Intelligent Investor: Gaurav Sodhi on Telstra’s hidden value
There’s value in this battered old household name, but it has yet to be unlocked
Here is what a rotting decline looks like: a decade back, Telstra generated revenues of just under $25 billion and operating profit of just over $10 billion. Nowadays revenues are about the same but operating profit has fallen 40% to $6 billion.
Telstra is a business in decay that continues to pay dividends it can’t afford.
Over the past 10 years, when smartphones have displaced computers and data consumption has grown exponentially, the country’s largest telecommunications business has gone backwards.
There is no mystery as to why. When a one-time monopolist enters a competitive world, margins and market share tend to fall. Telstra’s business has also changed with the advent of fibre, the decline of copper and the introduction of 5G.
If pressed, most would agree that Telstra’s best business is mobile. It boasts more than 18 million mobile customers – more than Optus and Vodafone combined – and it generates the best average revenue per user (ARPU) and the highest margins in the industry.
Yet despite the advantages of scale and network quality, mobile returns have withered. Operating margins have fallen from 45% to 35% and earnings are lower now than they were five years ago. All this from Telstra’s crown jewel.
The rest of the business has fared worse. The broadband business has had its wholesale monopoly torn apart and replaced by NBN. Margins and profitability have been shredded to reflect the business’s transition to a mere reseller. Telstra still accounts for one in two of every retail broadband connections but profitability has suffered and won’t be restored.
Worse, efforts at filling the earnings hole have been mixed and desperate.
Beginnings of a turnaround
Telstra has bought a bewildering array of businesses, from cybersecurity firms and IT consultancies to Chinese internet portals and an American streaming service. Attempts at finding a new crown jewel have failed. Until now.
A savage restructure involved the usual cost cuts, job losses and corporate-speak, but also resulted in Telstra splitting its infrastructure assets into a separate business. Dubbed InfraCo, these assets remain within Telstra but won’t stay there. Telstra has outlined plans to split into three distinct units with the aim of unlocking the value in its infrastructure.
The plan is more ambitious and far-reaching than we’d imagined and now we can see what was previously hidden: Telstra owns a ripper infrastructure business.
Originally consisting of Telstra’s exchanges, ducts, data centres and sub-sea cables worth over $11 billion in asset value, the fibre backhaul that supports the mobile business and the network of 8000 towers and masts that host Telstra’s networking gear will also be part of InfraCo.
Telstra’s tower assets alone could be worth billions if they were free to pursue new revenue. That now appears more likely. Towers, backhaul and other parts of InfraCo currently generate revenue from servicing Telstra alone. If liberated, they could service new customers and, because they are largely fixed costs, extra revenue could translate to profits at an exceptional margin.
It’s clear from Telstra’s financials and from the profit of international network operators that mobile and broadband are no longer the lucrative businesses they used to be. Infrastructure, however, is coveted due to its stable cash flows and high yields that tower above pygmy interest rates. Telstra is doing the right thing splitting its infrastructure from its services businesses.
The split, which includes two separate infrastructure businesses, should create substantial value because the infrastructure segments should attract higher valuation multiples than mobile, broadband and services.
Telstra has outlined three segments: InfraCo Fixed, InfraCo Towers and ServeCo. Let’s examine each in turn.
InfraCo Fixed
This will own and operate exchanges, ducts, fibre, subsea cables and data centres. These generate stable, high-margin cash flows and carry long-term leases to NBN and Telstra itself.
The largest portion of earnings will come from exchanges and ducts, which carry a net asset value of $7.2 billion. Fibre assets, which include linkages to data centres and mobile backhaul, carry net asset value of $2.6 billion. Subsea cables are worth $1.2 billion on the balance sheet.
We believe each of these assets is worth at least 20%-50% more than their accounting values imply.
InfraCo Towers
The towers business carries a modest value of $300 million on the balance sheet but is arguably the most attractive part of the business. This value has been heavily depreciated. Moreover, once towers are in place and connected to fibre backhaul, they are expensive to replicate.
Towers have been enormously successful overseas and create an infrastructure monopoly blessed with high recurring margins and limited competition.
American Tower, Crown Cas- tle and SBA collectively own most of the mobile towers in the US and charge operators for using that infrastructure. Verizon and AT&T, for example, pay to use tower sites in targeted locations. Those sites include land and infrastructure on which operators place their own sourced networking gear.
This is an efficient way to deliver mobile services, allowing the best tower locations to be shared by many carriers and generating stellar returns for the owners. Mobile networks are a natural monopoly, so it makes little sense to duplicate a network once it has been constructed.
Telstra uses about 8000 mobile towers and proposes another 6000. Some of these assets are owned by third parties and leased, but many are company-owned. Telstra owns the land, the tower and the fibre and has established its own network gear to operate on-site.
Depending on how Telstra’s tower contracts are structured, the business could be worth at least 10 times its current accounting value. If the towers are allowed to host other networks or offered future locations, the value could be even higher.
ServeCo
The conventional Telstra services business will be housed in ServeCo. Freed of its dividend obligations, which should naturally move into InfraCo segments, it should grow quickly. Telstra won’t just unlock hidden value from its assets, it may also become a more competitive business.
The plan outlined by management is more radical than even we expected. The mechanics and math of the split should create value, but they also send a signal to the market that has so far been ignored.
Welcome back, Telstra
Since the NBN was conceived, Telstra’s broadband business and wholesale monopoly have been doomed. Telstra has long known that profits would fall and for a decade has been obsessed with plugging the gap in earnings the NBN has created.
More than $3 billion a year has been snatched from operating profits and Telstra has been flailing wildly trying to replace that figure. Paying stupidly high dividends hasn’t been so much a reward for shareholders than an apology: compensation for lost value.
That mad scramble is now at an end. In splitting, Telstra has effectively accepted that its business has changed and that it must now adapt.
The new proposed structure should unlock the hidden value of Telstra’s enormous asset base and increase the competitiveness of its core business. Hopefully, better use of the company’s cash flows and a sensible dividend policy will follow.
That market hasn’t yet accepted or priced Telstra’s response accordingly. We think the business in its new, three-pillar form could ultimately be worth at least $4-$5 a share. We’re raising our buy price from $3.20 to $3.50 and our sell price from $4.50 to $5, although the numbers may change as we learn more about the future of its towers. This is a rare opportunity to buy a household name at a misjudged price.