Telstra Is not the next BHP

Rudi Filapek-Vandyck

Beware the dividend stock for which the share market starts anticipating a significant deterioration in operational dynamics and thus, eventually, a reduction or even removal of the dividend. It happened to prior stalwarts such as Metcash, Fleetwood, Origin Energy, even to BHP Billiton and Woodside Petroleum. One look at price charts leading into the eventual dividend outcome shows each time loyal shareholders are in for a triple, if not quadruple whammy.

The latest corpus delicti, or so it seems, is telco mogul Telstra. It was only two years ago bold forecasters were targeting $7 and beyond. Today, the share price is hovering marginally above $4. But is the story really this simple? And is the Telstra dividend cut inevitable? My take on things is that doomsayers have their timing wrong, and even then it remains an open debate whether doom scenarios are the sole and ultimate outcome.

First the bad news: for all those who followed their stockbroker's advice and bought the shares from the moment it dropped below $5; that was, simply, bad advice. The share price is highly unlikely to trade at that level again. Times and context have changed. Better reset those expectations and re-assess.

I haven't been a strong advocate for owning/buying shares in Telstra since 2015, and that is putting it mildly. Judging by the relentless downtrend that is now apparent on backward looking price charts, the heavy dose of Telstra-scepsis has been more than justified. But now the share price has fallen a further -20% since January, the question has to be asked whether the share market, as per usual, is not getting overly bearish, pushing the share price too low?

The answer, I believe, lies not with whether the current bad news cycle has further to run (it probably has), but with Telstra's ability, and determination, to maintain its dividend for shareholders.

Straight up: I don't believe Telstra is going to reduce its 31c payout per year anytime soon. But there won't be any further rises either. It is true the odds have moved into favour of dividend cuts sometime into the future, maybe four or five years from now, and this is what the share market is currently focusing on.

Set aside the global search for yield that once dominated the local share market, this shift in operational dynamics is essentially the driver behind Telstra's share price de-rating over the past two years. Previously, stockbroking analysts were projecting ongoing dividend increases to 32c, 33c, even 34c in the years ahead. That downshifted to 31c for as far as the eye can see.

In more recent times ongoing reductions to earnings per share (EPS) forecasts are suggesting Telstra's profits this year will be lower than 31c per share (see Stock Analysis on the FNArena website), further exacerbating investor angst that juicy yield from the former telco monopolist won't be on offer for much longer.

All this ignores the fact the company remains a cash cow and there will be ongoing NBN payments from the Australian government. Telstra has paid out higher dividends than its reported EPS on multiple occasions in the past.

Nevertheless, it does make sense for investors to focus on what can go wrong and what scenarios are likely, given most would own Telstra today for its annual payouts.

It wasn't that long ago many were holding on to their shares in BHP Billiton ((BHP)) as they believed the board's promise of sustaining a through-the-cycle, steadily rising annual dividend. But then things went from bad to worse and they got so bad, nobody believed the board could possibly stick to its promise. By the time the inevitable was announced publicly, BHP paid out less than one quarter in dividends from the previous year (i.e. they cut by nearly 75%). By then, the share price had already been slaughtered and started recovering.

Prior to the board's admission the progressive dividend policy was no longer sustainable, BHP shares too had been in a drawn out downtrend. For much of the post-2011 years the shares found support at the 4% prospective yield level, until market confidence shifted to the negative. After that, things moved quickly, and relentlessly.

There are more than a few lessons in here for investors investing for yield in the share market.

Some investors might still be traumatised by the BHP experience, but there is another recent reference point. Up until mid last year, Australian banks were also in a persistent downtrend amidst widespread belief they might have to cut their dividends, if not raise extra capital on top of the capital raisings of 2015. As it turned out, only ANZ Bank reduced its dividend, once, and it proved more of a haircut than another BHP/Rio Tinto experience. Bank shares have significantly outperformed the broader market since.

Telstra today is not the BHP Billiton of tomorrow. If, in coming year(s), the Telstra board proves me wrong and does decide to disappoint the circa 50% of retail investors on its shareholder register by reducing the annual dividend, it will be more of an ANZ Bank repeat experience rather than another BHP Billiton copycat. Of that I am even more convinced.

One of the more interesting research reports on Telstra was released at the end of last month, by analysts at UBS. In it, the analysts argue a prudent Telstra should reduce its dividend to 29c per annum (from 31c now). They also stated the Telstra board, very aware of the company's dividend status in the local market, was more likely to ignore their advice, until they no longer can.

This further reinforces my point: Telstra shareholders should not fear a dividend cut this year or next. It is too early for that. In the low odds outcome of a negative surprise, it'll be a small reduction a la ANZ Bank, not another sledgehammer experience a la BHP or -heaven forbid - Origin Energy.

Another intriguing report was released last week by Deutsche Bank, who believes Telstra's 31c dividend is safe until 2019. After that, a relatively benign reduction should be on the cards. The latter should be interpreted as 28c-29c instead of the 31c for the next three years (including current FY17).

What this means, point out analysts at Deutsche Bank, is that Telstra's share price at around $4.20 already is reflecting a 6.6% sustainable yield. Plus franking. No surprise thus, Deutsche Bank has upgraded the stock to Buy with a price target of $4.51. On the analysts calculations, Telstra shares are now trading at a -39% discount vis-a-vis the broader market

According to FNArena's Sentiment Indicator (see website), only four stocks out of 400+ in our database now offer a higher yield than Telstra does. Those four are: Crown Resorts, Fortescue Metals, Alumina Ltd and Harvey Norman. But even if we assume the current 7.38% is not 100% representative and we concentrate on the underlying, sustainable yield of 6.6% instead, only two more stocks jump above Telstra with a superior yield; Aventus Retail Property Fund and Rio Tinto.

While I don't think Telstra is ever going to be a fantastic investment, I do think it is but a matter of time before the gap between its current, beaten down share price and the rest of the yield offering stocks narrows. The average yield in today's market is closer to 4%. Major banks are offering between 4.9% and 5.8%. In comparison, Telstra's 6.6% underlying, if not the at face value 7.38% (short term secure) looks too attractive to ignore indefinitely.

Having said all of the above, there remains potential for ongoing bad news for the sector and for Telstra in particular, starting with a pending ACCC decision on whether to declare Telstra's mobile roaming service, which would give competitors access to Telstra's network without having to make substantial investments.

I recently spotted a technical view on the shares which suggested the new trading range could reach as low as $3.75. While nothing is impossible in the face of edgy traders and nervous investors, and it would be a brave man to declare the bad news cycle is over, but I'd be hugely surprised if the share price falls as low as suggested by that particular technical view. I'd be even more surprised if the share price won't be higher in 2018.

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Rudi Filapek-Vandyck

FNArena is a supplier of financial, business and economic news, analysis and data services.

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