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Telstra stands out in resilient telecoms sector

Glenn Freeman  |  17 Mar 2020Text size  Decrease  Increase  |  
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Internet and mobile phone usage in households across Australia is soaring as businesses direct staff to work from home to help slow the spread of coronavirus.

Millions of office workers are now logging on remotely including around 5500 staff from big-four consulting firm EY and 2500 from law firms King & Wood Mallesons and Clayton Utz.

The Australian Securities Exchange also sent staff home on Monday after a worker at its Sydney head office tested positive to COVID-19.

Australia's National Broadband Network faces its biggest test, which is a reminder of just how reliant we are on telecommunications services.

"When markets and the economy are like this, all sectors are at risk but telecommunications would be one of those that is relatively safe," says Morningstar senior equity analyst Brian Han.

"Telco earnings are relatively more dependable than earnings from other sectors," Han says.
"Then on top of that the businesses are generally in solid shape, and even if they are more highly geared than other sectors, there's a reason for it. Because of their dependable earnings, they can have higher debt and still be able to service it."

The following chart shows the share price movements of Telstra, TPG and Vocus since the end of January, versus the S&P / ASX 200 shown by the shaded line.

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Source: Morningstar

In the current market environment, Han says it's about which businesses have the balance sheet to survive and come out at the other end of the downturn.

Telstra is Han's pick of the three telecommunications companies on the research books of Morningstar Australia, all of which hold narrow economic moats.

"There is more upside to our fair value, and back to that point about balance sheet, it has the lowest gearing," he says.

Telstra (ASX: TLS)

Economic Moat: Narrow | Morningstar Rating: 4-star | Fair Value Estimate: $4.40 | Share Price: $3.35

Telstra's free cash flow rose by 36 per cent to $1 billion in the first half of fiscal 2020, as capital expenditure fell 39 per cent on the winding down of its $3 billion strategic investment program.

"It's net debt-to-EBITDA of 1.9 remains within the comfort range of 1.5 to 2 and is the lowest of all three [alongside TPG and Vocus," Han says.

He also notes Telstra is likely gaining market share in mobile services during the half, having added 137,000 post-paid and 135,000 prepaid customers.

"Little wonder management is alluding to higher gross mobile margins from the middle of fiscal 2021, consistent with our forecast 100 basis point increase in EBITDA margin in fiscal 2021 to 35 per cent."

There are some negatives, of course. Telstra's fixed broadband EBITDA that continues to "haemorrhage", falling 51 per cent in the first half to $419 million), says Han. Data and IP services also dropped 20 per cent to $647 million. 

"While the outlook for mobile is improving, its EBITDA did fall another 2 per cent to $1.9 billion in the period, with average revenue per user slumping 7 per cent," Han says.

"But none of this is a surprise. The bottom line remains that Telstra is satisfactorily executing on its simplification and the $2.5 billion 'weight-loss' program—factors within management's control."

TPG Telecom (ASX: TPM)

Economic Moat: Narrow | Morningstar rating: 3-star | Fair Value Estimate: $8.50 | Share Price: $6.93

Han lifted by 6 per cent his fair value for TPG earlier this month, on news the low-cost mobile service provider's merger with Vodafone had cleared its final regulatory hurdle.

The merger should be completed by July, after Australia's Federal Court overturned the Australian Competition & Consumer Commission's decision from more than 18 months earlier.

"This good news was supplemented by a better-than-expected 6 per cent decline in fiscal 2020 first-half underlying EBITDA to $424 million, primarily driven by corporate on-net fibre growth and continuing efficiency gains," Han says.

Soon after news of the merger bid's success, TPG shares were trading 4 per cent below Morningstar's fair value estimate. Further falls in the share price since then mean it's currently trading at an 18 per cent discount.

Han emphasises the strategic importance of the merger, which should see the combined TPG-Vodafone entity become a more formidable competitor to Telstra and Optus in both mobile and fixed broadband.

But he also notes the merger will increase the debt load of TPG, and he sees hiccups ahead as the two companies unite.

"Management's track record in extracting cost-savings from everyday operations and realising synergies from acquisitions is exemplary. But the merger with Vodafone is on a whole different scale and there could be many more cooks in the kitchen than TPG is used to when integrating businesses," Han says.

His EBITDA estimate for the combined entity is $2 billion, up from $1.9 billion previously. And Han factors in net debt of $4.5 billion for the merged group, up from $3.9 previously.

Vocus Group (ASX: VOC)

Economic Moat: Narrow | Morningstar Rating: 4-star | Fair Value Estimate: $3.20 | Share Price: $2.41

Vocus is a telecommunications company squarely focused on corporate and government customers. It owns an extensive fibre and data centre network that has been built up over a number of years, both organically and through acquisitions.

Han lifted his fair value estimate by 7 per cent to $3.20 a share last month after management reported 2 per cent growth in underlying EBITDA to $179 million.

"Benefits of a rejuvenated sales team, a more targeted approach to customer segments (oil and gas, government) and overhead cuts are evident in network services," Han says.

"As such, we have increased our estimates for the division and reduced our group overhead cost assumptions, leading to an average 5 per cent increase in our operating earnings forecasts beyond fiscal 2020."

First-half free cash flow of $16 million was up from a deficit of $78 million a year earlier. Last year's result was affected by $133 million spent on the Australian Singapore Cable project - a 4600km submarine cable system linking Perth, Western Australia, to Singapore, via Jakarta, Indonesia, and Christmas Island.

As a result, net debt declined to a little over $1 billion, reducing net debt-to-EBITDA to 2.8, from 2.9 six months ago and comfortably below the 3.5 covenant limit.

"We expect this deleveraging to continue, down to 2.6 by the end of fiscal 2020, versus covenant a limit at that time of 3.25," Han says.

is senior editor for Morningstar Australia

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