Is Telstra Good Value?

Telstra stock

Over the past month or so I’ve given you some basic valuation analysis on a few recent corporate basket cases. I told you fair value for Blue Sky Alternative Investments [ASX:BLA] was somewhere in the $2 region (when it was trading in the $4 region), and that fair value for AMP Limited [ASX:AMP] was anyone’s guess, and should therefore be avoided like the plague.

Blue Sky has enjoyed a few decent rallies this week but that’s only because the multitude of short sellers have bought some stock back to lock in a profit. Once the short covering is over, the stock will likely flounder again.

And AMP has found no love over the past few weeks. Why would it? I seriously don’t understand why anyone would buy it here. The upside is minimal and the downside is rather large. It’s a poor risk/reward scenario.

Now, we’ve got Telstra Corporation Ltd [ASX:TLS] to consider. Its share price declined 6.6% yesterday, after falling nearly 5% the day before. The trigger for the fall was a profit downgrade, followed by a realisation that the company doesn’t have a strategy to deal with the loss of earnings due to the NBN rollout, or increasing competition in mobiles, which is where Telstra has a dominant position.

So is it a buy at these levels? After all, the stock is down more than 50% from its highs in early 2015.

Before I provide a valuation based answer, let me give you a more a definitive view:

That is, never buy a stock in a downtrend. And Telstra, let me tell you, is in a downtrend. A quick look at the share price over the past three years (see chart below) tells you that.

Money Morning 16-05-18

Source: Bigcharts

[Click to open new window]

It’s the golden rule I operate by in my advisory Crisis & Opportunity. By sticking to it, you can easily avoid falling into traps like Telstra, AMP, Blue Sky and countless others that might look appealing after they’ve fallen considerably. 

But at some point, Telstra will become good value and you’ll see that verdict playing out in the charts. That is, you’ll see downward momentum slow and the stock price will start to form a bottom.

My guess is that you could see it occur at the lows from 2010/11, when the NBN rollout first started freaking Telstra’s investors out. You can see this rather large round trip in the chart below:

Money Morning 16-05-18

Source: Optuma

[Click to open new window]

So $2.50 per share, here we come.

The Fundamentals

Ok, let’s get to the fundamentals. Telstra’s problem is that the NBN is assuming the role of national telco wholesaler. This used to be Telstra’s role. While Telstra receives some payments from the NBN to ‘rent’ its infrastructure, it still loses a net $3 billion from operational earnings thanks to the rollout. This effectively represents a handover of the wholesale margin.

And then there’s the prospect of falling margins from the mobile division. There simply isn’t much in the way of growth in the pipeline for Telstra.

Despite this, the company isn’t exactly a basket case. It’s the dominant telco in the country, and generates a huge amount of free cash flow. Based on analysts’ forecasts, Telstra will generate earnings per share of 30 cents in FY18, which translates to a decent return on equity (ROE) of 23%.

It’s likely earnings will get downgraded in the next few days/weeks, so let’s assume a sustainable ROE of 20%. That’s still pretty good. And it’s why you should keep your eye on the stock.

The other potentially positive point to note on Telstra (in terms of value creation) is the fact that it cut its dividend and is now retaining a greater portion of earnings for reinvestment.

Provided it can reinvest those earnings at a 20% ROE (or thereabouts) Telstra should create shareholder value.

If you assume that Telstra can maintain a 20% ROE and a 70% dividend payout ratio (meaning 30% of profits are reinvested) what is an estimate of value, assuming a required rate of return of 10%?

I get an estimate of $3.50 per share. That means Telstra is reasonable value here. But as I said, the stock is in a downtrend and should therefore be avoided, good value or not.

The thing is, the share price might represent good value. Or it might accurately represent an ongoing deterioration in the business and earnings. You just don’t know. I’d prefer to wait for the downtrend to stabilise and then turn before getting interested.

At which point, Telstra could be a cracking buy.

Regards,

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan

Greg Canavan

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

Greg Canavan

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