In 2003 Swedish entrepreneurs Niklas Zennström and Janus Friis had a problem. KaZaA, their peer-to-peer music sharing program, was the most downloaded free software ever but was attracting lawsuits by the truckload. For some odd reason the music industry didn’t much take to the idea of free music sharing.
So the Swedes adapted it to create a voice-sharing program called Skype. That upset a few people too but they couldn’t do much about it. Almost overnight, incumbent telcos lost their monopolies on voice calls and the marginal cost of calls plummeted.
The writing was on the wall. The value in traditional telecommunications networks was dying and big telcos have been scrambling to get higher up the food chain ever since.
Since 2003, Telstra’s fixed voice call revenues have halved, although offset to some extent by an increase in retail broadband internet services. Still, fixed revenues now account for just 29% of Telstra’s total revenue, a decline that is likely to increase as the NBN rolls out.
In response, Telstra’s areas of growth are all closer to the consumer and higher up the value chain, in areas like media (Foxtel), software (including ‘network applications and services’, or NAS), network access and – last but not least – mobile.
IP Access revenues have 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).
Still, this is a business under threat as more companies are linked to the network by competitors’ fibre, including the NBN.
The greater prize is the opportunity to sell these businesses software products and here Telstra is doing okay. Whilst more than 20% annual growth is expected for the next few years, compared to big IT consultants like IBM and Accenture, it’s hard to see how that rate can be maintained.
Which brings us back to mobiles, the major driver of Telstra’s recent performance. 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%.
With about 16m mobile ‘services in operation’ (SIOs) at 31 Dec 2013, Telstra 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 delivers a better network and can spread its marketing costs across a bigger base, enabling it to increase market share and earn higher margins. That’s no mean feat.
But as good as this business is, there are two major problems with it. First, it’s extremely capital intensive. In 2013 Telstra spent $1.2bn on its mobile network and similar amount is expected for 2014.
Second, growth options are limited. Australia already has 36% more mobile phones than people. If growth is to occur it will have to come from further market share increases, higher average revenue per user (ARPU) or lower costs.
That might be a struggle. ARPU has actually fallen from $50 to $44 over the past five years and with a market share over 50%, the regulator may take a keen interest if that figure increases too much.
Overall, over the long term it’s hard to see growth of more than mid-single digits from Telstra’s mobile business, a figure that probably also applies to the whole business. And there are significant risks due to the possibility of regulatory intervention.
Against this, the forecast price-earnings ratio of 17 looks pretty steep. The much-vaunted dividend 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.
We’d 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).
Telstra has become a good, stable, utility-like business but it’s trading at a price that suggests it will grow a fair bit faster than it probably can.