Telstra: Dog or darling?

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The old saying goes; ‘there are two sides to every trade’, but in the case of Telstra, we have three. In this second part of our equity income series, we take a close look at Telstra following the announcement of the upcoming dividend cut, and the associated share price fall.

Contributors from Merlon Capital Partners, Vertium Asset Management, and Plato Investment Management each share their view on the stock and the sustainability of the dividend. Each has a decidedly different opinion, with one bullish, one bearish, and one that sits somewhere in between.

Why we’ve been buying Telstra

Neil Margolis, Merlon Capital Partners 

Telstra is an example of a company that over-distributed for many years relative to its sustainable free cash flow. Dividends were funded from one-off Government termination payments to disconnect customers from the copper network. Also, mobile margins were and continue to be high by global standards and the business requires high levels of ongoing capital expenditure.

We estimated sustainable free cash flow to be 19c per share when dividends were 28c, so we were not surprised by the size of the gap flagged by the company. Given our valuation has not changed, Telstra now offers more valuation upside and we have greater conviction as market perceptions adjust to the reality of the company's cash generating capacity.

We recently initiated a small investment in Telstra.

Technology’s a tough business

Dr Don Hamson, Plato Investment Management

We believe Telstra’s new stated payout for next year does look relatively sustainable, as the dividend now looks reasonable compared to underlying earnings excluding the NBN payments for customers transitioning from Telstra networks to the NBN. In our view, Telstra’s share price now fully reflects the announced lower dividend stream.  The fall in Telstra’s share price over the past year has mirrored the 29% fall in forecast dividends. 

The real question now is; will the money saved from reducing dividends that Telstra plans to reinvest into the business earn a good rate of return?  We think investing in technology is a tough business. 

Dividend unsustainable, even after the cut

Jason Teh, Vertium Asset Management

Looking ahead, with Telstra’s new dividend set at 22 cents per share, it may look like the dividend is sustainable at the current lower level. We do not think so. When the NBN migration is complete, we believe Telstra earnings per share will be very close to its dividend per share. By 2022, it’s déjà vu for Telstra because it will be faced with a 100% payout ratio scenario again.

One string Telstra had in its bow was the possibility of securitising its NBN infrastructure cash flows. By selling these cash flows at a higher multiple than the rest of the business, it would give Telstra firepower to embark on a share buy-back program. This would allow Telstra to reduce the share count of the company to offset any possibility of weaker earnings in the future and hence hold up its dividend per share. This plan is now off the table given NBN Co blocked Telstra’s securitisation proposal.

Your say

You’ve heard from the experts, now we want to hear from you. Let us know in the comments below what your view is on Telstra and the sustainability of its dividend.

In case you missed it...

In the first part of our equity income series, we heard the big-picture story of dividends on the ASX in 'The Dividend Dilemma'.

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