Is the party over for Telstra?
Telstra (ASX:TLS) has done well for its shareholders over the past several years. From a low of $2.60 in March 2011, TLS shares have risen to above $5.00, providing capital growth of around 90% as well as healthy, fully franked dividends along the way. This is well above the returns delivered by the broader market during that period.
More recently, the capital growth rate has eased back to “market” rates. For the last 12 months, TLS shares have added around 16%. This is still a very satisfactory result in absolute terms, but no better than the broader market which has also delivered 16% capital growth.
While the recent history of TLS returns is interesting, investors are naturally much more concerned with the future. The critical issue is: having delivered excellent returns for investors recently, is TLS poised to deliver further growth into the next few years?
Before we get into the analysis, it is worth making the point that as a general rule, assets that have delivered very good returns in recent periods tend to offer less attractive prospects going forward. The reason for this is that very good returns often come about as part of a process where prices move from being cheap to being fair value, or expensive. When prices become expensive, the balance of probability tilts against investors, and a move back towards underlying fair value becomes more likely than continued gains.
Of course there are exceptions. Some companies have the ability to steadily increase earnings year after year, and this drives their underlying intrinsic value higher. If intrinsic value rises indefinitely there is nothing to stop share prices rising indefinitely. Companies that have this character can deliver an exceptional investment experience – and are rightly prized by investors.
For TLS then, a useful question to consider is whether it has the ability to grow intrinsic value at a rate that can sustain returns into the future. If it doesn’t, then greater attention needs to be paid to the current intrinsic value, and what it would mean if the share price were to move closer to that intrinsic value.
A good starting point for growth in per-share intrinsic value is growth in earnings per share, and for an established business like TLS, history should tell us something about the future. A business that has not delivered earnings per share growth in the past may change its spots and do better in years to come, but these tend to be the exceptions rather than the norm.
When we look at the data for TLS, the historical picture is fairly stark. Over the past 10 years, TLS has delivered nearly flat EPS, averaging around 30 cents per share. FY13 was a bit better than average, with EPS hitting 32 cents, but this is no more than the result achieved in 2004. On a 10 year view, TLS EPS growth has effectively been nil.
This is an important point. It means that unless the future looks very different to the past, TLS is unlikely to deliver material growth in intrinsic value going forward. While the future is inherently unpredictable, it is worth noting that TLS is the dominant player in the Australian market, and technological change presents opportunities for nimble competitors to cherry-pick attractive market opportunities. In short, it seems difficult to mount a persuasive case for strong future growth for TLS.
This brings us to valuation. If TLS is unable to grow intrinsic value over time, then a comparison of current intrinsic value with share price should give us a sense of the potential future returns.
Estimating intrinsic value is as much an art as a science, but there are a few facts that are relevant. Firstly, over the last 10 years the TLS share price has fluctuated in a range between about $3.00 and $5.00 per share. The current share price is at the top of this range, and given that EPS has not grown in this period, it seems reasonable to expect that share price reversion back to the mean may be more likely than continued growth going forward.
Similarly, our estimate of intrinsic value for TLS sits well below the current share price. It must be stressed that this is only an estimate, but the conclusion is clear enough – there is more room for lower prices than higher prices going forward.
The timing of any reunion between price and value of course is impossible to predict. However, it is worth noting the role played by interest rates in current share price dynamics. With rates at record lows, it is natural that investors should favour stocks with the ability to pay a reliable dividend, and as long as rates remain low we should expect stocks like TLS to be viewed fondly.
When the market starts to anticipate increasing interest rates however, there is the potential for a significant reassessment of merits. We don’t know what the timing of that move might be, but from record lows it is clear that rates will rise at some point, and when you are convinced a party is likely to end badly, sometimes you can avoid a lot of stress by having a quiet night in.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Kent Wong
:
I am very happy with the consistent dividends of 28 cents in the past 5 years (?). In consideration of buying the shares below $3.00, the total return over the years are fantastic. I think the improvement of the share price in the past few years do not come with luck but reflects good management of Telstra especially the current CEO. He made several good decisions. I believe good management will improve EPS of the share and hence the intrinsic value of the share.
Wayne
:
Hi Roger,
A consistent yield 28 cents per share with credits would be ideal if you wanted not quite but almost certainty of revenue. The behaviour of the yield one could argue is like a long term bond. Maybe some investors like that?
Regards
Wayne
Dave B
:
Hi Roger,
Given your recent challenge to ‘technical analysis’ I’m a bit surprised to see the comment “over the last 10 years the TLS share price has fluctuated in a range between about $3.00 and $5.00 per share. The current share price is at the top of this range, and given that EPS has not grown in this period, it seems reasonable to expect that share price reversion back to the mean may be more likely than continued growth going forward”.
Not trying to catch you out but genuinely interested to know how this differs to quoting support and resistance, and do you consider this a good methodology?
Roger Montgomery
:
Just relating share price performance to eps. Notwithstanding any deterioration in ROE, share prices tend to correlate with eps over the long run.
Dario Petkovic
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As always – great article and analysis. I just hope I won’t get too greedy and hold TLS for too long!
Kent Wong
:
Roger
In general I agree with your view.
However I have a question. Have you considered the potential capital return when the government pay Telstra for its copper network ?
If it happens, does it mean the dividend yield of Telstra will improve to compensate for the effect of interest rate rise in the future ?
Also I believe Telstra is also undergoing cost cutting measures and acquisition of new business to improve its bottom line in future.
Hence I believe that the rise in the share price of Telstra is not only due to low interest rate but also the superior management of the current Board of directors.
Kent
Kent
Roger Montgomery
:
Just keep in mind, all of Telstra government compensation is just that; compensation. They are giving up something of value to receive those funds. Some years ago Telstra provided a slide deck listing all of the losses they were incurring and the compensation they would receive from the government in return. The money is not icing on the cake, it’s just cash compensation for giving something of value up.
Kent Wong
:
Roger
In general I agree with your view.
However I have a question. Have you considered the potential capital return when the government pay Telstra for its copper network ?
If it happens, does it mean the dividend yield of Telstra improves to compensate for the effect of interest rate rise in the future ?
Kent
waynelear1954
:
What would it take for earnings growth to occur with Telstra?
Roger Montgomery
:
A large increase in the population, the removal of competition so that prices could be raised etc etc etc….
matthew russo
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Hi Roger
Whilst Telstra’s growth may not be too flash a company with a very solid growth rate that you brought to my attention a while back was Silver Chef. I’m sure you have also noticed that the market has been less than pleased with its latest announcement. Are you still still as enthusiastic about its prospects as you once were? Or did you lose interest when debt to equity levels became a bit stretched earlier this year.
Regards
Matthew
Roger Montgomery
:
Not quite sure I understand the question Matthew but fortunately we sold it some time ago – unlike many other managers who attended the standing-room-only full year corporate briefing.
Alex Smith
:
“given that EPS has not grown in this period, it seems reasonable to expect that share price reversion back to the mean may be more likely than continued growth going forward.”
Correct me if I’m wrong but to me this statement essentially says the current P/E ratio is higher than it has been historically and it would be reasonable to expect some sort of mean reversion?
Why the focus on EPS (and therefore P/E) rather than ROE as a starting point for instrinsic value in this case?
Thanks
Roger Montgomery
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Just mixing it up here at the investors shack!
Vikings_7
:
Great analogy in the last sentence, lol.
Roger Montgomery
:
Thanks
Mike King
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Its not the past that matters but the future, and Telstra’s future will be different to its past. Just because Telstra has delivered flat earnings growth over the past ten years doesn’t mean it will in future.
That investment philosophy is like driving a car looking in the rear view mirror.
Roger Montgomery
:
Good point Mike but without a demonstrated track record you are speculating are you not?