Shares of telecommunications heavyweight, Telstra Corporation Ltd (ASX: TLS), have drifted marginally higher in afternoon trade following a key market announcement earlier today.
In an announcement to the ASX this morning Telstra said it has priced a $US1 billion debt issue in the United States at a coupon rate of 3.125% to mature in 2025. Telstra said the money from the notes will be used for, "general corporate purposes."
At 31 December 2014, Telstra had over $15.8 billion of debt on its balance sheet. With some other small liabilities and around $5.5 billion in cash, the enormous borrowings placed it in a net debt position of $10.5 billion.
With gearing at 43%, some investors may be concerned that Telstra's debt profile is too high.
However, it's important to look at it in context. Indeed, whilst on face value Telstra's debt pile appears huge, it generates enviable cash flows from its operations which comfortably support the interest payments.
Whilst Telstra's debt servicing of 0.9 times was below its target range of between 1.3 and 1.8 times, at 31 December 2014, its interest cover was 13.8 times (calculated as EBITDA/net interest) – well ahead of the 7 times management are currently targeting.
Moreover, Telstra's debt pile actually improves shareholder returns.
Indeed, similar to the way an investor uses a bank loan to buy a property and improve their returns, Telstra's cost of debt is significantly lower than its return on invested capital (ROIC) of 14.78%.
This means, hypothetically, if it can borrow debt for an average of, say, 5% but can invest that for a return of almost 15% – shareholders could potentially pocket the 10% difference.
Of course, there's the risk that Telstra would no longer be able to generate such impressive returns from its products or renew debt at the same low rates. However, with interest rates at record lows and much of Telstra's products now considered 'non-discretionary' (i.e. people are more likely than not to continue paying for their mobile phones even in the toughest financial conditions), that risk appears low in my opinion.
Should you buy Telstra Corporation shares?
Despite Telstra's ability to generate strong returns and pay out impressive dividends, the current valuation of its shares appears quite stretched. Indeed, at over $6.30 per share, Telstra shares do not appear to be a 'buy' but rather a 'hold'.
Any significant price drop below $5 per share could be a buying opportunity, but in this low interest rate environment that doesn't appear likely to occur anytime soon.
