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In recent months, we have argued a shift towards quality defensives has merit. As we move into the mid to late stages of the cycle, we prefer companies with resilient earnings profiles that are relatively insulated from the macro backdrop.

Figure 1: Telstra is a low beta company given its defensive earnings profile

Telstra’s major segments include:

Figure 2: Mobile is the key driver of Telstra’s income

Telstra’s earnings have been plagued by NBN headwinds over the last decade

Telstra’s share price started coming under pressure in 2015, largely due to the impact of the Federal Government’s NBN roll out, which has been a significant headwind to earnings in recent years.

Figure 3: Telstra’s EPS has more than halved since 2016

The NBN has progressively replaced Telstra’s legacy fixed-line copper wire network, which previously connected most of Australia’s homes. As a consequence, Telstra is no longer the predominant wholesale fixed line network provider in Australia, which has led to a significant loss of revenue as customers transition towards NBN broadband services.

In its fixed line business, Telstra has gone from being vertically integrated, as both an infrastructure owner and a retail service provider, to now merely acting as a retail provider that re-sells access to the NBN, competing with other service providers on a level playing field. Telstra has labelled this permanent, recurring loss of earnings to the NBN as the ‘in-year NBN headwind’.

The NBN roll out has also driven a significant increase in the cost of providing fixed broadband services for both Telstra and its competitors, putting fixed-line reseller margins under pressure. We have also witnessed elevated competitive intensity between major players in the mobile market, with aggressive price cutting squeezing operator margins even further.

The downward trajectory of Telstra’s earnings in recent years has reflected this challenging industry backdrop.

Figure 4: Telstra’s underlying EBITDA has drifted lower due to NBN headwinds and intense competition between mobile service providers

On the bright side, as the NBN roll out is now effectively complete, we are at the tail-end of the so-called NBN headwinds, with management suggesting the ongoing drag from the migration off its legacy network is all but over.

Figure 5: NBN Headwinds have nearly peaked

Of course, this still leaves a permanent hole in Telstra’s earnings given the loss of its legacy fixed-line network. However, as this hole is no longer growing, earnings will likely have bottomed out in FY22, establishing a new base to grow from in the future.

Consistent with the improved backdrop, we believe Telstra is entering into an EPS upgrade cycle, with analysts increasing their earnings forecasts in a sustained manner for the first time in years.

Figure 6: EPS expectations for Telstra are now being upgraded by the street

Telstra’s latest strategy, ‘T25’, has the objective of achieving a mid-single digit underlying EBITDA CAGR and a high-teens underlying EPS CAGR to FY25, which will represent a material step change in the company’s earnings trajectory, if achieved.

Figure 7: T25 Goals point to step change in Telstra’s underlying EBITDA trajectory

In addition to the end of the NBN headwinds, Telstra’s medium-term earnings outlook is supported by a number of factors:

Figure 8: Mobile ARPUs are starting to rise again

Telstra is close to structurally separating its consumer facing business from its infrastructure assets. This will position the company to realise shareholder value that has been hidden in the previous amalgamated structure, given the strong institutional investor demand for strategic infrastructure assets, which typically command substantially higher earnings multiples as pure play investments.

The company started unlocking the intrinsic value of its infrastructure in 2021 when it sold a 49% stake in its mobile towers (Amplitel) for $2.8bn, reflecting a total value of $5.9bn and an attractive EV/EBITDA multiple of 28x - a substantial premium to Telstra’s current trading multiple of ~7.9x. Around 50% of the net proceeds of the deal were returned directly to shareholders.

Other recent transactions in the ANZ telco infrastructure sector include:

Telstra is likely to monetise more of its infrastructure over the medium-term, likely through the sale of minority interests in its assets like the Amplitel deal.

The next logical candidate is InfraCo – Fixed, which generates more than 6x the earnings of Amplitel, delivering >$2bn p.a. in external access revenues for fibre, network sites and ducts. Putting the FY21 EBITDA contribution of InfraCo – Fixed ($2.66bn) on a 12x multiple – which could prove to be conservative – implies an enterprise value of ~$32bn.

We believe the capital raised by future asset divestments will help to underwrite Telstra’s ordinary dividend payments while delivering incremental value to shareholders by funding large capital management initiatives like special dividends and share buybacks.

We prefer to assess Telstra’s valuation using cash earnings, rather than statutory earnings, because the company’s CAPEX is expected to be structurally lower than its depreciation and amortisation over the medium-term, given historically higher CAPEX and the mix of asset lives. Therefore, cash flow provides the best measure of Telstra’s underlying performance and is likely to remain ahead of accounting earnings.

Taking this into consideration, Telstra trades on a 12-month forward EV/EBITDA of 7.9x and a forward Price/ Equity Free Cash Flow multiple of 16.4x. This looks attractive relative to other ASX defensives, and given the expected recovery in the company’s earnings and the significant intrinsic value embedded within its infrastructure assets that is likely to be unlocked over the medium-term.

Figure 9: Telstra’s valuation is relatively attractive

WILSONS think differently and delve deeper to uncover a broad range of interesting investment opportunities for their clients. To read more of our latest research, visit our Research and Insights.

David joined Wilsons in 2020 as Head of Investment Strategy having spent more than 25 years as one of Australia’s leading investment strategists. He is responsible for overseeing the development of Wilsons' global and domestic investment strategy,...

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