gottliebsen on dividends

Telstra precarious rather than prudent in paying out more than it earns
ANALYSIS
Robert Gottliebsen
16aug06

BY the old-fashioned rules of prudent financing Telstra should not promise a 28c a share dividend for 2006-07, let alone repeat last year's 6c a share special dividend.

But of course directors may take a punt and promise 28c or more because of pressure from a federal Government wanting to sell T3.
The company's earnings per share in 2005-06 were only 25.7c and did not cover even the base 28c a share dividend let alone the 34c that was paid. Whether current earnings can cover a 28c a share dividend will depend on the level of provisioning and the extent of the damage inflicted by the latest ruling from the Australian Competition and Consumer Commission. The cash flow sums are a better guide as to what is happening. Using simplified sums, in 2005-06 the company generated around $8.6 billion in cash from its operations - down from $9 billion in the previous year.

It spent a net $4 billion on capital investment, giving it free cash flow of a further $4.6 billion.

Directors were aggressive in trying to boost the share price and not only shelled out $5 billion in dividends but spent a further $750 million in a share buyback - a total payout of $5.75 billion. The company borrowed the shortfall. Directors defend their additional borrowing to fund capital and dividend payments by saying that the company's debt to equity was only 50 per cent compared with their target of 55 to 75 per cent. In addition, interest cover is sound.

In the current financial year Telstra was looking to a small rise in cash flow but the ACCC's latest ruling could start a price war, which will put further pressure on cash flow. Even if we are optimistic and assume that operating cash holds at $8.6 billion, the company is planning to increase its 2006-07 capital spending to between $5.4 billion and $5.7 billion, leaving only about $3 billion to distribute to shareholders without extra borrowing.

A 28c a share dividend would cost $3.5 billion.

Those who argue for maintaining the 28c a share dividend (or more) would point out that the company can still afford the extra borrowing and that in subsequent years capital expenditure will fall sharply.

Moreover management is aiming for 20 per cent returns on the higher spending in non-regulated areas (and to restrict spending in regulated low-return areas) so profits and cash generation in later years will rise - higher dividends this year are therefore a smoothing process.

But making Telstra forecasts is high risk. The company is caught in the worst of all worlds. The ACCC has been given a set of rules by the Government which say that there should be more competition in telecommunications and that Telstra should not be allowed excessively high returns in areas where it is the dominant or only provider of the infrastructure. Telstra says the ACCC has gone too far and not enabled it to cover its costs.

The Telstra board sacked its chairman and CEO because it could see a new strategy was required. Sol Trujillo was picked as CEO because directors believed he could play tough with the Government and the ACCC; develop new businesses; and revamp the existing operation.

If Trujillo and his team actually do transform Telstra then it will earn future returns sufficient to pay 28c a share dividend and a lot more. But a conservative board would wait until the runs are on the board before paying more dividend than is being earned - especially as earnings are under attack by the Government.