Why I like Telstra

Another week in the spin cycle and to use an old line "the future of pessimism has never looked brighter". There is no doubt that the NAB and ANZ writedowns have not only undermined sentiment but have highlighted the increasing volatility and earnings uncertainty in the current investment climate. In fact the only certainty in the market is increased uncertainty.

The current environment represents a timely reminder for investors to focus on companies with defensive, transparent, long-term earnings. However, I continue to believe investors are in total capitulation mode and are overlooking emerging value in some sectors and stocks, particularly if your investment time horizon is longer than two minutes.

Short leverage and long growth.

My core domestic strategy over the past six months has focused on being "short" the financial leverage of the banks, diversified financials, property trusts and infrastructure stocks, and "long" the growth of the resources and industrials exposed to the BRIC (Brazil, Russia, India and China) urbanisation theme.

There is no doubt that the relative outperformance of the "long" growth strategy has been very successful with the long duration, cash flows and earnings transparency of the resources companies, in contrast to the significant balance sheet deterioration and earnings uncertainty of the financials. In this regard, I firmly believe the "long" growth theme will continue to outperform.

Grossed-up yield

I have always believed that the strong, fully franked dividend growth of the major banks, within the context of the tax-effective changes to super, has been a major driver of the significant re-rating of the sector’s price/earnings multiple (P/E) .However, considering the dramatic sector underperformance, it appears that the after-tax advantages of grossed-up yield is yesterday’s news for superannuants and long-term investors. We strongly disagree.

I believe investors have long associated fully franked dividends with the major banks, and considering the negative view of the sector, I think investors have begun to overlook the attractiveness of fully franked industrial dividend yield. However, in an environment where 12-month industrial earnings growth and returns have slowed to low single digits, I expect fully franked dividend yield will be the single most important driver of industrial after tax returns.

Telstra

In this regard, I continue to recommend Telstra (TLS) as both a genuine growth stock and a fully franked yield play. The strong December-half result confirmed that Telstra has real defensive, long-term earnings growth combined with a very attractive 6.4% fully franked dividend yield in an environment of diminishing industrial returns. As a result, I believe Telstra should represent a core portfolio holding.

As regular readers are aware, I have been a long-term supporter of Telstra, particularly with the low pricing and the attractive grossed-up yield of the T3 instalment receipts. In this regard, Telstra has outperformed the ASX 200 by 19% over the past 12 months. However, despite the strong outperformance and the attractiveness of a fully franked 6.4% yield and transparent earnings growth, Telstra is still cheap at multiple of 13.5 times 2008-09 earnings. I believe Telstra is undervalued relative to domestic industrials and the international peer group.

High transparency

Over the past 12 months I have consistently highlighted my belief that earnings transparency would become a key theme for domestic equities this year. I genuinely believe that a primary factor supporting the outperformance of my "long" growth and "short" leverage theme has been the long-term earnings transparency for the major resource companies.

The clear confirmation lies in the massive writedowns for ANZ and NAB, despite management stating as recently as May that the assets were adequately provisioned. The major domestic banks, with the exception of Commonwealth Bank, are facing unprecedented earnings uncertainty.

I often highlight the high earnings transparency of the resources sector, particularly the companies with long-term contracted earnings leveraged to the positive fundamentals of the bulk commodities. However, it is worth noting that Telstra has a higher proportion of earnings transparency, considering 40–50% of revenues are generated on a contractual basis.

Strong balance sheet and cash flows

One of the key aims of Telstra' five-year transformation plan is focused on an aggressive cost-cutting program aimed at generating higher returns for shareholders. The prime initiative in reducing costs is a planned 12,000 cut in employee numbers by 2010.

In this regard, the strong interim result in February provided clear confirmation of success. The December-half result revealed a 26% increase in net operating cash flow compared with the previous corresponding period. In addition, as the current transformation capital expenditure peaks and the benefits of the employee reductions start to flow, we expect the June half to show a further increase in free cash flow, followed by a significant increase next year.

Importantly, the strong cash generation continues to mitigate the threat to the dividend yield, with the 2008-09 cash flow generation expected to cover the forecast dividend of 28¢ a share. As a result, a significant negative is set to be eliminated, with 2008-09 expected to be the first year in the last three years in which Telstra will be able to fully fund the dividend through earnings instead of borrowings. I expect a higher dividend in 2009-10.

In addition, a further strong recovery in 2008-09 cash flow is expected to provide the company with the opportunity to announce a $3–3.5 billion buyback, in the event of not participating in building the fibre to the node (FTTN) broadband network. At the half-way point of five-year plan, I believe management is clearly on track to meet the forecast target of $6–7 billion in free cash flow by 2010, which at the top end of the range implies a free cash yield of 10%.

Earnings growth.

Although the cost-cutting initiatives within the five-year transformation plan are an important driver of improving shareholder returns, I also believe it is impossible for a company to shrink to greatness. There is a fine line between cutting costs and revenue destruction. In this regard, last year at the Investor Briefing, management outlined a clear strategy focused on improving top-line sales growth.

The strategic aim is to better leverage Telstra’s competitive advantage to increase revenue growth. Telstra has a clear scale advantage, driven by greater network coverage and faster speeds in both mobile and fixed-line networks. The new strategy has supported a new aggressive pricing approach utilising Telstra's monopoly industry position and superior pricing power.

The strategy has concentrated on two key issues: first, increasing retail market share by more effective customer marketing and by utilising Telstra’s pricing power in the mobile phone and broadband sectors; and, second, by capitalising on its dominant industry position as the major network provider, to "squeeze" the competition in the wholesale market. In this regard management have been very successful.

There is no doubt that the December-half result clearly highlighted the success of the strategy and confirmed the revenue and earnings recovery. The 13% increase in headline interim earnings, to $1.94 billion, surprised expectations and exceeded consensus forecasts of $1.7 billion.

However the composition of the result was equally impressive. The interim sales growth of 5.3% (guidance 2–3%), and the 6.3% EBIT growth (guidance 5–7%), easily exceeded previous guidance and vindicated management's aggressive strategy targeting improved revenue growth. In addition, the strong rebound in revenue growth was reflected across the broad spectrum, with mobile growth up 14.5%, and strong retail broadband growth of 65%.

The key to Telstra’s earnings growth is to offset the inevitable long-term decline in fixed-line revenues by improving the contribution from other revenue drivers such as mobile and broadband. There is no doubt that management achieved this aim with the impressive December-half result. As a result, Telstra is generating real earnings momentum at a time where a major proportion of industrial earnings are slowing significantly.

Inflection point

The historic Telstra investment thesis has largely focused on a fully franked yield play or a proxy for cash. However, I believe management has generated real long term earnings momentum through a strategy of delivering improved revenue growth by using scale and pricing power. This will be further enhanced with the possibility of improved returns from the fibre to the node network.

Importantly, it is worth noting in the result for the first half of 2006-07, that the fall in fixed-line revenue was $312 million, compared to broadband revenue growth of $105 million, resulting in a net revenue loss of $207 million. However, in the latest December half, the decline in fixed-line revenue was $72 million, while broadband revenue rose to $160 million, for a net revenue gain of $88 million. I believe this represents a real milestone, an important inflection point for earnings.

Although I expect a continuing decline in fixed-line rates with the inevitable migration to mobile, there is no doubt that Telstra has slowed the deterioration by generating real earnings momentum in the mobile and broadband divisions. This turnaround is a key driver of the earnings recovery. As a result, I firmly believe that an earnings growth factor can be added to the already strong fully-franked yield investment thesis.

Guidance

Considering the strong December-half result, management upgraded guidance with 2007-08 revenue growth revised upwards to 3–4% (from 2–3% previously), and EBIT growth to 6–8% (from 5–7% previously). In line with the strong earnings momentum, I believe the 2007-08 guidance is conservative. However, there is a possibility that with consumer discretionary spending slowing, management will remain conservative with 2008-09 guidance.

FTTN: last man standing?

The strong December-half result highlighted an earnings inflection point, but the Telstra sceptics remain. However, analysts are still sceptical of Fortescue, despite the obvious operational success. In the case of Fortescue, the current negative is the quality of ore; the constant criticism for Telstra is the regulatory risk of the fibre to the node network (FTTN).

Obviously there is regulatory risk with the commercial success of any venture that depends on a favourable government decision. However, I believe the FTTN regulatory risk factor has been very overplayed. I strongly believe Telstra is the only logical FTTN network builder and the government is simply not committed to structural separation of Telstra's operating divisions.

After an "exhaustive" government process, Telstra will build the network but it will be without the monopoly rents of the copper network. However, at the same time, the FTTN will significantly improve earnings and shareholder returns by adding at least 50¢ to valuations. In the unlikely situation of missing the FTTN tender, strong cash flows will provide Telstra with the opportunity of a $3–3.5 billion capital return or an improved dividend. Either way, I believe it's a win/win for Telstra shareholders.

The 2008-09 result

The full-year result for 2007-08 is expected on August 13 and in the current "glass half-empty" environment, investors react very quickly and very irrationally to any hint of uncertainty. In this regard, I expect share price volatility if the Telstra headline profit number is complicated by a one-off factor, or the outlook is clouded by a cautionary comment, or management reveals delays in the IT transformation plan. In addition, a number of analysts are currently forecasting 2007-08 EBIT growth of 9–10%, which is well above official guidance of 6–8%.

There is no doubt that Telstra has genuine long-term earnings momentum, with the first signs of the cost-cutting and revenue initiatives of the five-year transformation plan clearly evident in the strong December-half result. In addition, I believe the current long-term guidance is very conservative and that earnings and dividends remain in an upgrade cycle. However, considering the slowdown in consumer discretionary spending, management could be cautious on the outlook.

Therefore, I believe there is the possibility for a negative knee-jerk reaction if the result slightly disappoints bullish expectations. This would provide investors with a real opportunity. In this situation, I urge investors to use any irrational sell-off as an opportunity to buy aggressively as I believe Telstra is cum further upgrades to long term earnings guidance.

Strong buy.

I'm not surprised that Telstra has outperformed the ASX 200 by 19% over the past 12 months. Telstra is generating transparent, defensive, long-term earnings growth with no exposure to the uncertainty of subprime-related earnings downgrades.

In an environment of rapidly diminishing earnings growth, where average industrial returns are expected to be in the low single digits, I expect Telstra to generate a 12-month return of at least 15%. In addition, I believe Telstra remains in a strong earnings cycle and is cum further earnings and dividend upgrades as well as having strong valuation support with a 2008-09 P/E of just 13.5 times. I'm recommending Telstra as a strong buy with a 12-month target of $5.25.

Charlie Aitken, a director of Southern Cross Equities, may have interests in any of the stocks mentioned.