Why Telstra Corporation Ltd shares might not be a buy today

Source: Telstra presentation

Australia’s largest telco, Telstra Corporation Ltd (ASX: TLS), is a household favourite both for its brand recognition and its huge dividend – currently 6.1%. However, the company faces some serious headwinds in the next few years that it will struggle to overcome:

  • $2 billion to $3 billion hit to Earnings Before Interest, Tax, Depreciation, and Amortisation (EBITDA) upon the completion of the NBN which is expected to be in 2020
  • Rising capital expenditure on the network
  • High levels of debt with gearing* at 49% and management’s target range between 50% and 70%
  • Rising interest rates over the longer term

*Gearing = net debt divided by (net debt + equity)

The bad news

From Telstra itself: “Overall, the forecast net effect on our business is a reduction of $2-3 billion in EBITDA per annum at the conclusion of the nbn™ build.” Telstra’s EBITDA was $10.6 billion in the latest full-year results, so $2 billion represents a significant chunk of this. With modest growth expected over the next few years, Telstra will struggle to replace this multi-billion dollar black hole. This could also place pressure on dividends.

In combination with this, capital expenditure and debt are rising, potentially due to having to conduct more maintenance on an ageing network. Readers will likely remember the repeat Telstra outages over the past year or so. Management has stated they intend to lift debt to invest in a number of opportunities including a $3 billion spend on ensuring ‘continued technology leadership to significantly improve customer experience’.

Although rising interest rates appear to be a long way off, investors shouldn’t overlook the potential impact from this. Telstra already carries $17 billion in debt, and each 0.25% increase in rates could cost the company more interest. With $5.8 billion earned in profit last year, a 1% rise in rates would start to measurably nibble away at Telstra’s hard-earned bottom line.

The good news

With strong cash flows and market dominance, Telstra is in a good position to invest in or buy additional growth opportunities outside the mainstream telco space – either here or overseas.

Unfortunately, while the company may or may not make successful future investments, it is guaranteed to bump into the above EBITDA headwinds and higher interest rates sooner or later. Investors should be sure to look at the company’s prospects carefully before buying Telstra shares today.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. 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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