Executive buyback of $1.5bn all gave the

Executive Summary

 

The headline numbers deceived. Net
profit growth of 3.6%, earnings per share growth of 37.4% 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.

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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 2.6% 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. This was a result that
displayed weakness rather than strength.

Linked Data:

Ø  https://www.telstra.com.au/content/dam/tcom/about-us/investors/pdf-e/FY16-Annual-Report.pdf

 

Ø 
https://www.telstra.com.au/content/dam/tcom/about-us/investors/pdf%20D/telstra-annual-report-2015.pdf

 

 

 

Profitability

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 therefore revenue actually fell.

How
can that be?

Operating Profit Margin

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.

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 the
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.

2015-06

2016-06

Revenue AUD Mil

25,119

25,845

Gross Margin %

74.1

73.4

Operating Income AUD Mil

6,008

6,000

Operating Margin %

23.9

23.2

Net Income AUD Mil

4,275

4,231

Earnings Per Share AUD

0.34

0.34

Dividends AUD

0.28

0.36

Payout Ratio % *

102.2

79.5

Shares Mil

12,464

12,264

Book Value Per Share * USD

0.97

0.84

Operating Cash Flow AUD Mil

8,613

8,311

Cap Spending AUD Mil

-3,762

-5,102

Free Cash Flow AUD Mil

4,851

3,209

Free Cash Flow Per Share * USD

0.32

0.23

Working Capital AUD Mil

1,754

-1,159

 

Return on Equity

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 my view, bound to fall.

Balance Sheet
Items (in %)

2015-06

2016-06

Cash
& Short-Term Investments

3.47

8.34

Accounts
Receivable

11.67

10.94

Inventory

1.21

1.29

Other
Current Assets

0.88

1.00

Total Current
Assets

17.23

21.58

Net
PP

50.56

47.55

Intangibles

23.07

21.32

Other
Long-Term Assets

9.13

9.56

Total Assets

100.00

100.00

Accounts
Payable

3.11

3.38

Short-Term
Debt

3.47

5.86

Taxes
Payable

Accrued
Liabilities

Other
Short-Term Liabilities

13.52

11.98

Total Current
Liabilities

20.10

21.23

Long-Term
Debt

34.34

33.22

Other
Long-Term Liabilities

10.70

8.89

Total Liabilities

65.13

63.33

Total
Stockholders’ Equity

34.87

36.67

Total Liabilities
& Equity

100.00

100.00

 

Debt/Equity

1.00

0.92

 

 

Return on Assets

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 (I 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.

Efficiency

Asset Turnover

2015-06

2016-06

Days
Sales Outstanding

62.80

66.81

Payables
Period

64.29

68.52

Cash Conversion
Cycle

21.17

24.68

Receivables
Turnover

5.81

5.46

Fixed
Assets Turnover

1.28

1.26

Asset
Turnover

0.65

0.62

 

 

 

Debtors
have been drawn out 6.39% from 2015, therefore the payables period has increased
and cashflow is weaker in 2016.

Inventory Turnover

2015-06

2016-06

Days
Inventory

22.66

26.39

Inventory
Turnover

16.11

13.83

Considering the inclusion of 560,000 new customers in 2016, inventory
turnover has increased by 16.49% compared to 2015.

 

Liquidity and Solvency

Current Ratio

2015-06

2016-06

Current
Ratio

0.86

1.02

Quick
Ratio

0.75

0.91

Due to
the buy back and selling of assets in 2016, the current ratio has increased. Without
this income, the current ratio would be weaker as compared to 2015.

Gearing Ratio

2015-06

2016-06

Financial
Leverage

2.87

2.73

Debt/Equity

1.00

0.92

Financial
Leverage has decreased due to the payables period increasing in 2016 as compared
to 2015, therefore cashflow is weaker in 2016.

Acid Test

Telstra’s
score card is one of the best in the world among incumbent telecommunications
companies. It is also well-positioned to increase its business in the emerging
digital, sharing and networking economy. It is successfully transforming itself
into a full services ICT company.

Telstra’s
mobile network is, and will continue to be, well-positioned to offer superior
services to those offered by the NBN company. Their aggressive pursuit of 4G,
and next on the list 5G, will guarantee this. While these mobile networks will
not cater for all of the ‘big iron’ broadband services, because of the
company’s superior and most likely competitive offering, a large number of
mobile-based access services will be used in this way. The ongoing delays in
the actual availability of the NBN are also playing in Telstra’s favour.
Furthermore, through its national Wi-Fi and fibre backbone networks it can
rapidly offload any heavy broadband traffic from its mobile network onto its
fibre backbone.

Companies
covered in this synopsis:

Telstra,
Vodafone, FOXTEL, SingTel Optus, Sensis.

 

Share Market Performance

Dividend Payout ratio  

2015-06

2016-06

Dividends AUD

0.28

0.36

Payout Ratio % *

102.2

79.5

Dividend
payout ratio decreased due to NBN investments in 2016.

 

Earning Per Share

2015-06

2016-06

Earnings Per Share AUD

0.34

0.34

Earnings
per share remained steady due to the $1.8b profit on sale of Autohome shares

 

 

Conclusion

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.

Revenue
and profits from key divisions is falling without remedy and more money is
being ploughed into maintaining returns I 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.

I
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 “HOLD”. 

 

 

 

Key
Financial Data

12 month price range

$3.38 – $5.22

Market cap (m)

42,340

Total shares (m)

11,893

Franking

100%

Industry

Telecommunication Services

 

Per Share

 

Year to Jun

Earnings

Dividends

Book Value

2016

$0.35

$0.31

$1.30

2015

$0.35

$0.31

$1.15

 

Capital Structure

Total Debt

Interest

Long Term Debt

Percent Debt

Preferred Stock

Share Equity

Percent Equity

$17,284,000

$729,000

$14,808,000

50%

$0

$14,541,000

0.5%

 

Key Ratios

Year

Operating Margin (%)

Income Tax Rate (%)

Employees ($T)

Return on Capital (%)

Return on Equity (%)

Payout Ratio (%)

2016

42.4

31.6

0

16

26.8

89

2015

41.3

29.4

36

17

30

88

 

Profit & Loss

 

 

2016

2015

Revenue ($M)

 

25,834

26,061

Net Profit Before Abs ($M)

4,245

4,229

Net Profit After Abs ($M)

 

5,780

4,231

 

Cashflow

 

2016

2015

Customer Receipts ($M)

$31,163

$29,521

Net Operating Cashflow ($M)

$8,133

$8,311

Net Investing Cashflow ($M)

$-2,207

$-5,692

Net Financing Cashflow ($M)

$-3,777

$-6,882

 

Market and Earnings

 

2016

2015

Market Cap ($M)

$67,975

$75,066

Dividend Yield (%)

5.6%

5%

 

 

Balance Sheet

 

2016

2015

Cash ($M)

3,550

1,396

Total Current Assets ($M)

9,340

6,970

Total Non-Current Assets ($M)

 

33,946

33,475

Total Assets ($M)

43,286

40,445

Total Current Liabilities ($M)

9,188

8,129

Total Non-Current Liabilities
($M)

18,191

17,806

Total Liabilities ($M)

27,379

25,935

Total Shareholders Equity ($M)

15,907

14,510