Telstra: Interim result 2016

With all the technobabble and accounting contortions, it's probably too much to expect excitement and intrigue from Telstra's results, but even by its standards its latest interim result was a dull affair.

For all its complexity, Telstra's profits were again anchored by its dominant mobile and fixed data divisions, which together account for 60% of revenue and about three-quarters of profit. That dominance could become a problem because it is clear that both businesses are slowing. Before we discuss the detail, though, let's peruse the whole.

The further down the income statement you go, the more sedate the results become. Total revenue rose 9% to $14bn, although lower margins hit earnings before interest and tax, which rose 1% to $3.4bn, while net profit was steady at $2.1bn.

These are large numbers which look even better when you consider that Telstra generates return on equity (ROE) of 30% and, adjusted for debt, boasts returns on capital of over 15%. On the numbers at least, this is a decent business generating better than decent returns.

Despite spending 15% of revenue on capital expenditure, the company still declared an interim dividend of 15.5 cents per share and currently yields a tempting 6%. Ordinarily, this would raise eyebrows.

A payout ratio of 90% and enormous capital expenditure usually suggest something will give but, with the company earning generous annual payments from the NBN transition, it can afford to invest heavily and pay dividends for now.

Hi margin

The engine of the business for many years has been mobile which alone generates about 40% of operating profit and boasts a 50% market share. User numbers climbed 3% to over 16m and average revenue per user remains an industry leading $69 per month. Although the operating margin is now falling – it fell one percentage point over the period – it remains outrageously high at 39%.

Telstra's margins still dwarf international peers such as China Mobile, Vodafone and Singtel and it generates ROE twice as high as the two Asian competitors and three times as much as Vodafone.

As we argued in Three sources of competitive advantage, outsized margins can signal either a competitive advantage or a prize to lose. Telstra has grown its mobile division by increasing both volumes and prices, a combination that, in a competitive market, should not persist over time. So here is the question: is the mobile market competitive?

We would argue it hasn't been for years but will be increasingly so in the future. Telstra has been blessed with competitors who have been either incompetent (yes I'm looking at you, Vodafone) or ineffective. Optus appears to have generated about zero subscriber growth for years if you exclude its third-party network sales.

That may be changing. Vodafone has been recapitalised by an embarrassed parent while Optus has become far more aggressive, winning market share recently. Perhaps the fiercest competitor in the industry, TPG, already the second-largest fixed line supplier, is contemplating a move into mobile.

Those terrific mobile margins are under threat and are likely to be squeezed in future. So how might Telstra make it up?

Filling the gap

Surely not from fixed broadband which will face lower margins in an NBN world. The other business lines – data, Network Application Services, Foxtel and media are too small to make a difference although we do note the excellent potential of Autohome, the Chinese car portal.

That suggests that the cash flows made today must be reinvested in riskier ventures. No longer will Telstra be a high-earning utility, it will have to contest new markets where all the advantages conferred upon it at home – market share dominance, recognition, scale – will count for nothing.

A taste of this new world is the Philippines, where Telstra will team up with a local conglomerate to build a mobile network to compete with powerful incumbents. It may sound ambitious but this is a decent idea. The market in The Philippines is a high-earning duopoly ripe for disruption and Telstra has structured the investment intelligently.

Can Telstra, the local behemoth, really be the disruptor elsewhere? We don't know but we don't want investment success to hinge on the answer.

On almost any metric today, Telstra appears reasonably priced. It trades on a price-earnings ratio of 15 and an enterprise value to earnings before interest, tax, depreciation and amortisation multiple of 8. The balance sheet is fine and the recent track record is outstanding, but that is a view of the past.

What matters for investors today is the future and, while we claim no crystal ball, more competition and lower margins are likely to be a feature of that world and the share price doesn't appear to take due account of it. There is a decent case to sell Telstra but NBN payments probably make the yield sustainable for now. We're chopping our Buy price from $5 to $4.50 and our Sell price from $7 to $6, but will stick with HOLD.