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Is the Telstra share price a dividend trap?

Is the Telstra Corporation Ltd (ASX: TLS) share price a dividend trap? That’s the question we’ll be looking at today in a thorough examination of Australia’s biggest telco.

The Telstra share price has caused a lot of interest in 2019 so far. Telstra shares started off the year at $2.77 but ended up at just over $4 by the start of August in an incredible run up of over 44%. However, sentiment shifted soon after and as of Friday, Telstra shares will only set you back $3.57.

At this level, Telstra is offering a dividend yield of 4.49% (which is bumped up to 6.4% if you include the full franking credits), based on Telstra’s most recent interim and final dividends of 8 cents per share each.

But is this dividend sustainable? To get an idea, let’s look at what’s happened to this former dividend darling over the last decade.

A brief history of Telstra

Telstra used to be a government-run company – a monopoly provider of telecommunications infrastructure and services in Australia. Back in the pre-internet era, this was a very simple operation. Telstra owned and maintained the ‘copper network’ of telephony infrastructure that all phone calls went through.

When competition was introduced into the telco markets in the 1990s, competitors (in a very bizarre arrangement) would actually have to rent Telstra’s copper lines before trying to compete against Telstra’s own phone services for customers.

Either way, Telstra won.

This made the company a very lucrative investment, and the government (knowing this) embarked on a privatisation of Telstra that took place over a decade (1996–2006).

As Telstra had such a strong monopolistic grip on Australia’s telecommunications infrastructure, it was able to pay a huge dividend to its investors. Telstra shares would typically offer a grossed-up yield around 10%, which was the status quo until around 2017.

The NBN wrecking ball

I would hazard a guess that almost no one hates the NBN (national broadband network) more than a long-term Telstra share holder. And here’s why. The NBN was dreamt up by the then-new Labor government back in 2007 – the plan was to build a government-owned national broadband network that would supply Australia with world-class internet speeds.

This would require optical fibre technology – which was far superior to the then-common ADSL service that utilised the existing copper network (which Telstra still owned). So Telstra was forced by the government to sell its copper network back to the government-owned NBN Co. for a tidy sum (which was rushed out the door in dividend form).

Shareholders were initially happy with the continuing cash flow, but in 2017 it became evident that Telstra was now in a lot of trouble.

The loss of its prized copper network meant that the rivers of cash were starting to run dry. The company had gone from owning the broadband network that its competitors leased in order to compete against it, to a level playing field for the first time.

Telstra was forced to slash its cherished dividend from an annual 32 cents per share to 11 cents per share. Over the past year, it has been cut again to just 8 cents per share.

The Telstra share price also followed, going from over $6.60 in 2015 to the all-time low of $2.62 last year – making this company one of the most hated shares on the ASX for a time.

Although things are looking better share price-wise, many investors are worried that Telstra’s dividend woes are not over yet.

Will Telstra cut its dividend again?

Well, that’s the $1.88 billion question. The first thing to note is that back when Telstra cut its dividend, it changed from a policy of paying out nearly 100% of its earnings as dividends, to paying out a new range of between 70–90%. Telstra wanted to use this money to help invest in its future – a future that will be less NBN/broadband-focused and more reliant on its mobile network as well as the rollout of 5G (more on that later).

In FY19, Telstra banked $7.98 billion in earnings before interest, tax, depreciation and amortisation (EBITDA) and $3.2 billion in free cash flow (adjusted $2.86 billion). The company has issued guidance for FY20 for expected earnings of between $7.3 billion and $7.8 billion, and free cash flow of between $3.4 billion and $3.9 billion.

I think it’s also worth noting this excerpt from a Telstra ASX announcement, released in August:

The clearest view of future financial performance of the business is provided by looking at underlying EBITDA, excluding the recurring in-year headwind of the nbn, which in FY20 is expected to grow by up to $500 million.

So from these numbers, I don’t see any immediate threat to Telstra’s dividend and I don’t see Telstra shares as a dividend trap.

Of course, if NBN connections don’t go to plan, or if there are unintended consequences from the T22 cost-cutting strategy, Telstra might be forced to undershoot its guidance and pay a lower dividend, but I feel this is unlikely. I wouldn’t expect a dividend pay-rise in the near term, but I do think that we can expect the Telstra payout to remain steady.

Is Telstra a buy right now?

Telstra has traditionally been seen as a dividend stock, and as discussed, I think it is still a worthwhile buy for income alone. But I also think Telstra is a high-quality company worth investing in for growth as well.

The first reason is Telstra’s market share. Although there are many competitors in both the mobile space and NBN broadband, Telstra has roughly a 50% market share across both sectors. The company’s reputation as having the best mobile network in the country is a formidable brand moat that will continue to benefit Telstra well into the future.  

Telstra has also taken a definitive lead in the race towards 5G mobile technology. 5G is the next wave of advancement in mobile data transmission and promises far superior speeds to the current 4G standard. Telstra is expecting the roll-out of 5G to facilitate a wave of innovation in the ‘internet of things’ space, so it goes without saying that this has a lot of tech enthusiasts as well as Telstra shareholders very excited.

If any ASX company is set to reap the potential benefits of 5G, it is Telstra and I think this is another reason for investors to look forward to this company’s future.

Foolish takeaway

After looking at Telstra, I still believe this company is a great stock to own for any dividend investors out there, and it also has a compelling growth narrative to take it into the coming decade. Of course, nothing is certain in investing (or life), so things could still go wrong for the company. But I think Telstra’s management team has done a great job so far in adapting Telstra into a leaner and more competitive business, and I’m still very bullish on what the future holds.

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Motley Fool contributor Sebastian Bowen owns shares of Telstra Limited. The Motley Fool Australia owns shares of and has recommended Telstra Limited. 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 Scott Phillips.