Preference for increased fully franked dividends

Telstra’s capital management update today surprised the market in that it did not contain the much talked about share buyback. Instead, Telstra has put the emphasis firmly on increasing its fully franked dividend based on anticipated excess free cash flow of up to $3 billion over the next three years. The dividend will remain at 28 cents per share for this year and 2013, but could potentially increase in 2014.

The National Broadband Network is a reality for all telecommunications carriers and Telstra sees it as an opportunity that will accelerate existing trends towards digital communications. But the progress of the NBN rollout will clearly affect the timing of migration payments to Telstra. In addition, the company repeated its shareholder safeguards attained in the NBN deal should the NBN rollout be significantly altered either under a new government or a substantially changed strategy by the current government.

“In dividends alone, the company has paid $32.4 billion to shareholders over the last ten years”

The key elements of the announcement today are:

• Telstra will maintain an annual dividend of 28 cents per share for 2012 and 2013
• The company’s preference is to increase dividends
• The company cannot fully frank an increased dividend until 2014
• An on-market share buyback is a viable alternative but there is insufficient excess capital to conduct one at present
• Telstra is expecting excess capital of $0.5-1.0 billion in FY12 and $2-3 billion over the next 3 years
• All excess free cash flow calculations depend on the timing and progress of the NBN rollout
• Excess free cash flow assumptions make an allowance for spectrum payments
• Telstra remains committed to a single-A credit rating, to ensure that dividends are fully franked, and that it will not borrow to fund dividends or share buybacks

The company’s definition of ‘excess capital’ is worth discussing. It begins with reported cash flow based on its reaffirmed guidance for this year which is expected to be in the range of $4.5-5.0 billion.

Debt-funded payments for spectrum and an allowance for other cash items such as the $320 million NBN residual payment from the government and Telstra’s share of the outlay for Foxtel’s acquisition of Austar are added back.

From that, the company then deducts provisions for dividend and interest payments and any other commitments outside normal operating requirements (unspecified).

The resulting excess free cash flow can then be considered by the Board for distribution to shareholders either through dividends or an on-market share buyback.

It is worth pausing on this point.

Back to the future

In April 2009, the government cancelled the previously agreed $1 billion regional broadband project awarded to the OPEL consortium (Optus and others) and decided that the fibre-to-the-node proposals put forward by Telstra and others were inadequate.

The government then sprang a complete surprise on Telstra and the Australian economy by instead committing the country to a taxpayer funded fibre-to-the-home network estimated to cost $43 billion.

The timeline of the crucial decisions is shown on the chart of Telstra’s share price below:

Telstra was the obvious target of the government’s frustration and its structural separation of the company’s wholesale and retail networks was a central plank of the new government plan. To say it was an ambitious and complicated objective to build a national network covering 93% of the population with fibre-optic capability to those premises with the balance supplied by other technology would be a massive understatement.

The effect on Telstra’s share price during that period was not so much a dousing as it was a torrential downpour of political and regulatory uncertainty.

It was also during this period that the Future Fund was aggressively selling down its initially large holding in Telstra (over 16% in August 2009) to less than 1% of the company two years later. This selling pressure kept a substantial lid on Telstra’s share price.

Fast forward to today and the clouds are dissipating quickly.

The mere fact that Telstra’s Board is considering capital management outcomes to benefit shareholders is recognition that the company is on a firm financial footing and indeed looking at a steady improvement.

New chief financial officer Andy Penn outlined the criteria that the company considers as its parameters for good financial management. These included maintaining the balance sheet settings consistent with a single A credit rating. At present, Telstra is well inside the requirements for this aspect with interest cover of 9.3x ahead of the minimum 7x, gearing at 54.9% within the 50%-70% boundaries and debt servicing of 1.48x also within the bounds of 1.5x-1.9x.

Importantly, Telstra will continue to limit its ratio of capital expenditure to sales to about 14%, excluding spectrum payments.

Payments from NBN Co. depend on the progress of the rollout. Telstra currently expects the peak to be around 2014 which would therefore coincide with the peak of the migration payments to Telstra from NBN Co.

We’ve already seen how malleable the NBN Co. rollout plan is with the latest set of plans indicating that the 2014 peak is probably optimistic.

Change of government wild card

The irony cannot be lost on Telstra’s Board or its management that the political pressure that has plagued the company for so long has swung completely around to focus squarely back on the government.

Telstra’s structural separation and subsequent NBN deal has relieved the company of its regulatory hangover.

Now it’s time for the government to sweat a bit as its popularity wanes and the possibility of a change of government by November 2013 becomes more likely.

The NBN deal contained some significant contingencies in the case of a change in government.

Chief executive David Thodey reiterated the more important aspects of what he termed ‘shareholder protection’ in the event that the NBN rollout is curtailed:

• If the NBN rollout ceases, Telstra will still receive access payments for certain infrastructure
• A rollout termination payment of up to $500 million is payable to Telstra if the NBN rollout ceases after 20% of homes are passed
• Protection against automatic termination of certain elements of the government package
• The right to continue to operate existing fixed line business in areas where the NBN has not been rolled out.

We have previously argued that it would be unlikely or impossible for the Coalition to completely undo whatever physical infrastructure had already been built by NBN Co. It would make far more sense for the Coalition to review the project – the missing cost/benefit analysis – and then revise the NBN to a more affordable and sensible scale.

All we do know at this point is that Telstra has some significant insurance if the NBN is changed in any substantial way.

South Brisbane

A sign of Telstra’s co-operation with NBN Co. is demonstrated in its South Brisbane project where fibre is being rolled out to over 10,000 premises by Telstra itself.

The company is halfway through this project and has learned a lot about the physical process of laying fibre-optic cable through the existing ducts and then switching customers from the copper to the fibre connection.

Of course, Telstra has vast experience in doing exactly this sort of work as much of its core network is already fibre-optic. But the process of going door-to-door at each and every premise in a contiguous area hasn’t been done since the original copper network was first implemented.

It seems obvious that Telstra will eventually sell the installed South Brisbane fibre to NBN Co. and will likely repeat the project at many other urban locations around the country.

In effect, Telstra will end up doing much of the spade work for NBN Co.

On reflection

It’s interesting to look back at Telstra’s cash flow performance over the last ten years.

In dividends alone, the company has paid $32.4 billion to shareholders.

Also of interest is the $36.9 billion the company has invested in its business over the same period – a curiously similar figure to the estimated cost of the 10-year NBN rollout cost.

After forming a bearish divergence in early 2012, where prices reached new highs, on the back of falling momentum (RSI) as marked by the red arrows, a correction unfolded. Prices are currently testing the 50 day moving average as support at the $3.31 level. Should this momentum indicator fail to lift prices, a deeper decline towards the technically important 200 day moving average at $3.18 is potentially on the cards.

With reference to the weekly chart, a sustained break above resistance at $3.46, would likely result in a strong boost of upward momentum to follow. Should this bullish scenario unfold, we would target an upside target towards the $3.71 level.

Summary

Telstra will be generating significant excess capital of up to $3 billion over the next three years, subject to the pace of the NBN rollout.

The company’s preference is to increase its dividend but will not have sufficient franking credits to do so until FY14. Until then, the company has reaffirmed its guidance of a 28cps annual dividend, fully franked.

The company reaffirmed its free cash flow guidance for this year and demonstrated that its financial situation is very solid.

Telstra remains a core stock in the Fat Prophets portfolio and we continue to recommend it as a buy to Members without exposure.