Telstra has a strong position, with 50 per cent share of both fixed line and mobile markets. Importantly, it also has an even more dominant position in the very profitable corporate, government and enterprise service areas. The profits from these businesses, together with its strong balance sheet, position the company well to be at the forefront of any future technological changes or business developments.
As an example, Telstra’s mobile business is very strong because its network has the highest download speeds and the best geographical coverage in Australia. This ensures it can charge a premium of around 20 per cent above Optus and Vodafone for its services.
We also believe that the long-term strategy being executed by Telstra’s strong management team is a good one. Its CEO, Andy Penn, is willing to invest in the company’s networks to maintain Telstra’s superiority. Telstra also knows it must improve its customer service, and its management team is working very hard on this, with part of their bonus calculation now linked to customer satisfaction.
Overall Telstra is a strong company and one that we are very happy to own at current prices.
Yes, Telstra has reduced next year’s dividend to a lower-than-expected 22 cents, a reduction of 30 per cent, with investor disappointment driving much of its recent share price fall.
In the last few weeks, we’ve met with CEO Andy Penn, CFO Warrick Bray and the Chairman of the Board John Mullen, to gain a better understanding of the company’s long-term strategy.
In our opinion, Telstra is still hopeful of sustaining, and eventually growing, its dividend over time. However, it also wants to be conservative and retain financial flexibility in the short term, allowing it to increase investment where required to fight off any competitive threats.
Even with this lower dividend, Telstra is still offering a 6.2 per cent fully-franked yield, certainly a very attractive proposition for investors in the current environment.
The impact of the NBN on Telstra
Telstra has traditionally provided the copper network across Australia, which all Telco companies have used to provide their fixed line services. The government-owned NBN Co is now taking over this ownership role, which effectively re-nationalises the access network.
While this change removes around $3 billion per year from Telstra’s pre-tax profit, Telstra will receive an ongoing rental income stream from NBN Co for the use of its exchanges and other infrastructure. In addition, Telstra is receiving one-off compensation payments for each customer that migrates to the NBN.
Other telcos we like
We also have a small holding in amaysim. amaysim holds about a 3 per cent share of the mobile market in Australia, operating as a reseller of the Optus network. It has phenomenal customer service, with about one sixth the complaints that other Telcos face. Best of all, because all of its customer interactions are handled online, or through an app, it has an extremely low ‘cost to serve’.
Two telcos to avoid
We have avoided both TPG and Vocus, given both earn most of their money from reselling fixed line services which, as we’ve discussed, has become a very competitive business under the NBN model. Both have suffered large share price declines, due to profit margins being squeezed right across the market.
TPG is an interesting company and its management team is very good, however we haven’t owned it because of its rich valuation, and our expectation that margins would fall as the NBN is rolled out. TPG has decided to diversify its business away from fixed line services by building mobile networks in both Singapore and Australia. Building mobile networks and acquiring the necessary spectrum is extremely expensive, and in our view looks to be a risky strategy, given both countries already have three established mobile players.
In Australia, TPG plans to spend only $200 million per year rolling out its new mobile network, compared to Telstra, Optus and Vodafone, which spend over $1 billion per year each. This means that the quality and coverage of TPG’s new network will be relatively low. In order to win customers, TPG will therefore need to offer large download allowances and lower prices – a strategy that we see is more likely to win customers from Vodafone, rather than Telstra, given their respective customer profiles and target markets.
Vocus Group is another Telco that we haven’t owned for many years and is one that has had a difficult period, as it tries to integrate a range of different acquisitions, like Dodo, Primus and Amcom. Integrating this number of acquisitions in such a short time is a monumental task for its management team - a task that has proven to be an unwanted distraction at a time when execution is critical, especially given the NBN roll out.
The future strategy for Australia’s Telcos
This really depends on the size of the Telco, its target market and where it sits in its long-term growth cycle.
TPG, for example, will focus on the roll out of its mobile networks in Singapore and Australia. For the more established players like Telstra and Optus, we see their focus on moving into content and applications delivered over their network, rather than just delivering the network itself.
For example, through its consumer plans, Telstra is now bundling up Foxtel, AFL, NRL and netball to its customers, as well as offering services like cloud storage and virus scanning. Similarly, Optus is offering YesTV, Optus TV and exclusive access to English Premier League football, along with streaming services like Netflix and Stan.
For Telstra, we will also see its corporate business (Network Application Services) become a bigger growth engine, as it is one of the few Telco companies that can service larger accounts, through already having its foot in the door with its infrastructure.
The road ahead for the sector
The Telco sector is an industry in transition, and we expect that the market will continue to be volatile. Over the coming year, the NBN market will continue to be very competitive. It is a big year for the NBN roll out, with about 25 per cent of Australia’s homes to transition to an NBN connection over the coming 12 months.
In this environment, our focus remains on those Telcos with a long-term competitive advantage and recurring earnings that will allow them to grow over time, providing an absolute real return and regular income for our investors. While uncertainty exists, we are comfortable with our holding in Telstra and have been adding in weakness to our position recently.
Read part one for background on the sector including the impact of the NBN: (VIEW LINK)
I was hoping you would make comment on the fact Telstra is building a 5G network, the only carrier committed to this. 5G I understand will ultimately be faster than anything NBN has to offer?
Hi Gregory, Yes, Telstra has already started preparing their network for 5G. From a financial perspective, they should get a better return on this investment than their competitors because they have the most customers to put onto the new technology. Economies of scale are important! 5G will indeed offer very high speeds (faster than today's NBN). However, we don't know yet how much these speeds will be affected at peak times, for example at 9pm when online TV is popular. My guess is that a percentage of users will be able to get by on 5G, but that the majority of homes will still use a fixed line connection.
Hi Nigel, good write-up on the telco sector. I noticed that soon after you wrote this article, IML began to sell down their stake in Amaysim in late Nov/Dec 2017. Your narrative does not quite fit with your firm's actions. Further, if you have lost confidence on the lowest cost operator in the industry it must be a sign that you must be losing confidence on the entire telco industry with Telstra at the epicentre. Also, most of your narrative is based on the qualitative aspects about the companies you discussed and nothing about valuation. The only reference to Telstra's valuation was based on next year's dividend yield. As we all know, that is not a great valuation measure on next year's earnings because its earnings are significantly lower in 2022 when the NBN migration is complete.