The turnaround begins

Telstra (TLS, NYSE) was first recommended in the Australasian report in February 2005 at A$5.02 at a time when the ADR was trading on the New York Stock Exchange at around $20.20. After hitting a high of $21.99, the share price declined steadily, a trend exacerbated by high dividend payments and capital returns amounting to A$0.40 cents. Since hitting a low of $14 late last year, the share price has recovered, and we believe the worst is now behind the company.

Telstra is Australia's incumbent telecommunication carrier and one of Australia's largest listed companies. The company has strong brand recognition and provides a broad range of telecommunications and information services, including over 10.3 million fixed line services and 6.5 million mobile services.

Telstra provides a range of services for its customers: 1. Basic access services to homes and businesses; 2. Local and long distance telephone calls, both domestic and international; 3. Mobile telecom services; 4. Management of business customers IT and telecom services; 5. Advertising, directories and information services; 6. Cable distribution services for FOXTEL's cable subscription TV services.

Despite Telstra's huge range of services, the company's share price was under pressure throughout 2005. The recent woes stem from a combination of industry overcapacity and regulatory uncertainty, both products of the company's history. Telstra was first privatised by the Australian Government in 1997 after being the monopoly provider of telecommunications services. To foster competition, Telstra was required to open access to its copper wires which link homes to the Telco's exchanges.

Years of competition and the advent of new telecommunications technology have seen Telstra's monopoly margins and profits decline. Like other telco's around the world, Telstra is suffering from a sharp decline in 'fixed line' revenues, as users opt for other, lower margin products. To some extent, this is being offset by growth in new technology areas such as broadband. However, declines in traditional revenues are faster and this is pressuring profitability and margins. For the year ending June 2006, Telstra is expected to post an EBIT decline of more than 20 percent.

In addition, Australia's regulatory authority, the Australian Competition and Consumer Commission (ACCC) is trying to get Telstra to slash the cost of its wholesale service, that is, what it charges competitors to access the country's telecommunications infrastructure. Telstra, of course, is resisting the planned changes, arguing that the ACCC is proposing an unfair pricing regime.

To complicate matters further, the Australian Government still owns just over 50 percent of the company, and is conducting what will be the world's largest float later this year. The conflict of interest issues regarding regulation and a government trying to get the best price for the impending sale have lead to further pressure on the share price.

In our opinion, all these ingredients combine to provide a solid opportunity for the contrarian investor. All the information is known, and we therefore believe that the negative sentiment directed towards Telstra is contained in the price. The company is embarking on a radical restructure which is designed to update the network with state-of-the-art technology and slash costs over the next few years. While a turnaround may take some time, the potential is not built into the share price.

The company's turnaround is being engineered by American Sol Trujillo. Readers may know of Sol from his days running US West. He has received much negative publicity regarding his previous exploits, however based on his performance in Australia so far, we are supportive of the strategic direction he is taking Telstra in.

Another reason for our positive long term view on Telstra is that we believe the industry is ripe for consolidation. Competition in the Australian market is fierce, especially in the mobiles market where growth has all but stalled. The classic symptoms of overcapacity are now occurring; margins, profits and share prices are all declining. As the pre-eminent Telco in Australia, we believe Telstra will benefit strongly from rationalisation.

While a turnaround in performance and industry conditions may take some time, investors will be rewarded with solid dividend payments. At the current price, Telstra's yield is attractive at around 7 percent.

Given the recent positive price action and the proximity of support at the January and December lows, we believe that downside risk is relatively low. Accordingly, we recommend Telstra as a buy to all Members at around $15.20

Disclosure: Interests associated with Fat Prophets declare a holding in TLS