25% further downside for Telstra?

Andrew Lewandowski

Telstra has been a core portfolio holding for many investors after being privatised at $3.30 per share in 1997. Today, the stock is trading at $2.73, well below its initial public offering price 21 years ago.

The difficult performance of Telstra since listing is because its dominant market position has gradually been eroded by the natural forces of competition and technological change.

In this wire, we highlight the risks around Telstra’s earnings and dividend from a further decay in Telstra’s core business of mobile phone subscriptions.

Our research suggests investors should be prepared for lower future earnings from Telstra - and a substantial cut in the dividend.

The market does not appreciate the decline in Telstra’s mobile earnings

The impact of the NBN on Telstra’s profitability is well understood as data moves from Telstra’s copper wires to the government’s fibre optic network.

What is less appreciated is the decline in Telstra’s mobile earnings now underway (mobile earnings represent 50% of TLS’ operating profit). Perhaps this is not surprising, as even Telstra has been late to acknowledge the deterioration in mobile profitability. Telstra were still targeting mobile earnings growth as recently as May 2018.

Background: The mobile phone industry

Telstra has dominant market share in Australia’s mobile sector, with almost 50% of post-paid mobile accounts, and circa 60% of mobile industry profits (EBITDA). Optus is the other major player with a 30% market share, with Vodafone at 20%.

Telstra’s mobile pricing is too high

Telstra’s mobile pricing is now 30% above Optus. We believe the combination of Telstra’s dominant market share and materially higher mobile prices have left Telstra vulnerable to intensifying mobile competition from the existing players, as well as new entrants such as TPG Telecom (TPM).

Who is leading the charge on mobile competition?

We see Optus as the key source of competitive pressure on Telstra’s mobile business. After substantial investment in recent years, Optus is now widely regarded as having comparable mobile network quality to Telstra, which is substantiated by a recent independent study ranking Optus as Australia’s top mobile network.

Telstra mobile pricing premium to Optus has continued to rise

Optus has capitalised on its significant mobile phone price discount to drive market leading mobile customer growth over the last two years. This has caused Optus’ market share to increase by +2.1% since 2016, while Telstra’s market share has declined -1%.

Telstra competitive response is not enough

We believe intensifying competition in the face of Telstra’s high pricing premiums has created pressure for Telstra to cut mobile prices to preserve its customer base. We are starting to see this unfold, with Telstra announcing at its June Investor Day that it will release lower priced mobile plans from July 2018.

What is Optus trying to achieve by aggressively chasing market share?

Optus is the second largest mobile phone player but has a market share significantly lower than Telstra. Their best strategy is to remain aggressive on price to produce material growth in customer numbers, grow market share and leverage the significant investment they have made in improving their network quality. This appears to be what they are doing.

Our work on the US mobile industry suggests Optus could be pursuing a similar strategy to challenger network T-Mobile in the US.

In 2014, T-Mobile was the number four mobile competitor in the USA. It priced its mobile offering ~20% below its competitors. In just four years T‑Mobile delivered customer growth of 11% per annum, versus peers at just 2% per annum. T Mobile’s operating profits almost doubled over the same period.

Telstra earnings and free cash flow implications

We expect to see continued downside pressure to Telstra’s share price over the months ahead.

If we factor in Telstra cutting its mobile phone charges by 20% over the next three years, we estimate a 30% decline in core free cash flow (excl. one-offs) over this same time period. We note, our analysis incorporates Telstra’s announced cost-out plans.

This would see core free cash flow per share decline from 20 cents to 14 cents per share, and the dividend declining to circa 12 cents per share. If we assume that Telstra trades on a 6% fully franked yield then it would trade at approximately $2.00 per share, representing 25% downside from current levels.

We expect to see continued downside pressure to Telstra’s share price over the months ahead.


Comments

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Mark Marshall

Andrew, I can assure you 100%, The Optus mobile network does not provide a reliable service once you travel 100km in from the coast, and on the east coast outside of major cities, and once you are over the range; FORGET ABOUT IT. In Mackay QLD I sat in a room of a rural property (March 2018 - 15km north from town centre) and took a couple of calls from my Telstra service. The owner of the rural property took a call from his daughter (Optus Network) and had to walk 80m outside to take the call on his mobile service.

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Robert Legg

I fell for the Optus mobile lower rates with included calls and more data. Data is insufferably slow for much of the day. This in Toowoomba. Most downloads dropout before completion. At least I am in no danger of exceeding my data limit. I did sell my TLS shares, some consolation. Rob Legg Toowoomba

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Michael Whelan

Mark - Even worse, in metro-Melbourne my neighbour (Optus) has to walk to the front of their house; otherwise, the call will drop-out. Data download is hopeless, they tell me. On Telstra, I have zero problems in comparison.

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andrew mulholland

Why would Telstra trade at a 6% fully franked yield at the bottom of its earnings cycle? 4% may be more appropriate at that stage. Telstra's 5G may enable bypass of the NBN network for some customers. What are the Access arrangements NBN has with Telstra's ducts and ROW? If leased, when do these leases expire? TLS has sold its copper and HFC network but still owns connections to large business and govt customers. When ACCC declared services TLS was required to sell naked DSL round $4/line/month. Now that Govt owns NBN, resellers buy NBN access at an unsustainable $52?/line/month. Govt will have to write NBN down by at least half.

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