The great American activist investor Carl Icahn believes Apple is worth $US1trillion dollars. With a current market cap of $US744 billion and forward P/E of 14.9 times, it’s hard to argue with Mr Icahn’s view that APPL.NAS could rise another 34% and become the world’s first trillion market cap company. For the record, Mr Icahn’s listed vehicle, Icahn Enterprises, would be a top-20 stock in Australia.
One of the key reasons I have been bullish on telecommunications stocks for the last few years is what I call “the Apple effect”. Smartphones are driving “mobile data addiction” (MDA), which, in turn, is driving revenue growth for telcos with reliable 4G networks. It makes complete sense that the correlation below Apple and Telstra (TLS) is as strong as evidenced in the chart below.
Apple vs. Telstra: Applestra
Crunching the numbers
There was clear evidence of “the Apple effect” in Telstra’s (TLS) record first-half FY15 earnings reported last week. What we can all observe in our daily life (1 million Australians now have two mobile devices) did translate to mobile driven earnings growth for Australia’s dominant telecommunications company. To me, this is clear confirmation of our thesis on Telstra actually being a “growth bond”.
Telstra’s managing director David Thodey, who has done a terrific job running the company, made a few comments earlier this week that were very similar to what I think are the genuine structural growth drivers of TLS earnings.
To quote Thodey directly:
Telstra stands to benefit from our customers’ love affair with high-tech gadgets.
We’ve got a long way to go in the mobile industry in terms of connectivity.
The use of tablets, the connectivity to machines, the opportunity to replace every PC, or augment every PC with a mobile device, you know cars will be connected etc.
Demand for mobile data was growing rapidly across industries as diverse as agriculture, mining and education.
It’s a fundamental change in the way we behave.
We really just touched the top millimetre here.
I couldn’t agree more with those comments, as I can see them in my own and my peer group’s commercial behaviour. This is the start of a major structural change and to my way of thinking, telecommunications companies are the “railroads” of the next century.
An essential service
I’ve written before that the Australian economy simply can’t open for business each day without Telstra’s networks, and as each day passes, that becomes a more and more accurate statement.
Telstra should command the P/E of a monopoly critical infrastructure stock, such as Sydney Airport (SYD) or Transurban (TCL), and that’s where I think Telstra’s P/E is headed, as investors bid down its highly reliable fully franked (and growing) dividend yield.
Let’s now look at some slides from the Telstra interim results pack.
Mobile revenues grew 9.6% in the half and mobile is now 42% of Telstra’s revenue mix. The EBITDA margins on mobile remain a very healthy 40%.
Mobile revenue growth drove EBITDA 0.5% in the half, but as has been the recent trend in Telstra, analysts again underestimated the translation to strong NPAT and EPS growth in the half. NPAT rose 21.7%, EPS rose 23.4c, and the interim dividend was lifted from 14.5c to 15c fully franked. ROE rose from 26.8% to 30.7%, while ROIC rose from 15.2% to 16.4%. Gearing dropped from 51.4% to 49%. Capex dropped 4.7%.
Telstra has been my single best large cap total return idea of the last five years. Ever since the note “Telstra, a gift from the Nation” when the Future Fund was dumping Telstra at $2.70, Telstra has been a high-conviction buy. Only for a very short period last year I downgraded Telstra to neutral at $5.75 then upgraded it again back to buy @$5.25 shortly after. The first note I wrote in 2015 was upgrading my Telstra price target from $6.45 to $7.00 when Telstra was $6.07.
Even though TLS has served me and readers of these notes very, very well, in all the time I have recommended Telstra, I have never seen the top down and bottom up drivers of growth being so strong, combined with macro factors, such as cash rates driving demand for stocks’ income attributes. The natural contrarian in me gets a little concerned by that, but this is a classic example of letting a winner run and that is exactly what I intend to do with Telstra.
Ticking all the boxes
The industry has structural growth, the company is superbly positioned to capture a disproportionate percentage of that growth, the brand is getting stronger daily, and the company’s products have effectively become an essential service.
If I then look at what Australian long bond yields are telling me about the medium-term interest rate and growth outlook in Australia. I see further growth in demand for large cap stocks that have Telstra’s attributes. All the macro and micro ingredients are in place and this cake (share price) will rise.
Interestingly, and one of the key reasons I am staying with Telstra, is the consensus analyst view remains sceptical. This has been the case the entire way up from $2.70 with analyst forecasts chasing the share price higher. Currently the buy/hold/sell ratio on Telstra is 5/12/4 and the median 12-month price target is $5.92. Good luck with that.
The chart below confirms Telstra analysts (yellow line) have been chasing the share price (white line) for the last two years. Their scepticism is again evident in this week’s broker research on Telstra.
Below is Telstra’s FY15 consensus EPS forecast versus the share price over the last six months. Telstra is in a structural earnings upgrade cycle. Note well the analysts only change their “forecasts” after results. I call that “back-casting”.
Sixteen of 21 Telstra analysts are “neutral” or “negative” but this is the EPS growth they forecast for the next four years.
My forecasts for FY15 for Telstra remain unchanged. I expect FY15 EPS of 35c and FY15 DPS’s of 32c. That implies a 17c fully franked final dividend on top of the 15-cent interim.
The future still looks good
With Telstra cum the interim 15 cents fully-franked today and prospectively paying another 17 cents fully-franked in September, the seven-month yield is 4.96% fully-franked, assuming my final dividend forecast proves correct. 7.08% grossed up for seven months is highly attractive versus cash at 2.25%.
In my first note on TLS this year I said: “There is simply no way that Telstra will continue to yield “grossed up” more than 3.5 times the equivalent 3-year government bond rate, or potentially more than three times the future RBA cash rate. Telstra yield will be bid down and inversely capital growth will be solid”.
Since I wrote that note, the RBA has cut cash rates to 2.25% and the interest rate futures market, post Tuesday’s sloppy employment data, is pricing in a 60% chance of another 25 basis point rate cut in March and a 90% chance of a second 25 basis point rate cut in April. Australian 3-year government bond yields have dropped from 2.16% to 1.87% since early January.
It think it’s very fair to assume the RBA cash rate will be 2.00% and the Australian Government Bond 3-year yield remain will below 2.00% for 2015. Both may well ended up even lower.
On that basis I am going to set a Telstra 12- to 18-month share price target based off a pre-tax yield three times the cash and fixed interest alternative. I am setting a grossed up yield target of 6.00%.
The result is, for the second time this year I AM UPGRADING MY MEDIUM TERM Telstra PRICE TARGET.
Taking into account the interim result and movements in interest rates I am upgrading my TLS price target from $7.00 to…$7.50.
Telstra remains a core high-conviction buy and core portfolio overweight.
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