Calling Telstra… please hold

Financial journalist and commentator on 3AW and Sky Business
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When earlier this month Telstra surged through $5 for the first time since 2005, one particular group of its shareholders felt most vindicated.

They bought the stock back in the dog days of November 2010, amid the strained negotiations over the National Broadband Network (NBN), when Telstra languished at $2.55. Back then, Telstra was considered a no-growth company – a utility, suitable mainly as a yield generator.

Regaining its Mojo

To give the company its due, it was seen as a better-than-average yield generator, with its 28 cent-a-share dividend equating, at $2.55, to a nominal yield of 11%. For an SMSF in accumulation mode, that was equivalent to 13.3%; for an SMSF paying a pension, Telstra shares bought at that price were paying 15.7%.

It would have been a courageous purchase, given the gloomy headlines around Telstra at the time; but it is history now that Telstra struck a deal with the ALP government that earned it $11 billion (in net present value terms) in return for committing to decommission progressively its copper-based customer network services and broadband services on its HFC (hybrid fibre-coaxial) cable network, and migrate its customers onto the NBN over its expected 10-year construction period. Telstra also agreed to provide NBN Co. with access to its infrastructure, for a period of between 35 and 40 years.

Once the final deal was struck in June 2011, Telstra shares went into over-drive, and any thoughts of the company being low-growth went out the window.

Political win-win for Telstra

And last month, when the Coalition released its mini-me NBN plan, Telstra was still in the pink. While telecommunication-heads argued about the merits of the Coalition’s proposed fibre-to-the-node (FTTN) offering, versus the government’s more expansive fibre-to-the-premises (FTTP) network, if the Coalition wins the September election, Telstra will still get its $11 billion – in fact, payments would start earlier, given that the Coalition plan can be rolled out quicker.

Importantly, the Coalition proposal also allows Telstra to retain its HFC cable and compete with the NBN for Pay TV and broadband-by-cable customers.

The twin NBN deals underwrote Telstra’s future. But it had already regained its growth mojo.

The half-year result to December 2012 was pretty sound, not least for the feat of generating an 8.8% lift in net profit, to $1.5 billion, on the back of just a 1% rise in revenue, to $12.4 billion. But what really impressed the market was the 607,000 new mobile customers it signed over the six-month period, as the churn rate (the proportion of customers Telstra lost) fell to 10.3% from 13.2% a year earlier.

Telstra followed-up in early May with the news that it had added a further 600,000 4G customers to its mobile network in the first quarter of calendar 2012, bringing the total number of devices it has sold to 2.1 million since the network’s 2011 launch. Telstra said it expected to expand 4G coverage to 66% of the Australian population by June.

Telstra picked up the lion’s share of new spectrum in the recent mobile auctions. The growth in the mobile (and data) business was highlighted as the main reason why the share price hit an eight-year high. But there is another major factor at work.

Investors flock to Big T’s yield

Much of the virtual doubling in Telstra’s share price in the last two years has come from the effect of yield-hungry investors piling into the stock. Along with the big four banks, Telstra has been one of the main sources of dividend yield income, as yields from competing investments – most notably term deposits – lose their shine with falling interest rates.

With one-year term deposits having fallen from an average of 6% in mid-2011 to about 4.1% now – almost a one-third fall – income-oriented investors view the top dividend-paying stocks as a superior place to park cash.

In Telstra’s case, it was only the early (and brave) birds who picked up the fat worm of an 11% nominal yield, but investors looking for yield can still pick up 5.5% nominal – at a share price of $5.07, and the company’s expected FY13 dividend of 28 cents. That equates to 6.7% for an SMSF in accumulation mode and 7.9% for an SMSF paying a pension.

(Of course, an investor buying the stock now has missed February’s interim dividend, but they will pick up two payouts for every 12 months that they hold Telstra. It is an individual’s purchase price that governs the yield in his hands represented by the dividends he receives.)

Telstra has committed to increase its 28 cent-a-share fully franked dividend “over time.” At present it pays out more than 100% of earnings as dividend, which it can do because of the huge free cash flow it generates. That will not be a material problem until the NBN disconnection payments wind down.

Market consensus expects 28.9 cents a share in FY14. At $5.07, that prices Telstra at a prospective FY14 yield of 5.7%; from which an SMSF in accumulation mode generates 6.9%, and a pension-mode SMSF augments to 8.1%.

So Telstra is definitely still a yield stock. But what about capital gain? After all, of Telstra’s 2012 total return, 21% came from dividends, with 79% coming from capital growth.

$6? Not this time

So, is Telstra a capital gain stock – is it going to $6?

Yes, it probably is – eventually. But in the meantime, it is going to take a detour southward.

The problem is that most brokers have a target price for Telstra that is significantly lower than where it is now.

If you take UBS, BA-Merrill Lynch, Deutsche Bank, JP Morgan, CIMB Securities, Macquarie, Citi and Credit Suisse, the consensus target price is $4.30 – which is about 15% lower than where Telstra is now.

And the most excited any of them can get is Deutsche Bank’s call of ‘hold.’ The others are ‘neutral’ or ‘underperform,’ with the exception of UBS, which has downgraded the stock to ‘sell.’

The outlook for Telstra’s earnings growth is flat to low-single-digit growth over the next few years. That will not justify a share price that is 17 times earnings. Any stock that doubles as quickly as Telstra did is in danger of over-shooting appropriate valuations. Telstra has done – and the market looks poised to bring it back.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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