Shares in Telstra (ASX: TLS) are at an attractive 21% discount to our $4.50 fair value estimate. There is no impact on that intrinsic valuation from the restructure and trading update, with fiscal 2024 earnings guidance reaffirmed and management's fiscal 2025 projections in line with our expectations.

However, management targets to achieve the guidance have shifted subtly. Rather than aspiring to revenue rejuvenation led by mobile, there will be even more attention on cost reductions, especially "resetting" the expense base for the fixed-line enterprise unit.

This is hardly a surprise as we forecast the division's earnings before interest, taxes, depreciation and amortisation (“EBITDA”) to crater to $127 million in fiscal 2024, from $912 million in fiscal 2020. Hopes of stopping the revenue decline of legacy products in data/connectivity and network-attached storage have all but evaporated and resizing the unit's cost base is now a priority.

Removing annual consumer price index-linked price reviews in July for postpaid mobile (24% of group revenue) eliminates an in-built revenue booster and a key consensus earnings growth driver. But with postpaid mobile subscribers approaching 9 million (on average revenue per user (“ARPU”) of over $53), from less than 8.6 million three years ago (on ARPU of $46), management could be forgiven for easing pricing and focusing on reducing churn from the current 11.4%. This is especially true since Telstra's mobile EBITDA margins are already at 47% (from 33% three years ago) and its mobile prices are still at a high 20% premium to the industry average.

Granted, removing the annual pricing review for postpaid mobile may indicate a step-up in competitive intensity. That would take the shine off our thesis of maintained rational pricing in the mobile industry. However, with Telstra's return on invested capital still at just 7.8% and lower for TPG (6.1%) and Optus (low single digits likely), we do not see irrational competitive behavior returning soon, particularly given the capital deployed rolling out 5G.

Business strategy and outlook

Telstra's performance during and since the depth of COVID-19 demonstrates the resilience of its earnings and the strength of its balance sheet, especially given the negative impact on high-margin roaming revenue was material during the pandemic. The $2.7 billion cost-out program under T22 has been delivered and management is now focused on hitting the $500 million cost reduction target under the T25 plan.

Telstra is the leading telecommunications services provider in Australia. It has dominant market share in each service category and customer segment, and enjoys cost advantages which underpin its narrow moat rating. While competition is robust, mobile market shares are likely to prove resilient.

Telstra's infrastructure provides the most comprehensive coverage for fixed-line, mobile, and broadband in Australia which drives reliable cash flow. Telstra is not the cheapest provider of telecommunications services but is the lowest-cost provider resulting in EBITDA margins of over 30%.

The NBN has reshaped Telstra and a slimmed-down operational base is now focused on mobiles, network applications and services, or NAS, and digital media. Competitive advantage in coverage and speed of the Telstra mobile network attracts customers demanding reliable mobile connectivity. The network has the capacity to handle escalating demand for data. NAS delivers value-add services on Telstra's high-speed networks, including cloud computing, high-definition video conferencing, and managed data networks for private and public sector entities.

Offsetting its success in mobile, fixed-voice products are experiencing both structural decline and increased competition. In line with global trends, revenue from traditional voice services provided by the public switched telephone network, or PSTN, or copper network, is in decline. The advent of the NBN will result in the gradual decommissioning and transfer of customers to the NBN, but Telstra will receive compensation.

Moat rating

We have assigned a narrow economic moat rating to Telstra. The key source for the moat is cost advantage, stemming from Telstra's dominant market shares across all segments of the Australian telecommunications space. This cost advantage is augmented by characteristics of efficient scale in the Australian telecommunications industry, aided further by Telstra's extensive infrastructure assets.

Telstra generates almost 60% of group operating earnings from the mobile telephony division. Its mobile subscriber base has ballooned from 12.2 million in fiscal 2011 (40% market share) to 22.5 million in fiscal 2023. The growth has been driven by the superior quality, speed and coverage of its mobile network—one that is capable of offering triple plays (mobile, data, audio-visual media), further enhancing its competitive positioning compared with peers.

Telstra also operates fixed-line broadband businesses. Even in this ultra-competitive space, the company is maintaining its dominant share of subscribers.

We also estimate that Telstra generates meaningful earnings from the corporate and wholesale telecommunications market—one in which we believe it commands an approximately 50% share.

This substantial scale across all Telstra's key business divisions furnishes Telstra with the ability to maintain/improve its competitive advantage via technology upgrade, marketing and promotion, content rights bidding. Any investment spending is able to be spread over a large customer base, thereby, reducing per-subscriber costs and placing Telstra in a superior position against competitors.

To complete the strategic picture, Telstra owns (or has large interests) in three of only five internet protocol transit (or submarine optical fibre cable) infrastructure out of Australia. It also owns one of only three national, intercity backhaul fibre networks in Australia which connects all the metropolitan and regional communications infrastructure.

The capital costs required for a new entrant to replicate even a small part of this infrastructure ownership, scale and brand power would be prohibitive, especially in a relatively small country such as Australia and in a relatively mature industry such as the Australian telecommunications market (low-single-digit compound annual growth rate over the past five years). Consequently, there are characteristics of efficient scale (mature demand, high sunk costs), with limited opportunity for new entrants to add profitable capacity.

All this has manifested in our estimated returns on invested capital exceeding the weighted average cost of capital—excess returns that we believe will continue for the next 10-plus years.