Last Updated: 24 December 2016
Telstra (TLS) is a household name in Australia. It is a provider of telecommunications (telco) and information products and services in Australia and offshore. In recent times it has revamped up it’s strategy with a bigger focus on its mobile and cloud storage solutions. In terms of Australian businesses there is little doubt that Telstra has a strong economic moat…
Telstra’s Economic Moat
Telstra’s origins dates back to the 1901 where it was established to manage all domestic telephone, telegraph and postal services. At the time it was integrated with the postal services under the Postmaster General’s Department (PMG). Telstra was then incorporated in 1991 as a public limited liability company and over the period of 1997 to 2007 it was fully privatised.
Telstra’s history as the manager of all domestic telephone and telegraph services meant that it owned all the infrastructure required to facilitate these services. In recent times the Australia government rolled out an initative coined the National Broadband Network (NBN) and established NBN Co Limited to manage it. The objective was to enhance Australia’s telecommunications capabilities in line with global standards. Since Telstra owns the infrastructure that facilitates telecommunication services there has been various deals between Telstra and the NBN Co Limited to ensure that Telstra is properly compensated for use or removal of their infrastructure.
Telstra operates in a monopolistic industry as the dominant player. Its economic moat comes from owning the infrastructure that enables telecommunication services to be viable in Australia i.e. it owns all the copper lines that are required for broadband and telephony services. In addition, the industry is driven by high initial capital investment and ongoing capital expenditure. The industry is operated by a small number of players. The main players in this industry excluding Telstra are Optus (owned by Singtel who is subsequently owned by the Singapore Government) and Vodafone.
More information here.
Business Strategy and Composition
Like any large corporation with a significant history, Telstra’s products and operating segments have changed over time so I will only be considering Telstra’s current structure as of FY16. While we are at it, we should probably look at their strategy as well…
The Strategy of a Telco Giant
To be honest, Telstra’s strategy is nothing revolutionary and is generally typical of large corporations. In the case of slow moving industries such as telco things are even less impressive. There are three pillars to Telstra’s strategy:
- Improving customer advocacy;
- Driving value and growth from their core business; and
- Building new growth businesses.
Yup…as generic as it can get. Again with large corporations like Telstra, I tend to care more about their actual performance over their strategy. Sure a bad strategy can be detrimental to the performance of the business however its performance provides confirmation that the strategy is working. Especially for well established businesses that don’t rely on an amazing strategy to be viable. For example Uber would rely much more on executing their vision then say Telstra would. WOO customer advocacy!!!
Current Operating Segments
According to the most recent annual financial report, Telstra is divided into four operating segments. The segments are mainly split up based on the profile of the clients they deal with as opposed to Telstra’s product lines. Three of the segments are client specific while the fourth segment deals with maintaining the infrastructure required to service Telstra’s clients. The FY16 annual report provides a very clear description of the roles of the different segments – a summary is provided below:
- Telstra Retail (TR): Services retail customers as well as small and medium businesses. It also operates the Telstra stores seen around Australia.
- Global Enterprise and Services (GES): Services government and large corporations globally. The segment offers more tailored telecommunication and data solutions to their clients complex requirements.
- Telstra Wholesale (TW) : Management of clients that leverage off Telstra’s telecommunication and data infrastructure such as other mobile service carriers.
- Telstra Operations (TOps) : Management and development of all Telstra infrastructure including the Telstra network. Provider of services under the NBN Definitive agreement and Telstra Universal Service Obligation Performance Agreement (TUSOPA)
From the FY16 annual report:
Below is a breakdown of FY16 sales by operating segment:
It comes to no surprise that Telstra being the dominant player in the Australian telco industry derives a large proportion of its revenue from its retail segment. I’m not sure whether 60% of Telstra’s revenue in retail is necessarily a bad thing but definitely something to keep in mind.
Current Product Lines
Through Telstra’s four operating segments the telco giant provides various products of which the main product lines can be categorised as fixed broadband, mobile, data and IP, network application & services (NAS), digital media and international. Below is a breakdown of sales and profit margin by business product line:
Over 60% of the revenue comes from the fixed broadband and mobile product lines which is reasonable given Telstra’s line of business. It has over the recent years expanded its footprint in the Data & IP and NAS product lines which demonstrates that it is adapting well to the changing technological environment.
It’s nice being on the top. An oligopoly is a market structure in where a few firms dominate the market. The telco industry generally exhibits the oligopoly market structure due to the capital and regulatory intensive nature of the industry. Businesses that operate in this industry can only be viable when they have achieved a certain level of economies of scale. Telstra operates as the leader of the telco oligopoly and this gives it a significant economic moat…
An Oligopoly in a Mature Industry
According the IBIS Industry Report published on the Oct 2016 the telecommunications service industry in Australia is a 43.4 billion industry that generates 6.4 billion in profits for the participating businesses. Over the last five years the industry has been driven by strong price competition in conjunction with the shift in consumer behaviour towards usage of mobile devices over the traditional fixed line services.
The industry is definitely not an aggressively growing industry. It is fairly stable with its established major players that have found the appropriate operating model that makes their business viable. It comes to no surprise then that the IBIS Industry Report say that over the last five years the revenue growth in the industry has been a measly 0.1% annualised. They also estimate that over the next five years the industry will experience 1.5% annualised revenue growth.
It is safe to say that this industry will stay in the long term. There will definitely be changes to products and services that the industry provides as consumers’ lifestyle and habits change but the fundamental driver is that consumers will still need a method to stay connected to the world. This is where the industry will continue to adapt by providing consumers these points of connectivity.
A good example of the adaptability of the industry is through the changes we have experienced recently in consumer behaviour. More and more people are turning to mobile devices to keep them connected to the world. This has translated into a significant amount of investment in the industry on mobile network infrastructure. The investment has paid off though and the growth in revenues over the last five years have been driven by increase usage of telecommunication and data services through mobile devices. This growth however has been offset by the decline in revenues from the high margin fixed line telephony services which are ever increasingly being replaced by low cost VOIP alternatives.
Market Share and Profit Margins
The major players in this oligopoly are Telstra, Optus and Vodafone Hutchison Australia (VHA). There are other minor players of which only three are worth mentioning: TPG (<5% market share), Vocus Communications (<1.5% market share) and NBN Co (<1% market share). NBN Co is a government owned entity that is tasked with purchasing all of Telstra’s fixed line infrastructure, upgrading it to a high speed, open-access wholesale-only network. The aim is to increase the competition in the telco industry and strip Telstra of its competitive advantage. Below is the market share of revenue of the major players according to the IBIS Industry Report published in Oct 2016.
As you can see from the numbers above, Telstra has a very high market share and this seems to have been the case over the years. It is worth noting that the Optus and VHA the other two main players have their own mobile network infrastructure which they have heavily invested in over the last five years to ensure a mobile network coverage that rivals Telstra.
In terms of EBITDA and profit margins, Telstra clearly dominates the industry in Australia. EBITDA and profit margins have been derived from the latest annual financial reports as of November 2016. Note that the margin calculations for Optus and Vodafone may include sales and earnings from their respective parent companies. I did not dig deeper because I am focusing on Telstra and did not want to undertake the time consuming task to derive the actual margins.
Managers and Owners
All information on Management and Ownership is as of 12 Nov 2016.
Who are the Telco Owners?
Since the complete of the privatization of Telstra in 2007, the government still holds a residual interest of 1.42% in Telstra. Managed funds dominate the list of telco owners with 88.36% while there is little interest from hedge funds at 0.45%. This is good as it demonstrates that Telstra’s stock is not an overcrowded investment idea by the hedge fund industry.
It also makes sense that there is little interest from hedge funds as Telstra is stable business in a mature industry as the industry leader with a fair valuation currently. These type of stocks do not provide the short term gains that hedges funds are looking for.
Ownership of Telstra by management is predominately through remuneration and nothing notable here. Although there was a recent purchase at the current low prices by insider. Director Jane Hemstritch bought 67,500 shares at 5.4465 which represents approximately 350K investment! A good sign that now might be a good buying point.
Interestingly, 37.71% of the telco owners are classified as Australians. A smaller amount than I expected. On the other hand, 32.67% is owned by the U.S. This is predominately through managed funds and represents a doubling since 2010 presumably because of global search for yield.
Overall the board and management seem properly remunerated and competent. Remuneration of the top executives are relatively inline with remuneration offered at competitors Singtel and VHA. There is also a clawback clause which ensures that in the event of losses suffered by Telstra due to inappropriate decisions by management their compensation may be taken back to cover the losses.
Short term (STI) and long term incentives (LTI) are based on relevant metrics and align with other competitors STI and LTI policies. STI is based on FCF, EBITDA, Total Income and Net Promoter Score (NPS). LTI is based on the relative total shareholder return.
- CEO: Andrew Richard Penn (Andy)
- 1.5yrs tenure
- Successor Thodey who was CEO for 6yrs.
- Was CFO for 3yrs before being appointed.
- Part of the Board of Directors.
- $2.325m base remuneration with $6.769m total remuneration.
- 1.2m shares of TLS, shares in the past year have been acquired through exercise rights.
- CFO: Warwick Bray
- 1.5yrs tenure
- Appointed after Andy was appointed the CEO role. Warwick has spent 6 years in Telstra prior to his role as CFO.
- $1.1m base remuneration with $2m total remuneration.
- Group Executives for divisions are relatively new with less than 0.5yrs tenure.
- Chairman: John Patrick Mullen – 0.5yrs tenure
- Current CEO of Asciano Ltd which he has held the role since 2011.
- Has been on the Board of TLS for 8 years.
Performance and Valuation
Telstra is your typical telco company. It is large, stable cash cow that doesn’t really have spectacular year on year growth. Below is a data dump of various metrics that paint the picture of Telstra’s performance.
Financial data comes from Commsec Research which is available with a Commsec account. Data is from 22 December 2016.
Net profit growth fluctuates a fair bit but top line growth is pretty stable.
Impressive operating margins with have been stable over the last 10 years even with the technological switch to mobile connectivity and the nbn program.
Solid return on equity which is consistently above 25% even during the GFC.
Solid dividend track record. The dividend growth is lacking however is a minor negative point.
In terms of valuation, I’m comfortable using my current valuation methodology that I have used on investments such as AAPL and BBY. My valuation approach for these investments is to assume constant zero growth with a reasonable valuation multiple driven by historical and peer comparisons. This valuation approach works well with Telstra because of the stability of its operating performance and long standing dominant position in its industry. Telstra has maintained a long history of strong performance in light of continual changes in technology rendering some of its products and businesses obsolete. It has a track record of shedding these obsolete businesses and successfully invested in new ones over the long run. This provides a level of safety in the assumption that Telstra will continue to be a profitable business in the long term.
Disclose:: I am/we have no positions in TLS, and will not initiate a long position over the next 72 hours.
Disclaimer: : I wrote this article myself, and it expresses my own opinions. I am not receiving any compensation for it. Please note that all investments carry some risk. You should be aware that the value of your managed investment may not increase as quickly as expected, if at all, or that the value may go down. I have no business relationship with any company whose stock is mentioned in this article.