excellent read

I have taken the libery to 'lift' this article from FNArena. This is IMO an excellent non bais article on the potential value of TLS. Pls note its is long, but well worth the read.

Cheers

Does Telstra Have Any Downside?
FNArena News - March 11 2010

By Greg Peel


Telstra (TLS) is an enigmatic beast. At best it represents how a combined private-public ownership model was always going to be fraught with difficulties and conflicts and at worst it represents a hasty and ill-informed decision by a previous government hell bent on privatisation of public property.

That is not to say only one government is to blame, because a the decision to force competition in cable television (which then became cable internet as well) by an earlier government was also a na�ve and ultimately costly decision. Costly for the Australian people who have suffered from stunted growth in global telecommunications technology from that point on.

What we have in Telstra is a stock widely held by the Australian public who also, given Telstra's dominance as a telco ,make up a lot of the customer numbers directly and, given Telstra owns Australia's only fixed-line network, are quasi-customers indirectly as well, regardless of which provider they choose.

What neither the Howard nor Keating governments were ever expected to anticipate was the rush of technological development in the space. When internet access was still �dial-up�, Telstra owned the only copper network. At the same time, Telstra owned one cable network for the delivery of cable television and Optus ((SGT)) owned the other. A microwave alternative was offered which is now what Austar ((AUN)) concentrates on but at that stage mobile phones were really still the stuff of sci-fi, other than the occasional house brick version.

Then broadband was introduced which first ran over the same cable television cables, offering a clear choice between Telstra and Optus as carriers, until software development ensured copper wires could deliver equivalent broadband as well. So Telstra was back to dominance with its copper network, given no one had to pay to connect anything new, such as a television cable, to their home.

In the meantime, mobile phone technology surged in leaps and bounds such that we all now have one, and what's more we all have one that can access broadband. Telstra spent a lot of money becoming dominant in this space as well.

Thus we have a telco in this country which is close to a monopoly because it has access to all of copper wire, cable, and mobile spectrum infrastructure. No one else has copper, only Optus has another cable network (limited as it is) while mobile spectra are up for grabs. In other countries, smart legislation from the outset ensured competition by disallowing ownership of any more than one or two forms of infrastructure. But Telstra has never been able to truly �monopolise�, because on the other side of the infrastructure equation has been the government's ongoing shareholding and capacity to set prices for the benefit of all Australians, but at the detriment of Telstra profits.

Telstra has responded by finding profits in other ways, such as streamlining service extensively to the point that Telstra is arguably the most hated service company in the country � even more so than the banks.

A combination of all of the above has meant Telstra shareholders have simply seen the value of their investment erode over time and it's hardly any wonder. It has only been cashflows converted into a very high yield that has maintained Telstra's investment appeal, and debt has been used to maintain that yield. Telstra's capacity to continue paying such high (franked) dividends is also now seriously under threat.

The Howard government left fighting an unresolved battle with Telstra over who might build and pay for a new fibre network � a more recent technological development � and the Rudd government has inherited the mess.

Rudd's answer to Telstra's refusal to build a fibre network and offer government-controlled access pricing has most recently been to threaten to build from scratch a complete new fibre-to-the-premises network which would ultimately render Telstra's copper network redundant. But Telstra was never too concerned, because (a) the sheer cost and time involved in such a build was considered by many to be the stuff of fairy tales and (b) Telstra was happy to hitch its wagon to ongoing mobile broadband development in competition anyway. There has always been consideration that by the time the government had finished its National Broadband Network (NBN) we would have all moved on to some other new space-aged technology anyway, which doesn't yet exist.

But take that attitude to the nth degree and you'd never build anything. It's like saying we won't build anymore roads because someone will come up with a flying car shortly.

What the Rudd government knew all along, nevertheless, was a fibre network could be built much more cheaply and quickly if it meant just gradually replacing Telstra's existing copper network with fibre, rather than building a parallel network from scratch. But for this it would need Telstra's cooperation � something which the previous government never received in any way, shape or form. But the Rudd government had a cunning plan.

The Rudd government knows that the private-public experiment has been a disaster for all concerned. The government can't make Telstra do what it wants because it sold off the copper network and Telstra can't make sufficient profits because the government can control pricing. It has proven a mutually destructive stalemate. And the Rudd government knows the Australian electorate is not happy either, given for years it has experienced poor service, or poor shareholder returns, or both.

The situation has thus empowered the government to get tough and provide Telstra with an ultimatum. Join the NBN project, bringing your copper network with you, or we will not only build our own fibre network but we will also forcibly split up your retail business from your infrastructure ownership and we will will limit your access to mobile spectra as well. In other words, we will force competition upon you and smash your monopoly.

This regulatory threat threat has been hanging over Telstra for a while now, sending its share price south and upsetting shareholders. But then Telstra had managed to send its own share price a long way south beforehand anyway, meaning the alternative has not seemed that rosy as it is. What's more, Telstra's latest profit result showed that the company is losing its fixed line business through technological attrition and losing mobile customers to boot, given better deals and service are being offered elsewhere.

Telstra is fast losing its leverage. The clear win-win situation for everyone would be for Telstra to come to the party, offer over its copper network and keep its retail business and mobile opportunities intact. But to sell back its infrastructure to the body that sold it to shareholders in the first place would require sufficient compensation to keep shareholders happy. Any deal really hinges on this amount, but as each day passes and Telstra loses more leverage that amount is eroding in value.

Indeed, the government could potentially offer nothing, suggesting to Telstra that it has no other choice. However, that would be to upset a lot of people who vote. It has become a fine line for the government to tread. Realistically, it needs to convince Telstra shareholders that an NBN solution with Telstra on board is the only way any value can be realised from their shareholding, threat of split-up or no threat of split-up.

But any ideas in that direction were dealt a blow yesterday. The weak interim result sent Telstra shares spiralling down to an historical low of $2.88 but yesterday's declaration by the Opposition it would block any regulation changes in the Senate sent the shares back up to $3.00 (and they're up again today). The implication here is that Rudd will have to fight over Telstra and the NBN in an election, so it's best get the deal right. Which means we're back at the compensation argument.

The question is: What exactly will Telstra, and Telstra's shareholders (given they will be given the opportunity to vote in an EGM) take as sufficient compensation? Telstra the company has less leverage now but Telstra shareholders could simply vote with their feet by voting out the government before any split threat could be realised.

But it's even more complicated than that, given the amount of Telstra stock held in bulk by fund managers who need to show returns, along with the Future Fund holding, which Peter Costello has a say over, all of which rather swamps little old individual investors anyway.

What a mess.

The analysts at Morgan Stanley have been working on the conundrum, deciding the best way to approach a Telstra investment recommendation is to first break the business down into its constituent parts from a valuation perspective. The major division is between those businesses unaffected whether the government builds an NBN or not not, and those threatened by a competing NBN.

The analysts declare the unaffected businesses to be worth $1.43, net of all debt. Those are the Sensis directory business, CSL in Hong Kong and TelstraClear in New Zealand, and the mobile business. There's also Foxtel, but Telstra may be forced by the government to sell its cable network stake and ascribing a representative discount means Morgan Stanley values this at only 10c.

The mobile business is of great importance given Telstra enjoys 42% market share with a skew towards higher value, post-paid customers. It also has the capacity to offer sweeter deals on fixed line bundling given it owns the fixed lines so all up Telstra's mobile margins run at about 34% to a comparative 27% at Optus. But Morgan Stanley has conservatively used 27% margins in its valuation given fixed line business is waning and given the introduction of new �smart phone� contracts will mean a bigger outlay to buy these more expensive phones without being able to pass all of the difference onto the customer.

The rest of Telstra's businesses and valuation are impacted by what happens with the NBN. The worst case scenario, says MS, is the NBN is built without Telstra over an eight-year period and slowly but surely Telstra loses business to the new network, forcing a gradual exit from a once dominant fixed line business. Eight more years of slowly declining revenues is worth, by the analysts' calculation, $1.45.

So at worst, Telstra is worth $1.43 plus $1.45 equals $2.88, which happens to be exactly the low point it bounced off last week.

So why wouldn't you buy Telstra at $2.88, argues Morgan Stanley. And what's more, alternative outcomes offer potentially �free� options over greater value.

When it's all said and done, the government is not going to offer nothing for Telstra's copper network. Even if commercially the copper network is a dinosaur watching a meteor approaching, it still involves the simple infrastructure elements of pipes and ducts and so forth the government would otherwise have to lay to feed its fibre network. MS is valuing this at $10bn or 22c per share.

Furthermore, MS does not think it's realistic to assume the last Telstra fixed line customer will hang up the day the fibre network is completed. There will still be a lingering customer base beyond 2018. So that's another free option above $2.88.

And MS also believes Telstra could actually retain its mobile margin premium over Optus anyway, given it is the dominant player.

Adding these values back takes us from a �bear case� of $2.88 to a �base case� of $3.65.

Now if we assume the government will actually pay more than $10bn for the copper network to keep everyone happy � MS suggests $20bn � and that as part of the new NBN Telstra achieves a market share of 50%, then we get to a �bull case� scenario valuation of $4.83.

So what Morgan Stanley is saying is that Telstra is worth no less than $2.88, is probably at least worth $3.65, and could be worth $4.83. You'd have to buy them here then, wouldn't you?

Well yes, but the MS analysts are also making one big assumption, as they declare, and that is Telstra has no choice but to engage the government in negotiation. The alternative is to risk being split up and that simply isn't viable. If that didn't actually ever happen, Telstra might also decide to build its own fibre network in competition and the expense of that would also send its share price south.

So Morgan Stanley's �bear case� valuation excludes these dire possibilities as being not worth considering in reality. As an investor, if you are prepared to agree then $2.88 offers nothing but upside (and today's $3.06 at the time of writing still most of the upside). But you will need to be patient, because it is the uncertainty of it all and general fear that is keeping the share price down at low levels.

One suggestion is for investors to cover the risk of Telstra and the government going their own ways by using call options as the investment tool from here. There is not another dividend payment due until August.