Value investor: Telstra shares are looking toppy

This popular investment looks fully priced and investors may also face slow dividend growth.

Welcome to the first weekly article for Business Spectator by StocksInValue. We aim to bring you equities research and insights with a refreshing, sceptical take on perceived certainty in the sharemarket.

Telstra Corp Ltd is one of the most widely held stocks in Australia. The stock is popular – should it be?

The shares bottomed at $2.55 in November 2010 before a powerful rally to a peak of $5.15 in May this year. Investor appetite for fully-franked dividend yields greater than fixed interest alternatives, perceived as relatively secure, drove the shares higher. This is ironic given Telstra’s annual dividend has been flat at 28 cents since fiscal 2007. The stock doubled; the dividend went sideways. Another reason for the rally was market share gains in mobile, especially after the failure of Vodafone’s network. Telstra’s gold-plated mobile network is a competitive advantage.

Graph for Value investor: Telstra shares are looking toppy

Source: Bloomberg

So Telstra shares are popular for their dividend yield; additionally many analysts forecast rising dividends. This popularity has pushed the shares above our $4.26 FY14 valuation. But in the absence of a rapid acceleration of NBN payments we expect a flat 28 cent dividend next year, reflecting a view Telstra should and will opt to reduce gearing as margin pressure grows. The company is highly profitable, with a 45 per cent normalised return on equity (NROE), and cashflow-positive but also mature, heavily geared and facing margin pressure.

Shareholders own a company earning a 45 per cent NROE but paying out 90 per cent of earnings, which suggests few opportunities to reinvest to grow the business. We think the share price moderately overstates the growth potential.

There are structural challenges to the legacy fixed-line and Sensis businesses, recent growth in mobile customer numbers is unsustainable, niche competitors like Netflix present competitive risks to Telstra’s “bundling” of services, and cost savings are becoming harder to find.

We think the 28 cent dividend is safe but investors who bought the stock around current prices for a dividend above 28 cents could be disappointed. Once the cash rate and retail fixed interest rates bottom and become more competitive we would expect income investors to lose some interest and for the stock to fall to our valuation.

It also matters what Telstra does with the earnings it retains. To accelerate value growth, Telstra needs to reinvest a higher proportion of earnings at rates of profitability well above our required return, and these opportunities need to be large enough to materially increase intrinsic value. This will be difficult because Telstra’s large size requires large investments and there are few available on this scale. What does Telstra do – compete harder in mobile? Make an offshore acquisition? Buy a TV station? Scale up in network applications?

We are moderately bullish on how the NBN’s evolution will affect Telstra’s intrinsic value. Despite the unknowns with the new government we think there is upside to the NBN payments, reflecting the structure of the NBN contract which is favourable to Telstra.

Telstra faces an array of competitive opportunities and threats. How the company uses its two main assets – strong free cashflow and profitability – in response to these will determine shareholder returns.

StocksInValue indicates which ASX-listed companies are cheap or expensive, poor-quality or investment grade, and also covers the behavioural aspects of value investing and explores the mind of the market for each stock and investment theme reviewed. Many investors find it too uncomfortable to act against the market’s prevailing mood but we will argue why you must do so to protect your capital and achieve satisfactory returns. We buy uncertainty and pessimism and sell buoyant optimism and blue sky, and think you should too.

David Walker is Head of Equities at StocksInValue, a joint venture between Clime Investment Management and the Eureka Report.  StocksInValue provides valuations and research on 400 ASX-listed companies. For a free trial please visit www.stocksinvalue.com.au or call 1300 136 225.

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