We have reduced our share price target on lower medium term earnings, but with what is hopefully the bear case now apparent, we think the risk swings to the upside. Over the next few years, the key operational risks relate to Telstra's ability to offset the negative impacts from the NBN and increased competition. Upside risk surrounds capital management and our bull case. We upgrade our recommendation from Hold to Add.

Key points

• Dividend aside, Telstra Corporation's (TLS) FY17 result and outlook were in line with our expectations.
• We had earlier flagged the risk of a dividend cut on the revised capital management framework but were not expecting the Board to cut the dividend to 22cps in FY18 as they have now done, albeit softened with a possible buyback.
• The revised dividend looks to us like an almost worst case scenario, with upside potential should the competitive landscape not deteriorate and/or should the NBN unravel.
• The lower dividend is disappointing but it helps position Telstra to navigate the future and, importantly, expectations are rebased so the uncertainty is removed. 

Result and outlook – rebasing the dividend to 22 cents in FY18

Telstra Corporation's (TLS) FY17 NPAT of A$3.8bn was up 1.5% year on year, 1% below consensus and 2% ahead of our forecasts. The 15.5cps final dividend (31cps for the full year) was as expected but the 30% cut to the dividend going forward was not expected. TLS has guided to a 22 cent dividend in FY18 (including specials). At the mid-point, TLS guided to FY18 EBITDA of A$10.9bn which is up approximately 3% year on year, in-line with our forecast and 3% below consensus.

Capital management consideration = reinvesting A$1bn per annum

The Board of Telstra released their revised capital management consideration and guided to a 22cps dividend in FY18. This dividend cut of approximately 30% is attributed to changing with the times and impacted by:

1. lower earnings as a result of the NBN;
2. lower earnings as a result of increased competition; and
3. retaining capital to increase balance sheet flexibility.

The 22 cent dividend in FY18 is based around a new dividend policy, which we discuss in more detail in our Research Note (available to clients). While not explained, we think the FY18 dividend comprises a 15.5c ordinary dividend (from underlying earnings) and a 6.5c special dividend (from NBN one-offs).

Is a 22 cps dividend throwing the worst case scenario out there?

The bear case scenario (unlikely in our view) could be 20cps or EPS and an 18cps dividend (from A$8bn of EBITDA) and potentially reflecting a 25% decline in EBITDA from current levels. This bear case doesn't factor in buy-backs or generating a return on the A$1bn per annum of additional capital Telstra retains after cutting the dividend. We think the bear case scenario is not a likely outcome. 

A bull case scenario is for lower last mile access costs due to competing/substitutive technology which could mean Telstra doesn't have a substantial EBITDA hole. We still think this bull case scenario is entirely possible, but do not currently include this in our forecasts.

By Nick Harris, Senior Analyst. Sectors Covered: Telecommunications, Technology and Financial Services:  (VIEW LINK)