Telstra: Interim result 2014

Telstra’s steady progress continues. Australia’s widest owned business reported a 4% rise in revenue to $12.6bn for the six months ended 31 December. Earnings before interest, tax, depreciation and amortisation (EBITDA) rose 8% to $5.3bn – testimony to the leaner business Telstra has become.

Earnings per share were 13.7 cents and an interim dividend of 14.5 cents was declared (fully franked, ex date 24 February), up from 14.0 cents and the first time the dividend has been increased in nearly a decade.

It’s welcome progress but we’d caution against excessive optimism: the increased dividend outstripped free cash flow, Telstra still faces significant capital spending requirements to maintain the dominance of its networks, and there remains uncertainty about the new NBN agreement.

Headline results only tell you so much about a multi-divisional business such as Telstra (or 21st Century Fox and Village Roadshow). Let’s unwind the result.

Telstra’s mobile division – its largest and most important – reported a 6% rise in revenue to $4.9bn thanks to 739,000 new connections. Switching customers to faster 4G connections also helped, where average usage tends to be higher. Overall, revenue per user was flat at $58.81, reversing a previously downward trend.

Elsewhere, the company's traditional fixed-line business – home phones and internet connections – saw revenue fall 1% to $3.6bn. This comprised a slower than expected decline in traditional fixed line telephone services, where revenue fell 7% to $2,059m, and 8% growth in fixed data to $928m. Still, with fixed-line telephone margins 50% higher than data connections, divisional profit fell.

Network and application services (NAS) continues to grow swiftly with revenue rising 29% to $821m for the half as more customers – principally businesses – buy its managed services.

The Data and IP division, however, reported a 3% dip in revenue to $1.5bn as growth in its newer IP based data products failed to offset the declines in traditional ISDN services. This division continues to lose incremental growth to newer nimble competitors such as Amcom Telecommunications, Vocus Communications and TPG Telecom.

Telstra’s media business also remains in decline with revenue falling 2% to $492m. This division includes Sensis and Trading Post – both in terminal decline. Fortunately, most of Sensis has recently been sold for $454m, and we’re sure Trading Post wouldn’t be too far behind if Telstra could find a buyer. The company's 50% investment in Foxtel continues to show improved performance with revenue rising 5% to $348m.

Finally, the international business had another strong half with revenue rising 28% to $1,083m. Divisional revenue will fall in future periods following the recent US$2.43bn sale of CSL – a Hong Kong based mobile provider which makes up two-thirds of the international business.

Payments from the current NBN agreement equaled $292m this half, below our earlier estimates due to the delayed roll out of the network. A new NBN agreement is pending, which at worst will deliver shareholders the same $11bn agreed in the pervious deal (see Telstra’s NBN guarantee from 04 Dec 13 (Hold – $5.04)).

What spare capital?

Management made much of the ‘spare $1.8bn’ of cash thanks to recent asset sales, with many encouraging Telstra to conduct a share buyback. We disagree. Indeed, rather than a capital surplus we spy a shortfall. Dividends currently absorb all free cash flow, which means additional expansion or acquisitions must be funded by debt.

A more prudent move would have been to leave the dividend unchanged and retain the cash for investment in the upcoming spectrum auction – the right to broadcast its mobile signals – or potential acquisition opportunities as they arise.

As we’ve highlighted for the past few years (see Telstra Pt I: Five major challenges from 30 May 12 (Hold – $3.54)) Telstra has to reinvent its business just to stand still – let alone grow.

Still, it’s extremely well place to do so: endowed with well-known brands, the largest retail store network and the best network infrastructure. Management is doing a fine job harnessing these advantages.

We’re also comforted by management's sensible approach to growth. They’ve shunned buying overseas mobile assets on valuation grounds, favouring capital-light partnerships and service-focused business such as recently listed Autohome (China’s Carsales.com).

Five years in to Thodey’s tenure and we couldn’t be happier. Just don’t be duped into thinking everything is going as perfectly as he might make out. Growth from here will still be tough and anything in line with the economy will be a great result for a giant business that already dominates the markets it’s in.

Telstra’s share price has risen 2% since 04 Dec 13 and, with a forecast dividend yield of 5.6%, it's a comfortable HOLD.