Fresh from a share price battering yesterday Telstra Corporation Ltd (ASX: TLS) is now trying to persuade investors that the decision to slash its dividend nearly 30% is the right one for the long-term strength of the business.
Back on July 18 Telstra's chairman softened up the market to expect a coming dividend cut when telling News Corp journalists: "If Telstra hadn't paid a dividend for 10 years we'd have a $50 billion war chest to take on these new competitors".
In so doing Mullen warned that Telstra is now competing in the technology space against powerful international rivals like Amazon. Inc that pay no dividends and reinvest free cash flows in new products and to gain market share.
Which way next?
Over the past year the stock has fallen 28% roughly in line with the dividend cut announced yesterday and going forward its share price will track expectations for dividends over the 36 months ahead.
Telstra now expects to pay out 70%-90% of underlying profits as dividends and up to 75% of NBN one-off payments will be returned as a special dividend. In effect it estimates that dividends in FY 2018 will total just 22 cents per share including NBN payments.
Selling for $3.90 today Telstra offers a fully franked yield of 5.64%, which is roughly in line with recent averages and suggests the stock is around fair value.
But two factors will dictate the future direction of the Telstra share price
Firstly, the level of the RBA's base cash rate will make the risk-adjusted returns more attractive to investors if it stays at 1.5% or even lower.
However, if the RBA lifts rates in 2018 as widely predicted the share price could come under pressure as the yield is less attractive and stocks like Telstra are valued on their ability to deliver an excess return over the risk free rate.
Debt, cash, money markets, and the risk free rates they offer ultimately act as the driver for what cash flow returns equity investors should demand in compensation for the additional risk they are taking on.
So Telstra investors today should consider the potential for Australian cash rates to rise between 2018 to 2020.
The second issue is whether Telstra will be forced to cut its dividend further in FY 2019 as its underlying profit falls under margin pressure from competition and due to the effects of the NBN.
At the end of the day share prices will follow a company's earnings and dividends higher or lower and if Telstra cannot deliver growth the shares could fall further over the 36 months ahead.
I expect the stock will track largely sideways over the 12 months ahead, so if you're looking for income and the potential for more growth it may be worth looking elsewhere.
