05/09/2006 - 22:00

Telstra’s future clearer, by and by

05/09/2006 - 22:00

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For the average Australian investor there is nothing more frustrating than trying to find someone with the guts to say whether Telstra is a buy or a sell. Even the prime minister, John Howard, the man in charge of privatising the telephone company, declines to give advice.

Mr Howard’s problem, despite the fact that he is the top man in government, is that he lacks an investment advisers licence, and to give advice would be a crime. Apart from that, he is obviously a seller (on the government’s behalf) but wants us to be buyers.

Briefcase, which never imagined that it would have equal standing as the PM (or should that be the other way round?), is also barred from advising. But should the word ‘buy’ slip into conversation, then all that can be said is that you’d be a fool to do anything suggested by a low-brow scribbler.

Now that the formalities are out of the way let’s cut through the political nonsense swirling around Telstra and look at the telco through a fine-combed magnifying glass (just joking).

Point one: Telstra is a cash cow, and from an investment point that must never be overlooked.

Point two: It is in a competitive business environment, and as the dominant player it is doomed to lose some market share.

Point three: Telstra is yet to actually behave as a pure business, and not as a captive of government.

One of those points, the high level of competition and squeezed margins caused by government regulation, is a negative on the stock.

The other two, which are being drowned by the politics of the T3 float, are positives. At the school Briefcase attended, without distinction, that’s called a two-thirds majority.

But, before acting (and you were told not to) there are questions of personal circumstance, the most important being that for the next few years Telstra will largely appeal as a yield stock. Growth is not really an option at this stage of the company’s evolution.

While growth, as reflected in the share price, is what many Australian investors look for, there is a class of investor interested in yield, or put more simply, the annual percentage return on his capital. If there were not such people the bond market would not exist.

As far as Briefcase can tell, an investment in Telstra today yields somewhere around 8.1 per cent (and more when grossed up). This is around two percentage points above the 90-day bank bill rate or, put another way, a yield 35 per cent higher than bank bills.

Today’s yield is the first tick in Telstra’s box. Next comes future performance, and despite the political flak and bad press, Telstra continues to pump out the cash. True, the cash isn’t growing, but it isn’t shrinking either.

According to the forward estimates Telstra’s revenue will hold around $22.5 billion this year, and next, before rising to around $24 billion in 2010. Profit will also hold around $3.2 billion, before rising to around $4 billion – and the dividend will be locked in at 28 cents a share for at least the next four years.

But, and here comes the big but, all this is before the chaps running the business really swing the axe at Telstra’s costs and reap the full benefits of modernising an ancient relic that still looks and feels like the government department it once was.

For an example of what can be achieved with modern management and streamlined costs look no further than Perth’s own Alinta, a business that was once the very humble gas section of the State Electricity Commission.

Five years ago, Alinta traded at $3 a share. Today it trades at $11. It still flogs gas, only more and better. The keenly awaited, and much criticised, T3 float is not just a capital raising for the Howard government. It is a get-out-of-jail card for Telstra, which might finally shrug off the dead hand of government controls and behave like a business.

•••

If Briefcase can’t give investment advice – and some of the better brokers in town are involved in the T3 deal and are also ducking for cover – than there is at least one firm prepared to produce some very interesting numbers.

Credit Suisse, in a late August assessment of Telstra, put the stock in its ‘outperform’ category for a number of reasons. It likes the potential for a major capital restructure (giving back spare cash to the shareholders). It likes the opportunity being created for more aggressive management, and it likes the potential to cut costs – as shown in this little gem.

According to CS, Telstra is 30 per cent less efficient than its rivals. The ratio of labour costs-to-sales at Telstra is said to be 24.5 per cent versus 14.5 per cent at Singapore Telecoms and 17.5 per cent at Telecom New Zealand.

Imagine if, and CS does it for us, Telstra could slash its costs. It’s a juicy prospect that has CS telling clients that Telstra’s share price target is $4.78, and that as an investment it has the potential to return 34.6 per cent as a capital gain over the next 12 months. This, in addition to delivering a gross yield on the dividend of 11.3 per cent, for a total annual return of 45.9 per cent. Nice.

•••

As a final observation on investment, and perhaps another example of the market sometimes getting it wrong, it’s worth looking at graphs which show how Telstra disconnected with the rest of the market about two years ago.

Since August 2004, the all ordinaries index of the ASX has risen by around 40 per cent. Telstra is down about 30 per cent; but we all know that, don’t we.

What’s more interesting is to look at the top two retailers, Woolworths and Coles Myer, where a similar disconnect can be seen in the Coles share price – until a team of clever US investment funds spotted the valuation gap.

Today, with speculation of a bid, or break-up, in the air, Coles Myer’s share price has risen – but guess how far? Yep, right back into line with the all ordinaries, and its arch-retail-rival, Woolworths.

In other words, Australian investors got it wrong and let Coles Myer drop too far. The smart Yanks have merely filled the gap and, presumably, their pockets.

•••

“The renown of great men should always be measured by the means which they have used to acquire it.” Duc de la Rochefoucauld (in 1665, not last week, and not in Perth, which is a surprise!)

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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