New strategy - customers up, margins down

Chief executive David Thodey has tired of watching customers walk out the door in their thousands. The time has come, he says, to do something about it. That has been the genesis of Telstra’s new strategy that will sacrifice operating profit margin to pursue new customers and retain existing ones in an unabashed tilt at regaining lost market share. The company is guiding the market to expect operating profit (EBITDA) to decline by a high single digit percentage in 2011 on flat revenue.

“We are amazed that the Opposition did not promise to put the NBN up for a cost-benefit analysis. Such a study surely would have killed it and justified their alternative proposition in one fell swoop”

Turning to the charts, Telstra gapped lower, breaking below the downtrend line and both the 50 (green line) and 200 (red line) moving averages. The rapid decline also broke below support at $2.88 and is oversold on the relative strength index (RSI). This is indicative of an exhaustive move to the downside, which generally translates to buying pressure to emerge over the near term.

In our previous note on Telstra (FAT480), we speculated that Telstra would use its free cash flow and reduced PSTN role under the NBN scenario to redeploy its activity towards the mobile and broadband markets. In essence we were right, but did not anticipate the ferocity of the pursuit.

As succinctly as we can put it, Telstra intends to compete aggressively on price to attract and retain customers. Mr Thodey described the new strategy as taking some “bold but necessary steps” to reverse the haemorrhaging of the last few years.

Perhaps it was inevitable. When Telstra commenced its five year transformation in 2005 under previous CEO Sol Trujillo, the company built two very futuristic networks – Next G and Next IP. The high quality of these networks determined that Telstra would not compromise on price. Mr Trujillo’s position was that customers would seek the superior quality and coverage of the Telstra networks regardless of any price differential in the market. The competition took the opportunity to snatch market share from Telstra with both hands. Consequently, Telstra’s market share in fixed retail broadband has fallen steadily to 48%, while its share of the mobile market is 42%.

At the same time, consumers around Australia have progressively bypassed using land line connections altogether, preferring to rely on mobile phones and wireless internet as a straight substitute. Telstra estimates that 12% of Australian households are now mobile only. That proportion will inexorably rise as prices for mobile communications continue to trend downwards.

The consequence of the flight to cheaper alternatives (such as TPG Telecom and iiNet) together with the increasing value of mobile phone packages has created a Gulf of Mexico sized leak in Telstra’s traditional PSTN revenue.

In the 2010 financial year alone, Telstra’s PSTN revenue declined by $504 million or 8.0% to $5.8 billion. The company roughly apportions the drop to line loss ($292 million), usage ($188 million) and interconnection ($25 million). Line loss is a combination of customers migrating to competitors’ networks through unbundled local loops (ULL) and through straight cancellation of land line access service. Total access lines in 2010 dropped by 4% to 8.66 million lines. ULL lines have grown from nothing in 2004 to 831,000 lines in 2010.

Even more alarming has been the decline in land line usage for making phone calls. In 2002, nearly 10.3 billion local calls were made and 9.2 billion national long distance calls. In 2010 these metrics had dropped to 4.1 billion and 5.9 billion respectively. Mr Thodey lamented that this meant each land line was making just 6 calls per month. Local call revenue is now a third of its 2002 levels.

Of course, it’s not all bad news. The mobile industry is still roaring along on the back of the smartphone revolution, supercharged by the wireless broadband market.

Telstra’s total mobile revenue for 2010 was $7.3 billion, and increase of 6.4% or $439 million, almost offsetting the PSTN drain. The big source of growth in mobiles has been the 34% increase in wireless broadband data revenue to $787 million and the 14.2% growth in SMS revenue to $1 billion.

Telstra added 608,000 wireless broadband subscribers during the year bringing the total to 1.654 million customers enjoying the coverage (2.1 million square kms) and speeds of the Next G network. Telstra already offers wireless download speeds up to 21 mbps, if a customer has the appropriate data card and will release a 42 mbps card later in FY11.

Telstra is already trialling the next generation mobile network technology, known as LTE. This is some way off becoming a commercial reality in Australia but being prepared for its inevitable launch is a sensible step.

Including wireless broadband subscribers, Telstra has over 10.5 million mobile customers.

The company has already begun revising its pricing and packages and finally has a range of capped call packages. We anticipate there will be substantially more effort put into this area. Telstra is likely to increase its sales and marketing effort in conjunction with the new strategy, and we expect this will form a big chunk of the increased expenditure – and therefore the lower operating profit – that is now being talked about.

In fixed broadband, Telstra will also look to sharpen its pricing but will also utilise bundling of services as effectively as it can. Wrapping up a range of services for a single total price can be a very effective tool to retain customers. Telstra has over 300,000 customers on such plans.

Another tool in the kit is new products such as the T-box and the T-hub. To date, Telstra has sold 15,000 and 50,000 of these respectively and will likely subsidise them in the same manner that mobile handsets are, in order to drive more packages.

A range of customer focussed initiatives are also planned, such as a 24/7 contact centre (from September). Importantly, Telstra is significantly altering management incentives towards customer satisfaction measures.

Strategy change will alter earnings forecasts downwards, initially

The strategy announcement from Telstra came as a surprise for the market. It has brought about some substantial earnings forecast downgrades in the vicinity of 15% for the 2011 financial year.

The accelerating shift in product mix from fixed line revenue to mobile and data revenue needs scrutiny. Telstra has provided indicative operating profit margins for each major category which shows PSTN margins falling from 61% in FY08 to 59% in FY10. It is reasonable to assume this trend will persist. Mobile operating margins have been growing from 31% to 35% across the same time frame, but are clearly lower than the PSTN margins. Now that Telstra will deliberately pursue market share in mobile and simply defend what it can in PSTN, we expect Telstra’s overall operating profit margin to decline from 43% in FY10 towards 40% or even lower in the next three years.

The new consensus in the market is emerging around earnings per share of about 26.5 cents per share, which immediately raises the question about the sustainability of Telstra’s 28 cents per share annual dividend.

Telstra’s response to the question was to suggest, without pre-empting the Board’s decision on the dividend, that the dividend could be maintained by utilising the balance sheet. In other words, Telstra could use debt to fund the dividend, as it has done in the past. Ratings agency Standard & Poors reaffirmed Telstra’s credit rating at A-/A1 after the profit announcement.

The irony of this situation is that one of the biggest aims of the five year transformation project was to generate sufficient free cash flow (in excess of $6 billion) to pay a sustainable dividend and support a capital expenditure program around 14% of sales.

The capex ratio is likely to stay, but clearly the dividend will now rely on the borrowing capacity of the balance sheet in the next few years. There’s no real problem with this as the company can easily afford and accommodate the debt, but it will cause anxiety for some shareholders nonetheless.

Franking credits are once again being generated by prepaying tax. The company will strike a balance between paying enough tax to fully frank a 28 cent dividend without jeopardising its tax position.

Our view is that Telstra will not want to reduce its annual dividend. The Board is focussed on returns to shareholders, so any compromise on this important element of that would send a bad signal. The fact that the Board did not reduce the FY10 final dividend tends to support this view.

The current year aside, the new strategy should hopefully begin to lift earnings per share sufficiently to once again exceed the dividend.

Government broadband policy post 21 August

Telstra sensibly noted that it remains non-partisan with respect to Australia’s telecommunications policy.

The current government’s broadband and telecommunications policy is probably better understood than that of the Opposition. But that may just be a consequence that it has been public for longer and therefore more closely scrutinised.

There are undoubtedly some very big holes in the government’s broadband strategy, singularly driven by its behemoth National Broadband Network. In our opinion, the NBN will be a non-commercial, taxpayer-subsidised government-owned monopoly of a wholesale network. Private industry is unlikely to invest in the NBN as the return on investment would be negligible. In effect, it will be a government service – not a commercial entity.

The assumptions around take-up rates alone are likely to prove fanciful enough to create a dichotomy between what the NBN promises to be and what it will be in reality.

For Telstra, it at least knows that it will receive cash flow of $9 billion for the enforced decommissioning of its copper network over the eight year construction of the NBN, plus a further $2 billion for the handing over of the Universal Service Obligation.

As we postulated in our previous note on Telstra (FAT480), this scenario could unleash substantial cash flow for Telstra to redirect towards broadband and mobile markets, in place of maintaining the legacy fixed line network. That is probably why Telstra signed the Heads of Agreement back in July.

The Coalition’s policy, on the other hand, is fresh onto the market and is already running into confusion about minimum download speeds and network reach. Despite a slightly shambolic presentation, at face value the mix of technologies combined with greater private industry participation looks a much better use of taxpayers’ money and should deliver the same result.

For a total outlay around $6.3 billion, the Coalition will provide funding for backhaul supply of up to 70,000 km ($3.5 billion), optimise the use of DSL technology for underserved areas ($750 million), provide fixed wireless technologies in rural and remote areas ($1 billion) and new fixed wireless services in outer metropolitan areas ($1 billion).

We are amazed that the Opposition did not promise to put the NBN up for a cost-benefit analysis. Such a study would surely have killed it and justified their alternative proposition in one fell swoop.

The government’s behemoth is never likely to achieve a commercial return and will always be subsidised by taxpayers, though they won’t really know it.

Summary

Telstra’s change in strategy is designed to recoup lost market share in broadband, but also to grow its mobile and data businesses. Its tactics will include aggressive new pricing and packaging initiatives that will inflame an already intensely competitive market.

The shift in product mix will accelerate a decline in Telstra’s group operating profit margin. This will drag its FY11 earnings below its current dividend of 28 cents per share, but we do not expect the Board to lower the dividend.

The Federal election could change the direction of Australian telecommunications policy if the Opposition wins power, but we see no further downside for Telstra in this regard.

The weekly chart depicts a move back into the downward range. Should further weakness result, we would expect downside support to be offered at the $2.75 level, which is the lower boundary of the consolidation.

We think the market has overreacted to Telstra’s new strategy and despite the lower earnings guidance in FY11, we believe the share price is cheap.

We are recommending Telstra as a buy at $2.88 per share.