Telstra: Interim result 2017

Is this a utility or a tech business? Telstra has long struggled with its dual identity but this result highlighted that it remains both, in an unflattering combination: it retains the sluggish growth of a utility but combines it with all the change and uncertainty of a tech business.

Everyone knows the NBN will cut into broadband margins. Until now, Telstra has owned all its infrastructure and earned stunning margins because of that ownership.

It has also been able claim superior network quality in fixed broadband. That will all change when NBN provides standard fibre used by all competitors and Telstra moves from being an asset owner to a reseller. Margins will fall.

That fact, as well as the loss of billions in annual earnings before interest, tax, depreciation and amortisation (EBITDA) from the closure of the shrinking but still lucrative copper wire business, has largely been responsible for the negativity surrounding Telstra and a large chunk of its share price decline.

Strong market share

Yet the migration to NBN is progressing well. Telstra's market share from NBN services remains high at 51% as it added 290,000 new connections – despite charging higher prices for the use of the same infrastructure.

Customer inertia is, so far, proving to be more powerful than competition.

Telstra is also being compensated for the loss of its copper network and will receive about $11bn in payments over the next few years. The company will also receive about $1bn a year for over 30 years from NBN Co for access to equipment like ducts and exchanges.

Telstra must maintain these assets, of course, but this will be a valuable annuity stream that, amid all the talk of decline, gets neglected.

Mobile decline

Despite gaining 200,000 new subscribers, mobile EBITDA fell 3% to $2bn for the half-year. Average revenue per user (ARPU) fell slightly but remains far above peers at over $67 per user per month.  

Competition is intensifying in the mobile business. Higher inclusions, more churn and lower penalty fees are all hurting but Telstra maintains market dominance and, at 41%, some of the highest EBITDA margins in the world. Those margins have held steady despite aggressive competition.

Telstra is spending madly to upgrade its network and maintain margins. Capital expenditure rose to $2.1bn or 16% of sales and the business will commit about 18% of revenues to capital expenditure next year as it seeks to develop new 5G technology.

It is hard to say whether this is an aggressive use of cash to entrench dominance or a deeply defensive strategy that recognises waning strength.

Away from mobiles, both the fixed line and data business reported lower EBITDA but Network Applications and Services (NAS, which is a collection of cloud services) again grew swiftly, increasing EBITDA by 330% to $117m.

It is notable that NAS profit growth came from a mere 18% jump in revenues. That suggests the business is highly scalable but also the focus on EBITDA exaggerates growth.

Unsurprisingly, Telstra is optimistic that growth in NAS as well as investments in new healthy technologies and media will offset declines elsewhere in the business. In our view, Telstra is better thought of as a stagnating business than a growing one.

Follow the cash

The combination of flat revenue, high dividends and high capital expenditure might raise an eyebrow.

Operating cash flow of $3.2bn is used primarily to fund capital expenditure of $2.2bn. The remaining $1bn of free cash flow isn't enough to cover the generous dividend of $1.9bn. Telstra borrowed almost $1bn to maintain its dividend, increasing net debt by 5%.

Net debt appears high at $14.8bn but Telstra generates plenty of cash and can handle some debt. Interest coverage, a measure of debt-servicing stress, sits at a comfortable 14 times.

Is the dividend sustainable? For at least the next two years, probably. Payments from NBN are lumpier than expected and are tied to NBN completions but they should be enough to meet the cash shortfall. In our view, however, dividends should be cut and the cash should be reinvested.

We've been critical of Telstra in the recent past even as its share price has soared. A dismal view has now become consensus and expectations have lowered considerably.   

It is possible the negativity has gone too far. Despite intense competition and unfavourable regulatory rulings, the mobile business is performing well and the NBN business has been strong. This result wasn't as bad as it appeared.

The stock's price-earnings multiple of 16 doesn't appear particularly cheap, but depreciation has risen to reflect higher capital expenditures and recent acquisitions. An EV/EBITDA multiple of less than 8 suggests Telstra is fairly priced, but some way from a level at which we'd be interested in buying. We'd cutting our Buy price down to $4 and our Sell price to $5.50. HOLD.