Why I'm Buying Telstra Shares

Watching the Government and Telstra square off is like watching a game of Russian roulette: it could end badly for at least one of the parties; or in this case, both. Alternatively, if common sense prevails the crisis should pass and leave everyone a winner.

Since Sol Trujillo became chief executive of Telstra on July 1, its share price has fallen by 14 per cent, causing much pain for shareholders. Or has it? Even before he took over, Telstra had been a poor performer. From the market bottom in March 2003 to his arrival, it had only risen 28 per cent against a market improvement of more than 60 per cent. Not even the 6–8 per cent annual yield shareholders have enjoyed makes up for that under performance.

The new management team is now arguing that Telstra’s historic underperformance was being caused by having to comply with heavy government regulations in a very competitive environment. Thus, traditional high-margin revenues have been under enormous pressure. Prior management had accepted its fate; it appears there had been an understanding with the Government. This involved management talking up the stock, cutting capital expenditure and paying special dividends. And making a disastrous foray into Asia.

The new management under Sol is taking a very different approach. To quote the vernacular: “They are not going to take it anymore”! Telstra is now set on a course that ensures everyone is aware that there is a cost to regulation.

And when you own 51 per cent that cost can be counted in the billions. Since Telstra’s initial profit warning, the value of the Government’s shares have dropped by about $4.5 billion. While the politicians argued about what they were going to do with the money, the money was disappearing. In the midst of all the political manoeuvring over spending the T3 proceeds, the “pollies” forgot the most basic concept: the value of the business itself. In the last month, Sol has reminded them.

And it could get worse. Trujillo acknowledged this in his Monday conference call with the market. If the Government continues on its current course there could be further downgrades, even a cut in the dividend. But getting worse is in no one’s interest '” not Trujillo’s, nor the Government’s, nor minority shareholders, many of whom are voters. Getting worse risks a mere company problem becoming a grave political crisis.

THE SCENARIOS

That’s why I think the most likely scenario is compromise. Telstra might not get everything it wants, but nor will the Government. This outcome makes the most political and economic sense, which is why I rate it a 60 per cent chance. The Government has already compromised with one constituency (rural voters) to get to the point where they now have the political strength to pass the T3 legislation. Further compromise is very logical. Compromise should see the share price return to at least $5.

One of the fascinating aspects of the Telstra situation is that no one can yet forecast the end game. There are simply too many moving parts and (players). So there are also some less palatable (though fortunately less likely) outcomes. They include:

• Telstra’s American experiment ends. I think this would be a pity for minority shareholders. For the first time (ever), they now have a management team prepared to fight rising regulations. However, because the Government has a 51 per cent share, replacing Sol and his team is a possibility. But such a step raises more problems for the Government than it solves. It risks deepening the crisis. A new CEO search is a lengthy process at the best of times, but finding a top-quality candidate after such a short reign and public brawl could delay T3 till 2007, an election year. It risks causing some more serious structural damage to the distracted telco. Under this scenario, a short-term share price gain is likely. Longer term, Telstra could be destined to remain a perennial under-performer. Overall probability: 10 per cent.

• The Government increases regulations as planned, but shelves T3. If the Government persists on its current regulatory course, further profit warnings and a probable dividend cut are likely. This would make Telstra unsaleable at current (already depressed) prices. The value of the Government’s remaining stake might sink another $2–4 billion, taking the total cost (to it) of regulation to $7–9 billion, even before handouts to rural Australia are counted. Under this scenario, the share price could fall to $4 or below. I think the probability of this is only about 20 per cent.
• The Government pushes ahead with both T3 and more regulations. Under this scenario, I think the share price could fall to $3.50. A dividend cut is likely. I think this is the least likely outcome simply because it makes no economic or political sense; that is, cutting the Government’s sale proceeds by another $2–4 billion. I believe the PM is sensible enough to realise this. Probability: 10 per cent.

I’m impressed with the manner Trujillo has adopted in explaining Telstra’s position. He has not been emotional, although the same cannot be said for some of his staff. He’s quietly pointing out that more regulation carries a cost. By remaining unemotional he has a far better chance of reaching an acceptable compromise with the Government. It would be in everyone’s interest for common sense to prevail.

THE FUNDAMENTALS

I believe in buying good quality businesses when they are temporarily out of favour. Although it has problems, Telstra remains such a business. It has a dominant market share in a growing sector of the economy. It should produce more than $3.5 billion a year (28¢ a share) in free cashflow (after capital expenditure) over the next three years. That’s enough to support at least the ordinary 28¢ dividend. That means Telstra is yielding at least 6.4 per cent at current prices. Meantime, Trujillo has repeated that the current dividend policy remains intact. Telstra is paying a 20¢ dividend in late October and has an intention to pay a further 20¢ dividend six months later. That’s a 9.3 per cent fully franked yield this year.

Monday’s announcement has led to earnings-per-share (EPS) downgrades of about 6 per cent. Consensus EPS forecasts over the next three years are now 30–32¢ pa. But the market fears more downgrades. Despite the risks, I remain optimistic; risks are part of business and forecasts. Based on my probability expectations, buyers of Telstra today should achieve a capital return of 15 per cent plus a dividend yield of 9.3 per cent fully franked over the next 12 months.

The author acquired more TLS after the latest profit downgrade.