Has Telstra Corporation Ltd become too risky?

Source: Telstra presentation

Last week I sold all the shares I held in Telstra Corporation Ltd (ASX: TLS) – something I didn’t expect to ever do.

There are a number of reasons for that.

  1. The full rollout of the National Broadband Network (NBN) will cause a $2 -$3 billion negative hit to earnings before interest, tax, depreciation and amortisation (EBITDA), according to Telstra’s chief financial officer Warwick Bray.
    That’s much larger than I envisioned, and despite the billions of dollars in compensation from the government, Telstra will need to generate between $5 and $7.4 billion in additional revenues at an EBITDA margin of around 40% to cover the hole. I see that as highly unlikely.
  2. Telstra’s gross debt was $16.2 billion at the end of June 2016, and with $3.6 billion of cash, net debt was $12.5 billion – but has been steadily growing.
    Gross borrowing costs were 5.6% which appears fairly high when interest rates around the world are still near zero. Should interest rates rise, Telstra’s interest costs will rise, cutting into net profit and cash flow available to pay out dividends.
  3. Capital expenditure is growing, with Telstra forecasting up to $3 billion in additional capital expenditure over the next three years, resulting in a capex to sales ratio of around 18%. In the 2016 financial year, Telstra had $25.8 billion in revenues. Paying out nearly a fifth of that in capex each year ($4.6 billion) will impinge on the group’s ability to continue to maintain its existing dividend payments.
    While that capex will generate a return in future years and Telstra is targeting a return in excess of its return on invested capital (ROIC). But ROIC has been falling too and was at 13.6% in 2016 compared to 15.7% in FY2015.
  4. Better opportunities elsewhere. It’s clear that Telstra’s dominance in mobile and broadband means the company struggles to generate meaningful growth in earnings. Unless the company can expand offshore successfully – which is risky, or find new ways to generate growth domestically, the company will struggle to fill the hole caused by the NBN in the short to medium-term. Longer term, I see Telstra potentially able to expand into profitable new areas like eHealth, but they may take some time to develop and grow.
  5. Increased competition from the likes of TPG Telecom Ltd (ASX: TPM), Optus and Vocus Communications Limited (ASX: VOC) could see Telstra lose some of its market share.

In the meantime, there are better opportunities in smaller companies growing fast, without the problems Telstra faces – like Flight Centre Travel Group Ltd (ASX: FLT) – which also has a lower P/E ratio than Telstra’s current 16.2x, or home builder Tamawood Limited (ASX: TWD) – which has a P/E ratio of 10.7x and pays a dividend yield of 7.4% – better than Telstra’s current 6.1%.

Foolish takeaway

Paying a premium price for a blue chip that is struggling to grow and faces a number of growing threats is probably not a great way to beat the market. So it’s goodbye for now to Telstra.


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Motley Fool writer/analyst Mike King owns shares in Flight Centre, TPG Telecom and Vocus Communications. You can follow Mike on Twitter @TMFKinga

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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