Telstra is Australia’s largest telecommunication company with market leading positions in mobile, enterprise and residential broadband.
Early last decade it was regarded as a blue-chip income stock and its share price rose from $2.79 at the beginning of 2011 to $6.59 in 2015. At this point industry change weakened Telstra’s business and profits deteriorated. Telstra fell out of favour with investors which saw its share price decline to $2.73 in October last year.
As its share price reached its lows, the seeds of a business turnaround had firmly taken root providing a great contrarian investment opportunity in an Australian stalwart.
The Issues Telstra Faced
Telstra owned Australia’s most substantial copper phone lines business which gave it a dominant market position in the provision of broadband services. The issues however rose from the fact commercial entities such as Telstra had little incentive to build network capabilities in uneconomic areas therefore there was a materially different internet experience for Australians in regional locations. This led to the formation of The National Broadband Network initiative (‘nbn’) where the government essentially took control of Australia’s residential broadband networks to ensure all Australians had access to high quality internet.
Previously Telstra would offer internet services to a residential customer largely over their own copper network however they now had to pay the Government to use the nbn network. This saw margins, in what was a large division, fall significantly for a number of years.
Concurrent to this, deteriorating economics in residential broadband saw competitors encroach on Telstra’s more profitable enterprise segment, reducing profitability in this division as companies searched for other ways to monetise their network.
Finally, mobile competition was becoming quite irrational as companies such as Optus focused on market share gains rather than profitability. This was exacerbated by TPG putting the pieces in place to launch a fourth competing mobile network.
This all led to a serious strategy reset at Telstra and a material cutting of the dividend from a peak of 31c per share in FY17 to 16c per share today.
All of these issues really reached their crescendo around two years ago and at this point the outlook for Telstra started to improve.
The nbn network roll out was nearing completion and therefore margins in their fixed business began to stabilise from what had been a bit of a free fall.
The mobile market also began to improve as:
- Vodafone and TPG merged, removing a potential fourth entrant. This merger was a large drawn-out process given the ACCC tried to block it which proved to be a material distraction for both businesses.
- Huawei equipment was banned from being used on 5G networks. Vodafone and Optus had utilised Huawei hardware for their 3G and 4G networks and therefore needed to replace a lot of hardware if they were to offer 5G. This not only gave Telstra a head start with their 5G roll out but was also a very expensive exercise for its competitors.
- There was also a shift in competitive intensity from Optus as they changed their strategy from market share at any cost to profitable growth.
The final key thread to Telstra’s turnaround (which we believe the market really misunderstood at the time) was the declining capital intensity of the business. Whilst the nbn was terrible for the profitability of their broadband division, it did offload what is the most capital heavy part of its network. Hence, cash flow was set to improve significantly, despite accounting earnings being under pressure. This proved to be correct as in FY21 Telstra generated profit of $1.9b vs free cash flow of $3.2b. We therefore had high confidence the dividend was sustainable and could potentially grow.
Alongside all of this, Telstra started to explore ways to monetise some hidden value within their business. For example, they sold a 49% stake in their tower assets at a significant premium to the value they were held at on their balance sheet. Moreover, there are still more divestment opportunities available to Telstra.
Despite all of the above, the market has been very slow to react to what are clear improving trends on a number of fronts for Telstra. It is often hard to break the negative sentiment towards a business that has built up because of years of earnings downgrades and disappointing results. This market pessimism has allowed us to build a significant position at very attractive levels with the market seemingly paying limited attention to the continuing improvement in the fundamentals and outlook for the business. This highlights very good investment returns can be achieved in even the most mature of businesses.