Telstra climbs the food chain

In 2003 Swedish entrepreneurs Niklas Zennström and Janus Friis had a problem. Their peer-to-peer music sharing program KaZaA was the most downloaded free software ever, with over 230m downloads, but it was attracting lawsuits left, right and centre because it turned out that the music industry didn’t think much of free music sharing.

They wondered what else could be shared, without upsetting anyone, and they settled on voice. So they adapted their software to create a voice-sharing program which they launched later that year. They originally thought of calling it Sky Peer-to-Peer, but that can't have been for long because they obviously liked a snappy name, and in the end they settled on Skype.

Of course Skype has upset a few people, but they’ve not been able to do much about it. Overnight, incumbent telcos around the world lost their monopolies on voice calls and the marginal cost of calls has plummeted.

The internet lends itself very well to peer-to-peer networks. Indeed, that’s specifically how its precursor ARPANET was designed back in the 1960s, so that its military computers could still exchange data even if large portions of the network failed (perhaps due to nuclear attack). Nowadays, we use this distributed network to share music, news, video, scientific research – and of course to talk. There’s little need for anyone to sit in the middle of it all, other than to maintain those physical links. The network owners don’t add a great deal of value.

The value is instead created in the software on users’ machines, in the content they can create and display with it, and in the way those machines gain access to the network. So big telcos have been scrambling to get higher up the food chain, closer to the consumer that ultimately pays the bills, and Telstra is no exception.

NBN shambles

So far, Telstra has weathered the storm better than many of its global peers, mainly thanks to a relatively benign regulatory environment. Whilst political blundering is no doubt partly to blame for this, Australia suffers from two major problems where telecoms infrastructure is concerned.

The first is that it’s a very big country, with an even bigger disparity between the population density of its metropolitan and regional areas. This means that the former must subsidise the latter’s telecommunications infrastructure.

The second problem is that we have a short political cycle. The Abbott government has spent almost a year reviewing the NBN shambles and now has barely two years to do anything about it before it faces the electorate again; but we’ve been here before.

Whatever happens with the NBN, however, the fixed network is no longer the main game. Since 2003, Telstra’s fixed voice call revenues have halved and now represent just 17% of revenue, compared to 40% in 2003. This has been offset to some extent by an increase in retail broadband internet services but, even including those, fixed revenues now account for just 29% of Telstra’s total, down from 45%.

The slide is likely to accelerate as the NBN ramps up and, while the Coalition Government has said it will match the deal offered to Telstra by Labour (which included $11bn worth of payments in return for access to and/or ownership of Telstra infrastructure), after such a tough budget it won’t want to be seen to be giving much away.

Getting closer to the customer

Telstra’s strategy now is to ‘drive value from the core’ (ie make the most of what’s left of its quasi-monopolies) to ‘build new growth businesses’. The targeted areas for growth are all closer to the consumer, in areas such as media (eg Foxtel), software (including ‘network applications and services’, or NAS, for things like security, data centres, mobility and teleconferencing) and accessing the network, through the premium ‘IP access’ solutions provided to business and – last but definitely not least – mobile. Management has also highlighted the possibility of making acquisitions in Asia, although late last year it chose to sell its Hong Kong-based mobile business CSL for about $2bn.

IP Access revenues have certainly been growing strongly, more than doubling in the five years to June 2013, to $1.1bn (4% of the group total), more than offsetting a 20% fall in ISDN revenues to $777m (3% of the group total).

In all, Data and IP Access revenues have managed a 20% rise over the period, although there was a small decline in 2012 and 2013. Over the long term, however, these revenues are under threat as businesses are increasingly linked to the network by fibre owned by competitors, including the NBN.

The greater prize from new access technologies is that they give Telstra the opportunity to sell businesses its software products. Almost half of Telstra’s IP Access customers also have an NAS product, helping revenues from that division to grow by about 50% over the past five years, with an accelerating trend: in 2013 they added 18% and more than 20% annual growth is expected for the next couple of years.

The trouble is that as the network and fixed access become more commoditised, it’s hard to see what Telstra brings to the table in terms of application services, compared to the big IT consultants like IBM and Accenture, and even their smaller local rivals, such as SMS Management & Technology and DWS.

This is an area that’s been highlighted for the possibility of acquisitions in Asia, but it’s even harder to see how Telstra could add much value overseas and we’d be nervous of any moves in this area. Over the long term, then, it will get harder to ‘drive value from the core’ in NAS and we’d expect its growth to moderate.

Mobile extends its lead

The greatest revelation for Telstra over the past few years has been its mobile business, which has been the major driver of better than expected results and of the share price. In the five years to 2013, mobile revenues increased by 47% (8% a year), while earnings before interest, tax, depreciation and amortisation rose 86% (13% a year) as the EBITDA margin expanded from 30% to 38%.

The performance reflects the economies of scale Telstra has in this business. With about 16m mobile ‘services in operation’ (SIOs) at 31 Dec 2013, it had 52% of the market compared to 31% for Optus and 17% for Vodafone Hutchison Australia (VHA).

By spreading its infrastructure investment over more customers, Telstra is able to provide a better network and, by spreading its marketing costs, it’s been able to get this message across very effectively. This has enabled it to increase its market share while at the same time earning higher margins than the competition.

It’s hard to make margin comparisons because Singapore Telecommunications doesn’t split out Optus’s mobile EBITDA margin, but it’s probably not far from Optus’s overall EBITDA margin of 30%. VHA meanwhile remains a mess, with its EBITDA margin rising from zero to around 15% in the year to March 2014, but that was at the expense of losing about 10% of its customer base and it was still making a loss after accounting for depreciation and amortisation.

SingTel and Vodafone are no minnows, though, and they can each bring economies to bear from technology and systems in their global operations where they each have many more customers than Telstra.

Major problems

There are two major problems with the mobile business. The first is that it is extremely capital intensive. In 2013, for example, Telstra spent $1.2bn on its mobile network and similar amount is expected for 2014. This may be somewhat higher than average, but on top of it you have to allow for spectrum licences, which we’d expect to average about $100m-300m a year. All up, you probably have to knock about a third off the division’s EBITDA, of $3.5bn in 2013, to arrive at a figure for underlying operating profit.

The other problem is that with the total number of mobile SIOs in Australia already running at about 36% more than the total population, growth will likely have to come from further market share increases, higher average revenue per user (ARPU) or lower costs.

With Telstra’s mobile market share over 50%, the regulator will no doubt want to keep it from growing too much further, and people are already showing great resistance to paying much more for their phones; indeed ARPU has actually fallen from $50 to $44 over the past five years, helped along by an increasing proportion of data plans for iPads and the like – a trend that will continue. Overall it’s hard to see growth of more than the mid-single digits from Telstra’s mobile business over the long term.

More to lose than to gain

We expect something similar from Foxtel, although with the proviso that it’s much more risky, as we’ve mentioned in previous reviews of co-owner News Corp (see Old Murdoch, new News on 25 Jul 13 (Speculative Buy – $17.00)).

We also wouldn’t be surprised to see Telstra using its vast customer base to enter new areas, such as insurance or electricity retailing. But other than the customers it’s hard to see what Telstra could add in these areas, so it’s likely to just be a reseller for someone else’s offering and any efforts in this area are likely to be small in relation to the overall group.

Putting it all together, we’d expect Telstra to provide long-term earnings growth in the low to mid single digits but, while it’s hard to imagine much more than this, there are significant risks due to the possibility of regulatory intervention.

Against this, the forecast price-earnings ratio of 17, based the consensus estimate for 2014 earnings per share of 32 cents, looks pretty steep. The much-vaunted dividend has resumed growth and will probably come in at 29 cents for 2014, giving the stock a fully franked yield of 5.3% on top of its growth, but that’s scant consolation for the risks.

We’d much prefer to pay a little more for stocks like ASX (PER of 18), Woolworths (PER of 19) or Perpetual (PER of 19), or – in the telecoms space – quite a bit less for M2 Group (PER of 12).

However, with the stock up 5% since Telstra: Interim result 2014 on 13 Feb 14 (Hold – $5.16), we’ll settle for nudging up our fundamental risk rating to medium and our share price risk rating to medium high, trimming our recommended maximum portfolio weighting from 8% to 7% and warning that we’re nearer to our $6 Sell price than to our $4.25 Buy price. HOLD.

Note: Our model Growth and Income portfolios hold shares in ASX, M2 Group, Perpetual and Woolworths. The Growth Portfolio also holds News Corp.