The headline numbers deceived. Net profit growth of 35%, earnings per share growth of 37% and a buyback of $1.5bn all gave the impression of a growing, stable business (see Table 1) but that impression isn’t quite right.
The numbers were flattered by the sale of the Autohome business, which generated a profit of $1.8bn.
Without that sale, Telstra’s performance wasn’t as riveting with EBITDA up just 2% and revenue less than 2% higher. In its key divisions – mobile and broadband – operating profit was slightly negative or flat, depending on how you measure it. No, this was a result that displayed weakness rather than strength.
Margins are vulnerable
More capex announced
Telstra may not have much growth but it does have plenty of cash and it isn’t shy about spending it.
Operating cash flow of $7bn (we had to adjust operating cash flow line for interest charges which Telstra doesn’t include) was enough to cover capital expenditure of $4.4bn, but generous dividends and a $1.5bn buyback requires proceeds from Autohome and continuing payments from NBN.
The NBN deal, celebrated at the time of its announcement, will ultimately cost the business between $2–3bn per year in EBITDA, cash that will be hard to replace. Telstra is, slowly, shrinking.
Mobiles and margins
The pinch isn’t just from the NBN; it is also evident in the mobile business. Although customer growth was strong – Telstra added 560,000 new customers to its network – revenue actually fell.
How can that be?
|Year to June||2016||2015|| /(–)
There are two reasons. Firstly, the average revenue per user fell about 1% to (a still astonishing) $68.40 a month, the highest in the market. More important was the impact of competition.
To maintain subscribers, Telstra is being forced to offer more inclusions, particularly higher data limits across all plans. It has also joined the rest of the industry in introducing fixed charges for additional data.
At a stroke, this has eliminated hundreds of millions of dollars the business once earned from charging customers usurious penalty rates for exceeding data caps. That profit will not return. This highlights Telstra’s plight and illustrates why we are negative on the stock.
Telstra added half a million customer accounts but, because the market is more competitive, it still made less money. There is no clearer proof that the mobile business has been overearning for years and returns are now falling.
EBITDA margins of 42% offer plenty of room for returns to slide further. Internationally, these margins are unmatched outside monopoly providers. Telstra looks a lot like Woolworths did in its heyday: greedy and vulnerable.
With mobile generating 40% of all revenue and a similar proportion of profit, falling returns is a problem that isn’t easy to fix. Management’s solution is to pour billions of dollars into the division. Over the past few years, Telstra has spent an average of 15% of revenue on capital expenditure. That sum will now climb to 18% for at least the next three years to defend declining margins.
If cash were pouring into the fast growing parts of the business, we would be more comfortable that the spending would ultimately lead to higher earnings. Instead, capex is being used as a competitive weapon to shore up margins that are too high and, in our view, bound to fall.
Not all of Telstra is stagnant. There are parts of the business that are growing rapidly. The network application business, for example, has performed splendidly but it generates less than 2% of profit. Despite efforts at diversification, Telstra remains a mobile and broadband business. Any change to than mix will involve a large risky acquisition.
Which brings us back to our longstanding dilemma. For most investors, Telstra is a sell.
Revenue and profits from key divisions is falling without remedy and more money is being ploughed into maintaining returns we think are unsustainable. There is a chance the business can buy a terrific asset to replace lost earnings but this is a risk as much as it is an opportunity.
Yet even with those problems, this is a powerful cash generator yielding 5.6%, fully franked. Telstra’s payout ratio, at 98%, is already maxed out and, after NBN payments cease in 3–4 years, dividends will fall unless growth can generate additional cash flows.
We don’t recommend chasing yields but this one, for the next few years at least, is large and sustainable. And it’s better than just about any other blue chip yield available right now. For that reason alone, Telstra earns a tentative HOLD.