted that under Telstra's optimistic assumptions (not shown) they expect all the increased debt to be repaid by 2009-10.

Another way to look at Telstra's cash flow is on per-share basis. The following table summarises the above table on a per-share basis and is derived from slides 22 and 24 of the CFO’s presentation.

	2006 est	2007 est	2008 est	2009 est	2010 est
EPS (forecasts)	$0.30	$0.32	$0.33	$0.36	$0.39
Depreciation	$0.34	$0.34	$0.34	$0.34	$0.34
less total capex per share	$0.41	$0.48	$0.35	$0.29	$0.21
less other outlays	$0.05	$0.05	$0.05	$0.05	$0.05
Free cashflow before dps	$0.19	$0.14	$0.28	$0.37	$0.47
less dps	$0.40	$0.28	$0.28	$0.28	$0.28
Change in net debt	-$0.21	-$0.14	$0.00	$0.09	$0.19

Telstra expects net debt to rise about 35¢ per share in 2005-06 and 2006-07. Most of this should be repaid by 2009-10. Debt levels do not deteoriate further because according to chief executive Sol Trujillo, Telstra's additional capital expenditure is only $2–3 billion over and above what it would otherwise have spent to maintain the status quo.

The charts show Telstra will be raising debt levels in the first two years, but only by $4.4 billion or 35¢ per share. As net debt at 30 June was about 95¢ per share, Telstra’s plan calls for raising debt levels by about a third over the next two years. On Telstra’s calculations, debt levels should return to 2004-05 levels by about 2009-10. With luck they could be much lower.

Telstra has plenty of capacity to absorb more debt. Its current gearing is 80%, based on the book value of equity but a very low 23% based on the market value of equity. At the point of maximum debt pain (2007-08), EBIT cover should still be a very healthy six times, meaning the company can afford to borrow even more than their scenarios have allowed.

Many commentators have criticised Telstra’s public campaign for regulatory relief; they would prefer a “behind closed doors” approach. But as Trujillo would say, “shareholders have seen that movie already”. And “that movie” is a big part of the reason Telstra has ended up in its current mess. So I suspect most shareholders will say to Telstra: "Go for it."

Besides, I think right now Telstra has the Federal Government over a barrel. If the Government cannot deliver regulatory relief, then Telstra's clearly stated "status quo" outlook calls for a decline in net profit after tax (NPAT) of 18–20% a year over the next five years. No shareholder, including one owning 51%, wants that.

But there is more to it than just falling earnings. Can you imagine what share price the Government would get in its selldown if the best Telstra management can sign off on, is earnings per share (EPS) declines of 18–20% a year over the next five years. At that rate, by 2009-10 Telstra's EPS would be 12–13¢. What multiple do you pay for that? At 10 times it would be $1.20–1.30. That might be generous.

I don’t think the Government has yet appraised what it is facing here. The logic is simple: the Government wants to sell down 51%. But to persuade buyers, management has to sign off on forecasts. And unless management gets what it wants, the Government can forget $3 a share and probably even $2 a share.

This is why its wrong to compare Telstra's behaviour towards regulatory relief with other companies. Other public companies do not have a government share overhang to place in the market. Telstra does. As I said, Telstra has the Government over a barrel. The thing is, the Government doesn't realise it yet, because it is not yet at the point where it is asking management to sign up to prospectus forecasts.

There has been plenty of valid concern expressed about Telstra’s high execution risk, but this ignores the alternative status quo scenario laid out by Telstra: net profit declines of 18–20% a year over the next five years. Maintaining the status quo is untenable. I think embarking on a company-wide restructuring would carry far lower risk than maintaining the status quo.

Consensus has written Telstra off, and in the short term consensus is probably right. But I’ve always been wary of consensus; it gives little room for error because the consensus view is by definition already priced into the share price. Even if my contrarian view is only partly right '” that Telstra gets just a bit of regulatory relief '” the stock will rally. The more relief, the more Telstra will rally. And if their execution works, I'll wager the stock will be bid to $5–6 before you can lift the phone to tell your broker to buy back all those shares that were sold at $4.

Five years ago consensus viewed Telstra as a growth stock. It wasn’t. Back then it traded on a price/earnings (p/e) multiple of 25–30 times (dot com values). Its since lost its growth mantle and now trades on a p/e about half that. In industry parlance, Telstra is now a value stock. I'm willing to bet that in another five years, Telstra will emerge from its current malaise, newly re-equipped (after its capital expenditure), with a more benign regulatory environment and again dominating the telco landscape. And at that point I wouldn’t be surprised to see it re-rated as a growth stock.

In the short term it may well continue to struggle. As discussed above, a lot of uncertainty needs to be cleared up and that might take a year, perhaps more. But if I'm right, Telstra could give a capital return of 50–100% over the next five years (ie, 9–15% pa compound capital return) plus a fully franked yield of 6.5%. And that’s certainly not a consensus view.