With the RBA cutting interest rates to 1.5% this week, higher yielding shares such as Wesfarmers Ltd (ASX: WES) and Woolworths Limited (ASX: WOW) may now have greater appeal. However, Telstra Corporation Ltd's (ASX: TLS) dividend appeal and yield of 5.4% stand out even among higher yielding shares in my opinion. In fact, I think that Telstra's shares will rise for the following three reasons, which will cause the company's dividend yield to shrink.
Financial strength
While a high yield is appealing, it is the affordability and sustainability of Telstra's dividend which makes it a relatively strong dividend stock in my view. For example, Telstra's net operating cash flow has averaged $8.5 billion per annum during the last two financial years. Despite major capital expenditure of $4.5 billion per year over that period, Telstra's free cash flow of $4 billion per annum was sufficient to cover dividends 1.11 times.
Further, Telstra's balance sheet remains sound, with the company having a debt to equity ratio of 117%. While this may be high relative to other ASX-listed stocks, Telstra's stable business model and resilient track record of financial performance allows it to borrow in order to maximise return on equity (ROE), which stood at 30.7% in FY 2015.
Growth prospects
Telstra's dividend growth prospects are also high, with the company focused on becoming Australia's leading provider of consumer and business services on the National Broadband Network (NBN). In my view, Telstra's strategy to clearly differentiate its services versus peers through higher network quality and unique products and content experiences is a sound strategy which could allow it to generate higher margins than its rivals. Examples include Telstra TV and Telstra Air and with NBN connections rising by 56% in the first half of FY 2016 to 329,000, Telstra's strategy appears to be paying off.
Further, Telstra has growth prospects outside of Australia via its goal of generating a third of revenue from the Asia-Pacific region by 2020. To do this, an aggressive M&A strategy is being pursued which includes the acquisition of Pacnet. This has expanded the scale and capability of Telstra's fixed infrastructure in the region, as well as improving its reach and network density.
Diversification
While Telstra's increasing geographic diversification lowers its risk profile, so too does its move into healthcare. That's because with the launch of Telstra Health in 2015, it will gradually become less reliant on telecoms and media for top and bottom line growth. In my view, this makes its dividend even more reliable, while also providing growth opportunities which could boost free cash flow and the amount paid to the company's investors.
For example, Telstra is seeking to provide new solutions within ehealthcare which leverage its existing strength in connectivity and which therefore may allow Telstra to gain a competitive advantage over its ehealthcare rivals. Together with its strong financial standing, growth in Australia and abroad, as well as its increasingly diverse earnings profile, I think that Telstra's share price will rise over the medium term. This means that its 5.4% yield may not be on offer for all that much longer.
