In the late 1980s, IBM Ltd [NYSE:IBM] was the most admired company in the world.
IBM was making profits hand over fist. Executives were getting rich. Shareholders were watching their stock climb ever higher. IBM could do no wrong as demand for computers was exploding.
The company sold the hardware. It was cheap, easy to make. And if demand kept up there was no telling how high the stock would climb.
But upon seeing how much money IBM was making, others saw an opportunity.
All IBM really did was make indistinguishable computer parts. No one bought a computer solely because it had IBM parts inside. Big Blue simply had a dominant market position in an industry growing to the moon.
So when companies like Compaq and Fujitsu came into the market, IBM’s amazing margins spiralled down.
In fact margins fell so far, IBM went from making US$6 billion to losing US$8 billion.
Quickly, IBM had to find another wave to ride. Thankfully, the internet was emerging at the same time. IBM built a consulting division from the ground up and started helping businesses get online.
In just a few years, IBM climbed back to admiration. And today the US$130 billion firm resides as an aristocrat of American business in the Dow Jones.
The question most Aussie investors are asking is if Telstra Corporation Ltd [ASX:TLS] can now do the same.
Disrupt or die
Almost all Aussies own a bit of Telstra stock. Maybe not in a personal trading account. But I’ll bet your super holds Telstra.
And what a terrible stock it’s been.
Had you bought Telstra since listing, you’d now be down more than 60%. Had you bought the stock three years ago, you’d be down more than 50%.
Only those who bought at lows during 2010 and 2011 would be able to say they’ve made money. And they’d have an 8–9% return to show for it.
Safe to say management has failed shareholders.
But could the following years be different for Australia’s largest telco? The stock is trading at a seven year low after all.
Current boss Andy Penn has also adopted a ‘disrupt or die’ mentality.
You see, Penn is trying to do what IBM did in the 1990s. The low margin infrastructure business is a leg Telstra can no longer stand on.
If they want a stock they can be proud of, Telstra needs to become a global tech giant. Like IBM riding the internet wave, Penn believes Telstra’s wave is 5G.
The Australian Financial Review reports:
‘The bigger picture Penn is selling is the equivalent of a global telecommunications revolution coming with 5G and trying to position Telstra to take advantage of this – to the mutual advantage of its customers and its bottom line. As he sees it, telecommunications is “at a tipping point”.
‘The economic value of the explosion in the demand for more data, he says, was not really captured by the world’s telcos despite their spending on capital investment.
‘That has led to a decline in returns on their invested capital over the past 10 to 15 years. Penn’s aim is to get Telstra’s return on invested capital back above 10 per cent in a post-NBN world. But how?
‘He still describes connectivity as the core business, sustained by ever more data and ever more sophisticated technology. (NB Canberra: He describes his “enormous regard” for China’s Huawei even though Telstra, unlike Optus, Vodafone and TPG, mainly uses Ericsson.)
‘But “the telco of the future”, as he describes it, will also require very different skills in areas like the internet of things, software defined networks, big data and data analytics.
‘So in his view, migration to 5G will provide a massive opportunity for new economic value to be created and “the crucial question” is whether telcos can capture more of that from now on.’
But is this reason to jump at a beaten down Telstra?
The transition won’t be easy
I’d like to draw your attention to a few figures.
That was Telstra’s profit margin in the first half of 2018. It’s not the worst, but it’s definitely not the best. You could say its representative of the service Telstra sells.
What really sways Aussies when buying a mobile plan?
For most, I’ll bet its price. No one other than rural residents has an incentive to buy into Telstra’s service if not for price.
You or I could easily switch to Optus or Vodafone, which is why so many providers try to lock you in for 24 months.
That’s how much of Telstra’s assets are tied up in expensive networks and equipment. This also happens to be the percentage Telstra spends from cash generated each period to keep the business humming.
While these large costs prevent new competitors from coming into the market, its impacts the amount of future cash Telstra can generate.
But it’s why Penn plans to leave behind the old infrastructure business and pursue higher margin projects like the internet of things, software defined networks, big data and data analytics.
I’m not entirely sure if Telstra can pull it off. Not only will it take a number of years and lot of cash but also an intense focus on users.
How do think tech giants like Amazon, Google or Alibaba become so successful? They focused on giving customers a better price, experience and service.
If Telstra can’t get this right, it’s probably best to keep watching the stock from afar.
Editor, Money Morning