Please wait while I place you on hold, forever
We have all had an experience with this company in some way. Whether it was through their phone services or through some shares we were given, everyone is familiar with the Telstra, the once great Australian investment. (I'm sure we've all had this experience: being on hold for a week when all you want to do is change plans!)
To the naked eye, Telstra looks like it should shoot the lights out as an investment. A high yielding dividend, very high returns on equity, a halved share price which is surely cheap and monopolistic like business qualities.
However, Telstra doesn't quite cut it as a potential investment. Frankly, it's never ever been a good investment……..
The share price
The share price has had a pretty significant decline since as early as 2000. We can see from the above the share price was trading at over $7 at this time.
At the time this price seemed very reasonable. Telstra had a return on equity of 35, which is fantastic for any business. They operated a massive monopoly over Australia, owning all the land line based infrastructure. So what happened?
The payout ratio
Remember, we need to think about all business’s as if they were lemonade stands. Telstra was a fantastic money making machine; the owners were receiving a 35% return on the money they had put in.
The downfall of the share price though, was that the owners were not reinvesting this money into the business, they were paying it out to shareholders (themselves). Take a look at the grey line in the graph, that represents the payout ratio.
Telstra’s management started paying out the majority of it’s earnings, and established itself as Australia’s premier income stock. They did this because they knew there was little growth left for them to achieve across Australia, reinvesting the money wouldn't have been the best allocation of capital.
So Telstra was fine for a couple of years. But remember what happens when a company achieves high returns on equity.....every man and his dog wants in on it.
More competition in the form of TPG, Vodafone and Optus entered the market, and undercut Telstra's prices. Telstra's strong earnings margins had to be cut after a couple of years. Telstra had been earning roughly the same amount of profit from the same amount of equity for most of the 2000's.
Their strong return on equity was a bit of a facade. Because they were paying out so much in dividends, often more than 100% of earnings; there was never any retained earnings on the balance sheet.
Retained earnings are recorded under equity; Telstra's equity was flat, never increasing which is why return on equity stayed so strong. They were generating the same earnings, off the same equity base.
When you become an income stock, you begin to deal with the a notoriously difficult group to handle in society: The retirees.....
Retirees depend on income stocks to fund their retirement. They do not act kindly to dividend cuts, as it directly affects their livelihood. This is why Telstra from 2004-2007 were paying out more in dividends than they were earning, to avoid pissing off investors by cutting their dividends. Whilst this pleased income hungry investors (the retirees), the share price reacted accordingly.
Book value per share
This is the most important metric for us. We want to invest money into a business, and watch that money earn a return, and let these returns compound.
Take a look at the above graph. The book value per share of Telstra has hardly moved in 20 years. The original shareholders who fronted up their capital back in 1998; the value of that money is almost the same, because Telstra never reinvested money back into the business; all money was paid out.
Now dividends are another form of return, we all know that. But you need to consider the price you pay for an investment, because if you pay an overvalued price, your returns will be negated over the long run. This is what happened with Telstra. The overvalued price in the early 2000’s was a combination of excitement regarding the tech boom, and Telstra’s strong returns on equity.
If we plug Telstra into our intrinsic value formula, using 2018 numbers, this is the share price we get for a 10% required return.
24.82/10 x 1.26
Now, because Telstra is primarily a dividend stock, the above valuation doesn’t quite work. The returns generated aren’t added to book value per share.
Telstra paid a 10 cent dividend last year. For simplicities sake let’s say that continues. That is a 12.6% yield over the book value per share. This would be a good return; 12.6% return on our equity (remember that most of Telstra’s earnings are paid as dividend).
However with a share price of double this, that’s only an approximate 6% return. There is far too much risk in telecommunication industries, to warrant paying over $3 a share, for a 6% return.
Telstra may seem like it’s offering value, but with declining returns on equity (which they hardly utilise by adopting such a high payout ratio), a declining earnings base, structurally challenged earnings and a decreasing dividend, there is no valuation given; it's futile to value a company with declining metrics.
Remember, no one can predict the future....
NBS does outlooks a little differently. This isn’t your cookie cutter, one-two year outlook on revenue and future dividends & earnings etc. I try be more creative, and look at the longer term trends. In no way do I believe my predictions are going to be correct, because I respect that humans have a horrible track record of predicting which technologies will change the future. However, if an existing service is poor, its guaranteed that someone, one day will come in with a new business idea, to make it efficient and more profitable.
WIFI has gotten cheaper, quicker and more accessible over the years. Gone are the days of slow dial up internet and needing to have a telephone line next to your phone box.
The way the world is travelling, data and the internet are going to become even cheaper and even more accessible, probably at an accelerated rate.
Check out this blog. I believe this is where our telecommunications technology will be in a few years. I see little long term value in existing structures/infrastructure such as power lines and phone boxes; it can be done more efficiently, and thus more profitable, with methods such as satellite technology.