Joseph Taylor: Hey, Brian. So, we're here to talk about Telstra today, and it's fair to say that things are going pretty well in the business?

Brian Han: Definitely, Joseph. As you would have seen in their results, I think the mobile business is going really well, but equally importantly, I think in their fixed line businesses where you have revenue pressures, they are doing really well in terms of taking costs out to respond to that revenue pressure. So, all is well, the dividend looks secure, and I think that's what most retail investors are looking for in Telstra.

Taylor: So, a big part of the story, as you talked about there, is cost cutting, especially in the fixed line business. We had quite a few job losses there in May. Is there any more fat to trim there?

Han: I think there will constantly be rationalization going on in that business because when you think about it, those fixed line revenues are under persistent pressure, especially in those legacy businesses. And also in the network application services business, I think they've come to realize that the revenue potential is not as big as they previously thought. So, they are running really hard in terms of rationalizing the cost base to reconfigure the whole cost structure to respond to that lower revenue outlook in that whole business.

"Margins are rising to perhaps embarrassingly high levels"

Taylor: On the mobile side, things are a lot rosier in terms of growth and the market position.

Han: Well, Joseph, three years ago, mobile margins were about 35%. Now they are about 46%, 47%. What I'm trying to say is the margins are rising to perhaps embarrassingly high levels and that's why in their results they started giving veiled messages to the regulators in saying “look, our margins are high, but we invested a lot and therefore we are not gouging consumers. This is what we deserve to have because we invested a lot and those margins”. I think they'll continue to go up because their mobile subscriber share is holding up very well. I mean, they are the market leader, and they are holding up very well and that's simply because people recognize the quality of Telstra's network, especially compared to the other two. And I think investors and even consumers realize that the prices that they're paying for those mobile prices, they were perhaps a little bit on the low side before because all these competitors were basically having a bun fight to fight for subscribers by discounting. Now they've come to realize that you know what, all those billions of capital that we're investing in the network, we better get a commercial return on those. So, you have a situation where you have a market with only three players. Each player is now more focused on return on that capital and therefore you see this phenomenon of rising prices finally from all three operators.

Taylor: So for the mobile side, it's a mature business and Telstra has a very strong position. There's not many competitors, only two of them really of note. What does that mean for the dividend? It's a mature kind of cash cow business. What's the outlook there?

"The dividend outlook hinges on how successful they are in all these efficiency gains and cost cutting initiatives"

Han: Yeah, the outlook right now is probably stable. And I only say that because as you know, Telstra is not just a mobile business. Over half of their earnings come from mobile, which means the other half you still have to look out for. And the other half consists mostly of those fixed line businesses where revenues are under pressure. So, on the dividend outlook, it really hinges on how successful they are in all these efficiency gains and cost cutting initiatives that they're undertaking. So, it's very important that they keep on doing that to adjust the cost base in their fixed line businesses so that the earnings continue to come through to support that dividend because you can't really rely on mobile earnings to underpin the current dividends.

Taylor: Great. So, the outlook for the mobile side looks good, but cost cutting is still key in the other side of the business?

Han: Exactly, exactly. And then one thing that investors should keep in mind is that – or especially Telstra should keep in mind is that from now on, whatever new investments that they undertake, they need to be mindful of the return that they will get from that investment. Because as I said before, you don't want a situation where Telstra starts thinking of itself as a public service provider, putting in all this capital and all the value accrued to the users, including tech companies. So, it is important that from now on, whatever capital spending that they do outside of mobile and their core businesses, that there is a good investment return case for doing so.

"It is very important that they continue to be disciplined about price rises"

Taylor: And the shares at the moment, they're just under four bucks a share. Your fair value is $4.50. So, a little bit of value there?

Han: I believe so. I think there is dividend support to underpin the current share price. But then beyond that, it really is about the cost cutting on the fixed line side and then continued margin stabilization on the mobile side. And on that mobile side, it is very important that they continue to be disciplined about price rises, not to excessively high levels, but enough so that they get adequate returns on the capital that they're sinking into the network and into 5G.

Telstra

  • Star rating:★★★★
  • Economic moat: Narrow
  • Fair Value estimate: $4.20 per share
  • Share price on August 16: $3.95

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.