When Telstra chairman John Mullen went on television last week to talk about how good Amazon has it because it doesn’t have to pay shareholder returns, the immediate assumption was he was softening up his 1.6 million investors for a dividend cut next month.
Mullen, the former chief executive of rail giant Asciano, is the kind of guy who speaks his mind, and his comments would not have attracted so much attention if they had not come a week after a closely-watched Citi telecommunications analyst predicted Telstra was preparing to cut its dividend from 31¢ to 25¢ next year.
The telecoms giant is not the kind of company that traditionally goes around cutting its coveted dividend. Returns have, at worse, remained steady year-on-year since the federal government sold the first tranche of Telstra shares in 1997 and its history of paying strong returns has always been a drawcard for retail and institutional investors.
However, many analysts and investors in the $49 billion company now believe chief executive Andy Penn now has no choice as Telstra comes under pressure to re-invest profits back into the business which faces rising national broadband network (NBN) access charges and growing competition in its core mobile business. Penn also believes his shareholders want him to invest for the future and strengthen itself against new rivals.
“They have been overpaying their underlying earnings and we have felt for some time that a day of reckoning is coming,” says one fund manager who no longer holds Telstra stock. “Telstra has been softening people up. It has not had growth for years but investors stick with them. When the dividends are cut there will be a big rotation on the register.”
A modest dividend cut has already been factored into Telstra’s share price, which has been the fourth worst performer in the S&P/ASX100 over the past 12 months, coming in only behind Santos, Vocus and TPG Telecom. The stock has fallen 30 per cent during that period while the broader market is up 4 per cent. Telstra shares have slipped around 6 per cent in the past fortnight.
One school of thought is that Telstra will gently reset expectations with progressive cuts to the dividend over the next few years as new mobile competitors, a dwindling fixed-line business, and payments to NBN for broadband access chip away at its ability to capitalise on its monopoly over phone and internet infrastructure. Telstra has traditionally paid almost 100 per cent of its earnings out in dividends, giving it one of the best payout ratios in the market.
Mullen, who replaced Catherine Livingstone as chairman in April last year and talks to Penn at least once a week, has a background in turnaround stories and is not afraid of making tough decisions when a company needs fixing. There are precedents for taking the knife to luxuries such as dividends in order to reposition a company for future growth. This is something former Transurban chief Chris Lynch did successfully at toll-road operator Transurban.
However, other investors disagree, arguing Telstra has the strong balance sheet, ample free cashflow and the earnings growth to support a sustainable dividend policy for years to come, although they are not adverse to the idea of redirecting excess funds to buybacks while the share price is low.
“Their dividend is covered by earnings and will continue to be for a few years. If they cut it they would then have money to reinvest, to buy back shares. It is really a case of do they need the money? They have a competitive position which makes it a higher quality business than the average business,” says Investors Mutual portfolio manager Hugh Giddy.
“I think Telstra should do a combination of allocating capital to best use, buybacks when the share price is low, and investing in things which are promising.” Giddy says, adding if he had to make a guess, there will not be a dividend cut next month. Telstra will announce the outcome of its capital management review strategy on August 17 when there should also be guidance on whether or not it will securitise the payments in receives from NBN Co.
Penn’s biggest challenge is finding new revenue streams in a market where the telco’s core fixed-line and mobile business is losing traction. When investors ask him what the strategy is, Penn talks about repositioning Telstra as a world-leading technology company, something Australia does not have at the moment. Penn is not trying to replicate Google, Amazon or Facebook but is focused on tapping into the huge potential of e-health, the Internet of Things and other revolutionary technologies that are going to require high-speed data networks. The only company that comes close to his vision is US wireless giant Verizon but that does not have a fixed-line business.
There are huge opportunities for Telstra from its customers’ insatiable appetite for high-speed data. Telstra is investing in new technologies but it will take years before they will generate the same revenues as its traditional telco services. Mobile made up 39 per cent of Telstra’s revenue by product in the first-half of 2017, against 25 per cent for fixed, 11 per cent for data and 11 per cent for Network Application and Services division, which is Telstra’s IT business..
There were high expectations for Penn, the former AXA Asia Pacific boss with a reputation for striking deals in Asia who had been waiting in the wings as chief financial offer. A string of outages which crippled services last year hurt the company’s reputation, although there are signs customer satisfaction levels are improving. Expectations around a big Asia push never materialised and investors are disappointed Penn never sold Telstra’s stake in Foxtel, which has been forced to slash its pricing model since the arrival of streaming services like Amazon. Telstra has a history of missing the boat on asset sales such as Sensis which was worth $9 billion at its peak, although it made a profit on the sale of Autohome in China in 2014.
Penn inherited more than he bargained for when he took the hot seat. Few predicted TPG’s aggressive crack at the mobile market or some of the unfavourable regulatory decisions. “I think Andy is in a tough spot. He was handed a bit of a hospital pass. David Thodey harvested this business and ran it dry,” one investor says. Criticism of Thodey, who exited the company on a high, is rare as the former chief executive was credited with transforming customer service, negotiating an $11 billion deal to sell its copper networks to the National Broadband Network (NBN) and kicking off the investment in new start-ups and ventures such as health.
The golden days are clearly over. Citi expects earnings before interest, tax and depreciation to fall from about $10 billion in the 2016 financial year to just below $8 billion by the end of the 2022 financial year, largely due to the NBN. NBN access charges and growing mobile competition will squeeze margins, although cost cuts will partly offset some of the pain. Investors will be watching the full-year results next month for any signs the mobile business is under pressure as competition ramps up. Telstra has committed to $3 billion in “customer-focused” investments over three years but its rivals are also spending up big. Optus on Friday announced it was spending $1 billion on its network while TPG splurged on $1.2 billion in spectrum in April as it prepares to be the fourth-largest player in mobiles.
Goldman Sachs says mobile competition increased in early July instead of moderating as expected. Optus has been discounting mobile plans but Telstra’s current price premiums of 18 per cent are in line with its recent average of 16 per cent. Juniors such as Amaysim Australia are undercutting the established players with cheap mobile plans.
Penn is heavily focused on the new opportunities in the technology space. The chief executive, who has 41,000 Twitter followers, said in a LinkedIn article published this month that the expected surge in data volumes over the next few years was comparable to the volume of traffic on your street increasing tenfold overnight. Telstra expects a 5G network to be operational in Australia by 2019/2020, which will be crucial to enable networks to cope with the number of devices, data volumes and the high speeds needed for things like driverless cars. Telstra Ventures also invests in start-ups and companies such as Snapchat. If Telstra is to retain its dominance in a fast-changing industry, Penn and Mullen may have to reset expectations around a company that might no longer be the cash cow it once was.