This week Robert Swift takes a look at the Chinese property market and the effect it will have on Australia and the World.
We have written on the China “marvel” before and continue to scratch our head on this enigma and the sustainability of it. You have to give them huge credit for what they have achieved – the greatest economic expansion in history improving the lives of so many people in a 30 year period.
I was back in Southern China again in early October on a client visit to Shenzhen – which has grown from a fishing port of 30,000 people in 1979 to over 11m people today! Shenzhen is the epitome of China’s success, otherwise known as the “silicon valley of China” it has some of the highest salaries and has now surpassed Beijing in terms of property prices.
Source: Thomson Reuters
Success and rapid growth rarely comes without its problems and its excesses. A lot of it has been built on debt – at the corporate (in particular), household and government levels. In a country that has not seen any significant downturn in the economy or property price levels, you can imagine that a feeling of infallibility and hubris is pretty strong. Trying to explain that property prices on a par with the best areas of London’s West End is rather extreme and worrying doesn’t get too many worrying at the dinner table – China’s different they say – and we’ve all heard that one before! It is clear that the Chinese government has let the residential property market get way out of control.
Of course, there have been strong fundamental drivers to the incredible rise in property prices. A close contact of ours with 30 years’ experience of investing and visiting the Asian region, Stewart Patterson has recently written a study of the Chinese residential property market.
In his report he identified three key growth drivers of residential property development in China
The increase in urban population;
The increase in living space per person and
The upgrading of sub-standard housing.
The result of these three drivers is that private urban residential property development in China has grown in nominal terms from USD300bn in 2008 to USD1.4tr now – a compound annual growth rate of 21%. Residential property sales in China are now larger than the GDP of Russia or Australia. The urban property stock in China has grown from 9.3bn sqm in 2000 to 29bn sqm at end 2016 – an annualized growth rate of 7.3%. While Chinese economic growth has accounted for more than half global growth since 2008, property (together with its multiplier impact) has been one of the key drivers of Chinese growth. If these three drivers of urban residential property demand are drying up, the global economy could well face a nasty deflationary shock. Although the Chinese government can always “manufacture” growth by increasing government borrowing, which is still relatively by world standards at around 46% of GDP, it may be difficult to contain the upheaval and the political fallout that may result in vast losses of wealth by Chinese households.
China has experienced a rapid urbanization of its population. Back in 2000 the urbanization ratio was just 36% rising to 50% in 2010 and 58% in 2016. The current pace of urbanisation, a net migration to urban areas of about 21m people per year ( out of a population of 1.36bn) is producing a rise in the urbanisation ratio of 1.5 percentage point per year. In 15 years time, on current trends, China’s urbanisation ratio will have converged on the USA, UK, France and a cluster of other OECD countries at around 78-83%. Whether it then trends higher towards Japan at 93% remains to be seen. From a housing demand perspective the key points are:
The net migration of 21m or so has been very stable over the past 20 years there is no structural growth in this number and it will fade with time as there is simply less scope for migration to the cities albeit the fade may be a decade away.
Housing demand from net urban migration as a percentage of total private housing sales is declining even if one assumes that a new migrant moves into an average sized space (which itself has been increasing). So for example: In 2000, the urban population increased by 21.6m people and the average living space per person was then 20.3 sqm. So new arrivals (either by birth or migration) required, assuming an average living space , 438m sqm. Yet in 2000, private residential urban property sales were just 151m sqm so new arrivals require 2.9x new private property sales (these exclude affordable housing and other forms of social housing). Last year the situation was dramatically different. New arrivals required (21.8m new arrivals * 36.6sqm / person) 800m sqm of property against sales of 1.35bn sqm or just 58% of the total.
The conclusion I think for this driver is that it will not drive growth in property sales anymore. It need not necessarily become a drag and produce a reduction in property sales any time soon but it is a ticking bomb in that 21m new arrivals to urban areas is not a sustainable number beyond 2030 and it may fade sooner than that.
The second driver of market growth has been the dramatic rise in the living space per person in Chinese urban areas. Back in 1985, China’s housing stock afforded just 10 sqm of living space per person in urban area. That number doubled over 15 years to 20.3 sqm in 2000. In 2016 a further 16.6 sqm per person had been added bringing the total living area per person to 36.6 sqm. The 2000 to 2016 Cagr in living space per person was 3.8%.
Clearly, 10 sqm per person was inadequate even for a country with a high population density but 36 sqm per head is a generous living space by international comparison even without adjusting for income per capita and population density. In Europe for example, the Baltic states, Poland and Czech range from 35-38 sqm per head but they have higher per capita GDP and low population densities. The UN sets a threshold of 20 sqm / capita as a benchmark for adequate housing as an economic development goal. In Japan, which is perhaps the best benchmark as to where china is heading, the ministry of land recommends a household of 2 people having 55 sqm (27.5 / head) in urban areas. A household of 3 is 23.3 meters / head.
By any standard it would appear that living space per head of urban population has ceased to be a necessary driver of growth in China’s housing stock and that in fact the urban housing stock, in aggregate has, if anything been over built in recent years.
At the end of 2016, China’s urban housing stock was 29bn sqm according to the NBS that was an increase of 25% or 5.7bn sqm over the level in 2012. So a minimum of 20% of China’s housing stock is less than 4 years old. 65% of China’s end 2016 housing stock of 29bn sqm did not exist in 2000 (when the stock was 9bn sqm) so it must be less than 16 years old. In addition, housing that was demolished and replaced between 2000 and 2016 is also less than 16 years old. Whichever way one slices the numbers (one needs demolition numbers to complete the model) it is hard to avoid the conclusion that the median age of urban housing in China is no more than 10 years. When Japan’s housing bubble burst in 1989, the average age of a housing unit was 12 years and the stock has now aged to an average age of 22 years. Housing starts, even now, 28 years after the bubble economy burst are just 50% of the peak. In the US the median age of a house is 37 years (with a range by state of 55 years in New York to 23 years in Arizona). New buildings in the US now are built with a recommended life expectancy of 75 years (implying a replacement rate of just 1.5% of the stock per year). The aging process of China’s housing stock will likely result in meaningfully lower investment.
The fundamental factors therefore clearly point to a potential ending of the property boom in China, which has been a big driver in the overall economic growth rate. But what about the speculative element of property demand? It is difficult to gauge the size of speculative demand from the paucity of statistics coming out of China but from my anecdotal evidence it appears significant. It would appear that a significant number of apartments lay empty and are simply held for capital appreciation purposes. It appears that a small but significant percentage of the business/professional classes engage in property speculation – and on paper at least, have made many millions of RMB this way. Many of these properties have been bought with mortgages. So you have potentially very “weak holders” of property here if they start to run in to cash flow problems if there business isn’t doing so well or if they start to think that property prices may start to decline or are indeed declining. So you have a potential recipe for a very volatile situation.
So why should we care about residential property prices in China? Well, the residential sector has clearly been a key driver of growth in China – even if it is with borrowed money! Higher prices drive more construction and more demand for raw materials like copper, steel etc and a whole lot of other inputs – some of which come from overseas. So a potential blow up in the Chinese residential market will have a significant impact on the world economy. There will be secondary effects too. The Chinese middle classes will pull in their expenditure on overseas trips, luxury items, etc.
The conclusion seems to be that while urbanisation will likely continue and hence the urban population will grow at about 3% to 2.5% year on year or 20-22m new additions per year, the current housing stock is large enough for the existing urban population and is incredibly new on average. The key demand drivers for housing development have peaked at best or are exhausted at worst. A major engine of both Chinese economic growth and global reflation is potentially running on empty. As development becomes less necessary, it will become even more speculative, cyclical and that coupled with its increasing debt-dependency (albeit still low by international standards) in our view makes it more prone to a sudden down turn.
This week Guy Carson takes a look at REITs and their potential role as the source of crisis in the Australian economy.
A version of this article was published in The Australian on 21 October 2017.
Back in 2007, the wheels began to fall off the global equity market rally. The key driver was a tightening within credit markets globally to the point where some companies were completely frozen out and couldn’t refinance their debt. The REIT sector was the epicentre of the crisis in Australia and the poster child for problems was Centro Property Group.
Centro operated as a funds management company with ownership stakes across the underlying investment funds. These funds then undertook developments, and deployed capital. After an initial equity raising, the funds would use debt to complete developments whilst booking revaluation gains. The head company, Centro would use debt to fund their equity stakes in new funds and increase their gearing there as well, effectively creating gearing on gearing. As a result the financial statements were opaque and the company hid negative cashflow and rising debt levels behind asset revaluations. This behaviour was prevalent across the industry and other players such as Goodman Group, Charter Hall and GPT were all forced into deeply discounted equity raisings just to survive.
When you look back at history and examine businesses that have failed, they all have one thing in common. High debt levels combined with insufficient or negative cashflow. Typically these companies will rely on capital markets to fund their operations and when those capital markets close, the music stops. This happened in 2007 for the REIT sector and the poor capital management was exposed.
Understandably, with interest rates starting to rise globally, investors are now starting to get nervous and many worry about a repeat of 2007 and 2008. However, when we look across the sector we do see vastly improved capital management in recent years than we did during the previous bull market. The funds management model has evolved and companies such as Charter Hall and Goodman Group have become more efficient at using other people’s capital and taking less development risk on their own balance sheet. The potential problem for them comes if that capital pipeline dries up and rising rates could potentially do that. If demand for property funds fall then earnings could falter. As a result we don’t think it’s necessarily a good time to buy REITS but given their vastly improved capital structures we don’t believe solvency is an issue like last time.
Elsewhere in the sector, some companies do have elevated gearing levels and will feel some pain such as Cromwell (who has recently been downgraded by Moody’s), although again we are not overly concerned around solvency. In fact, of all the major REITs we would consider Westfield as the one most reliant on capital markets and hence most at risk. Since spinning out Scentre back in 2014, the company has been in development mode and as a result has had negative free cash flow, rallying instead on capital markets to finance its growth. With a $9bn development pipeline left to complete this need for funds will continue for a number of years yet, whilst at the same time valuations of Retail property assets are coming under pressure globally.
Given we don’t expect REITs to be the epicentre of the next crisis; it’s worth looking at what sectors might be. The obvious answer would be the financial sector and obviously the banks are under scrutiny from investors but the rise of the small cap finance sector warrants some watching with a large amount of junior companies operating in niche sectors. Another popular sector amongst investors that stands out due to complex financial reporting is the Aged Care sector.
As we mentioned above, the characteristics that lead to business failure are debt levels that are too high and insufficient cashflow. In the Aged Care sector we worry that the companies are potentially understating the amount of debt they have and overstating their cashflows. This phenomenon comes about through what is referred to as Refundable Accommodation Deposits (RADs). The RADs are a lump sum payment paid upfront for entry into an Aged Care facility. They can be used for multiple purposes and sit on the balance sheet as a liability but not as pure debt. As a result they can be used as a third source of funding (alongside equity and debt) and can effectively be used to increase a company’s return on equity. The current listed players (Estia Health, Japara Healthcare and Regis Healthcare) have historically used these funds plus debt to make acquisitions, adding more RADs and hence more funding to the balance sheet. In addition some of the listed players include the change in RADs in operating cashflow, which potentially overstates the cash they are earning.
If we take Estia for example, we find their current debt level is $121m against $1,798m of total assets. At first glance it appears there is nothing to be worried about (a gearing ratio of 6.7%), however we delve a little deeper we discover some cracks. Of the $1,798m of assets we find $1,036m are intangible, predominantly goodwill from acquisitions. In addition the RADs on the balance sheet are $730m; hence if we were to include these as debt (they do have to be repaid and the holder does receive government mandated interest) the company has negative Net Tangible Assets.
The problem for these companies comes about if the proportion of residents who pay via RADs starts to fall. If this proportion does fall, these companies will experience potentially negative cashflow in what is effectively a forced reduction in debt. A large reversal in resident behaviour would cause tremendous financial strain. The three major players are all recent listings that came to market riding changes in legislation (the Living Longer Living Better reforms) and a thematic that investors were exciting by (an aging population). However, at the heart of these companies are low returning assets juiced up by financial engineering and subject to regulatory scrutiny. We don’t believe the sector has been fully tested as yet and we worry about what happens when it is.
This week the TAMIM Small Cap team take a look at the embedded value within their portfolio.
Summary:
As the portfolio underlying the TAMIM Australian Equity Small Cap IMA approaches its 3 year anniversary we believe the embedded value opportunity within the portfolio is as compelling as when the portfolio was launched. The strategy is invested in high quality smaller companies which are trading well below our view of fair value. The portfolio is currently trading at a 32% FY18 P/E discount versus the All Ords despite the fact that expected FY18 earnings growth is expected to be almost four times greater.
What is embedded value?
Embedded value is generally defined as being the underlying value of an asset based upon:
Earnings – The underlying value of the asset is generally calculated as the net present value of expected future cash flows.
Assets – The underlying value of the asset is generally calculated as the realiseable value of the assets, or the price they could be sold at on the market.
In the TAMIM Small Cap strategy, we are looking for high quality smaller companies in which embedded value is far in excess of the current market cap.
The TAMIM Small Cap portfolio embedded value opportunity in numbers:
The TAMIM Australian Equity Small Cap IMA portfolio currently owns 17 high conviction stocks which we believe are the “best of the best” high quality smaller company opportunities listed on the ASX. At present, the vast majority of these positions are earnings based positions – i.e. stocks in which we believe the discounted value of these companies’ future cash-flows is far in excess of their current market caps.
At a portfolio level the most effective way to present the earnings based embedded value opportunity is to show the underlying portfolio’s weighted average P/E valuation versus the weighted average for the All Ords, and then to compare the weighted average expected earnings growth for FY18 with the All Ords.
TAMIM Australian Equity Small Cap underlying portfolio weighted average P/E vs the All Ords (assuming portfolio is fully invested as cash has no P/E):
The TAMIM Australian Equity Small Cap portfolio is trading at a significant valuation discount versus the broader market.
TAMIM Australian Equity Small Cap underlying portfolio weighted average expected FY18 earnings growth vs the All Ords (assuming portfolio is fully invested as cash has no EPS):
The TAMIM Australian Equity Small Cap portfolio’s expected earnings growth is 3.6x that of the broader market.
It is the combination of the above table and chart which shows the TAMIM Australian Equity Small Cap portfolio’s embedded value opportunity: i.e. The portfolio is trading at a 32% valuation discount versus the broader market and yet earnings growth is expected to be almost four times the market average. In our experience, this is an usual combination within the investment company universe, and highlights the size of the strategy’s opportunity looking forward.
How will the embedded value opportunity be realised for investors?
Earnings positions: Typically for earnings based positions the value opportunity will be realised through earnings reports which highlight cash flow growth rates above market expectations, and thus lead to an increase in market expectations regarding future cash flow growth rates.
Example: Zentias (ASX:ZNT) is a typical TAMIM Small Cap portfolio earnings based position in that it ticks all our boxes for a high quality company, is trading at a significant sector discount, and its expected catalysts are earnings upgrades driven organically and through acquisitions. We believe the stock is trading significantly below its embedded value at present.
ZNT has been covered in a recent research article (again here).
Asset positions: Asset based catalysts tend to be less predictable than for earnings positions as they are often driven by one significant catalyst as opposed to regular quarterly earnings reports. The key major catalysts we generally expect for asset based positions include: asset sales, asset purchases, and growing sum of the parts visibility based on improved market communication/disclosure.
Example: Elanor Investors (ASX:ENN) offers a compelling asset valuation opportunity at present in our opinion as the stock is currently trading roughly in line with its current net asset value which implies its highly profitable fund management business is trading at a significant discount to fair value. This is a typical example of the sum of the parts becoming increasingly visible in an asset based position over time.
A generally long term perspective: We believe we have a significant advantage over shorter term focused investors/traders over the long term. By “not caring” about the short term market noise we find that we are well positioned for the value creation in our stocks as and when it arrives. This long term perspective will be absolutely key in realising the embedded value within the TAMIM Small Cap potfolio.
Conclusion:
Buying stakes in ASX listed companies in which embedded value is far in excess of the current market value is what we are focused upon day in, day out. We believe this underlying value will be realised through catalysts such as earnings upgrades, as well as our old friend, time.
This week Robert Swift and Roger McIntosh, of the TAMIM Global Equity High Conviction IMA, take a look at the tricky subject of creative accounting and how it must be factored into your stock analysis.
Quantitative stock selection models such as our VMQ assessment, provide a sound and proven framework for identifying attractive and unattractive stocks.
However, quantitative signals that are based on financial statement information can fail to spot creative accounting techniques which may fool the signal and give false comfort. Consequently, we perform complementary ‘fundamental’ research based on Accounting, Strategic and Governance perspectives.
These are as equally important as our quantitative signals. Although we dislike the term, some people call it a ‘quantamental’ approach to stock analysis and selection. It’s actually quite hard to use both sets of signals since most portfolio managers believe these two kinds assessment models are from competing philosophies. We believe they are complementary philosophies and wouldn’t invest without analysing both.
One currently overlooked aspect of company profitability and its sustainability, is that of corporate taxation. Many companies know that EPS are the driving force behind share price growth and will consequently do all they can to boost that number. This can be done by creative accounting including tax avoidance, and simply by underinvesting in the business by reducing capital expenditure and thus depreciation charges.
If a company has been systematically underpaying tax then it is quite likely, now more than ever, that its day of reckoning will come. We have been working with a forensic accounting service, Bucephalus Research in Hong Kong, to identify companies which are creatively avoiding tax (and performing other accounting shenanigans) and are concerned where this tax avoidance alone makes their shares look cheap. We believe in an era of greater scrutiny and cooperation on corporate behaviour, this is a risk to share prices which is underestimated. Our portfolios, we believe, have very limited exposure to companies with earnings boosted by this creative accounting.
Where we do have exposure, such as Gilead, we try to ensure that we understand why.
Tax is incurred and payable as part of a company’s regular business and can provide a good indication of the real level of cash earnings behind profits. Since cash pays the bills, cash earnings do matter. For most companies, their tax expense is close to their notional and national tax rate, but disparities do exist. This is typically due to the nature of cashflow within different industries. Tax expensed is not the same as tax paid. While there can be many reasons, these differences are typically short term and wash out quite quickly – this is normal and doesn’t bother us.
For some companies however, even when adjustments are made to take these additional factors into account, discrepancies persist. These are the companies where investors should question why and how the company is more able to book non-taxable profits. Are other matters being hidden? Is the circumstance sustainable? The OECD, a body which seeks greater global cooperation and conformity, has established a Base Erosion and Profit Shifting (BEPS) programme in 2016. This was established in the wake of different profit shifting scandals, and aims to prevent jurisdiction shopping where companies move to declare profits in places of more favourable tax rates. The BEPS framework will make it harder for companies to maintain this situation and ultimately will lead to higher tax costs for certain businesses and industries.
Tax is important for different reasons. Higher tax paid on profits reduces shareholder access to this via dividends. We are seeing some moves across different countries to reduce company tax rates to retain and grow business activity. Companies, particularly international entities, in different industries and regions can relocated cashflow to legitimately pay a different effective tax rate.
Analysis of tax paid can also identify anomalies in financial statement information such as whether a company is applying creative accounting techniques to elements that form the input to quantitative valuation signals. It can identify whether a company is utilising debt manipulation techniques to provide a set of accounts that meet credit requirements and investor expectations, but glosses over reality.
Robert Medd from Bucephalus recently identified Amazon as a company suspiciously paying little tax. This is in line with a recent article we wrote where we argued that this was just as anti-social as a company which was involved in high carbon emissions, and armaments manufacture. Yet this aspect of company behaviour is, not yet, remarked upon. So, the ESG advocate, who argues for shutting coal mines is quite happy to do so having bought their corporate wardrobe on line via Amazon! We have had a few provocative and animated discussions on this one.
We recreate here Robert’s recent work on the USA companies most likely to be at risk of being “called to account”.
Recent tax penalties:
Source: Bucephalus Research Partnership
Companies that may be most affected by BEPS – NB Gilead!
Source: Bucephalus Research Partnership
Certain companies and industries have greater ability to move cashflow to minimise the impact of tax on ongoing cashflow. The monitoring and enhancement of fundamental characteristics and oversight through company knowledge can help to ensure the strategy avoid investment based on aggressive or even misleading information
What this all means is that any investment process should maintain a robust fundamental oversight on all information that is available. This ensures that any stock is verified as truly attractive with all risks identified. As we state in our presentations – It’s Valuation Momentum Quality (VMQ) + Accounting Strategic Governance (ASG). Sources: ‘Tax matters: Creative accounting and tax laundering’, Robert Medd, Bucephalus Research Partnership, September 2017
This week we present a piece by Hamish Carlisle, analyst with the TAMIM Australian Equity Income IMA powered by Merlon Capital Partners, as they review their analysis of Telstra.
When Merlon was established in 2010 and we first formally reviewed Telstra, the stock was trading at $2.64. The top down (and perhaps consensus) view at that time was that the company faced enormous structural challenges stemming from the ongoing decline in fixed line voice services, intense competition in mobile and broadband, and the loss of its monopoly position as provider of last mile access to 9 million homes and small businesses. At that time, we valued Telstra at between $3.20 and $4.35 per share.
Fast forward to 2017 and not a lot has changed, least of all our valuation of Telstra shares which currently stands at between $2.70 and $4.35 per share. Taking into account the stock’s high dividend yield over the intervening period the shares have delivered a total return on our initial valuation in line with our standardised equity discount rate of 12 percent.
Nonetheless, the poor performance of the stock in more recent years has prompted questions from many of our clients and stakeholders so we thought it might be worthwhile outlining our current thinking.
Case study: US railroad industry
By the mid-1950s the US railroad industry was already in decline before being hit with its own equivalent of the National Broadband Network (NBN) in the completion of the interstate highway system creating severe competition from the trucking industry and reduced passenger travel. At the same time, airlines were taking almost all long haul passengers away from the railroads.
Nevertheless, since 1957 railroad stocks have outperformed not only the airlines and trucking industries but also the S&P 500 index itself. This occurred simply because the “top down” issues facing the industry were well and truly factored into investor expectations and only small improvement was necessary for these companies to beat such a dim outlook.
And better times were coming. In 1980 there was a major deregulation of the railroads that spurred consolidation and greatly increased their efficiency. Despite falling revenues, rail productivity has tripled since 1980, generating healthy profits for the carriers.
The lesson: An industry in decline can offer good returns if investor expectations are sufficiently low. If such a firm can halt its decline – and pay dividends – its shares can deliver excellent returns.
The question with Telstra is whether expectations are sufficiently low.
Gauging market expectations
Comparing a company’s share price with some measure of intrinsic value can give some indication as to whether market expectations are optimistic or pessimistic. Merlon’s preferred measure of intrinsic value is to compare a company’s enterprise (or unleveraged) value with its sustainable enterprise-free-cash-flow.
To give a guide to management’s expectation of Telstra’s “sustainable free-cash-flow”, Telstra’s most recent result presentation noted:
Telstra generated “recurring core” EBITDA in the 2017 financial year of $10,068m;
The recurring impact on 2017 EBITDA from the NBN is likely to be around $2.5 billion;
The company is targeting a capital expenditure (capex) to sales ratio of around 14% from 2020.
Putting these pieces together one might conclude that the Telstra’s board and management expect the company’s enterprise-free-cash-flow to settle at around $2.5 billion.
Source: Company 2017 full year result presentation, Merlon Capital Partners
Taking into account anticipated one-off NBN receipts this would imply the company is trading on approximately 20x sustainable-free-cash-flow. This is hardly a bargain but in line with the median multiple for ASX200 companies under our coverage. This suggests to us that the market has largely taken management estimates of profitability and cash flow at face value.
Source: Bloomberg, Merlon Capital Partners
Ignore the cash flow statement at your peril
As we persistently highlight, management teams and boards are becoming ever increasingly creative about how they define profitability. Some of the measures in Figure 1 are examples of this. “Recurring core Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA)” is not a measure of profitability defined in any accounting textbook and guidance about the “recurring impact from the NBN” is an estimate at best and a guess at worst. We discuss this further below.
The bottom line is that management teams can define profitability however they choose but can’t as easily hide from the realities of the cash flow statement. Eventually these realities come home to roost and when this happens stocks with low earnings quality tend to underperform.
Along these lines it is important to note that Telstra’s earnings quality is poor. The company’s gross operating cash flow (“GOCF”) of $9.5 billion (which can be found on page 74 of the company’s annual report) bears little resemblance to the EBITDA figure of $10.7 billion quoted in Figure 1.
Source: Bloomberg, Merlon Capital Partners
At Merlon, our focus is on the cash flow statement rather than measures of “advertised” earnings. Typically listed companies do a good job singing the virtues of such advertised metrics often with advisers, brokers, analysts, journalists and other commentators cheering on from the sidelines. Often these advertised metrics form the basis for variable remuneration prompting board members to join the chorus.
Focusing on the cash flow statement reveals a vastly different picture of Telstra’s continuing businesses. Had it not been for non-recurring NBN receipts and the network cost holiday being enjoyed ahead of NBN rollout, Telstra would have been in cash flow deficit during the 2017 financial year.
Source: Company 2017 full year result presentation, Merlon Capital Partners
If nothing else, the above analysis highlights the significant work ahead of Telstra management to meet market expectations.
The NBN earnings gap
As highlighted in the tables above, management have indicated that “the recurring impact from the rollout of the NBN” is likely to be around $2.5b per year. Our analysis suggests that the ultimate outcome could be much worse than this. Key headwinds we highlight are as follows:
Incremental NBN costs of approximately $2.5 billion per annum: The NBN’s corporate plan has the company achieving revenue of $5 billion in the 2020 financial year. We think it is reasonable to assume Telstra will account for 60 percent of this amount, or $3 billion. About $500m of this amount is already reflected in Telstra’s 2017 accounts so the incremental cost from here is likely to be about $2.5b.
Loss of wholesale revenues amounting to approximately $1.3 billion per annum: Telstra currently generates revenues from wholesaling its products and renting out its network to other retailers such as TPG/iiNet, Vocus, and Optus. These revenues will not continue following the rollout of the NBN.
Potential recurrence of NBN connection costs of around $0.4 billion per annum: Telstra has incurred significant costs in connecting customers to the NBN. While the company has excluded these costs from recurring earnings it is possible that a component these costs will prove to be ongoing due to normal customer churn.
Potential recurrence of restructuring costs of around $0.4 billion per annum: Given the scale of cost reductions required to deal with the above items and the company’s history of incurring restructuring costs, it is likely that at least some component of restructuring will prove to be ongoing.
Potential market share loss due to structural separation of network: Prior to the rollout of the NBN, Telstra enjoyed a monopoly position with regard to its ownership of the fixed line network. It is likely that the progressive levelling of the playing field as the NBN rolls out will see heightened competition and some market share loss for Telstra.
Potential repricing of fixed line services: Telstra currently enjoys average monthly revenues per user of around $95 compared to more competitive offers in the market ranging from $55 to $75. It is likely that Telstra will see progressive price deflation with regard to its products.
Offsetting these factors Telstra has targeted annualised productivity gains of $1 billion by 2020 and is adamant that restructuring and cost to connect costs will not persist. Our analysis suggests that these aspects may not be enough to offset headwinds with an additional $1.1 billion of cost savings or additional revenues required to achieve the company’s ambition of limiting the recurring impact of the NBN to $2.5 billion.
Source: Company reports, Merlon Capital Partners
Mobile pricing
The mobile division delivered a strong result in 2017, ahead of both our own internal and market expectations. A key driver of continued strong performance within this division has been Telstra’s capacity to maintain a meaningful price premium to its major competitors.
Source: Macquarie Equities Research
It would appear that the company has further increased its pricing premium since the result which may represent an earnings tailwind for the current period. We are cautious about the sustainability of this pricing premium and cautious about the sustainability of margins within Telstra’s mobile division. We believe Telstra’s network advantage is not as material as it was 5 years ago, particularly for metro areas. We note the entry of TPG into the market and we note the likely emergence of no-SIM mobile devices in coming years.
As we have discussed in previous commentaries, our investment process explicitly deals with industry structure and competitive advantage through our qualitative scorecard. We do not screen companies in or out of the portfolio based on these scores but believe deeply that returns on capital are ultimately determined by the qualitative characteristics of the industry and each player’s competitive positioning. High returns on capital support high cash conversion and hence have a direct impact on our assessments of sustainable free-cash-flow and valuations.
It follows that we have built some price deflation into our assessment of sustainable free-cash-flow for Telstra’s mobile division, although we accept that it is difficult to be too scientific about the quantum but directionally we feel that Telstra’s mobile returns will deteriorate over the next three to five years.
Source: Bloomberg, Merlon Capital Partners
Capital intensity
At Merlon we apply a standardised approach to valuation for all investments based on our assessment of sustainable free-cash-flow. It follows that our valuations are highly sensitive to assumed levels of sustainable capital expenditure.
Our analysis of global network operators and telco resellers has consistently led us to conclude that Telstra’s capital expenditure should be significantly lower as a reseller of fixed line services rather than vertically integrated network operator and that Telstra spends an unusually high amount on capital expenditure.
It follows that we were shocked by the company’s announcement that it would be spending $15 billion in capex over the three years to June 2019. The company’s capex agenda is strikingly high when we consider that 27% of the company’s recurring revenue will come from fixed line services utilising third party infrastructure (i.e. the NBN).
Telstra have indicated to the market that it expects capex to reduce to approximately 14% of sales in 2020. Since the NBN was announced Telstra has had little incentive to invest in its fixed line network. It is also the case that Telstra’s Network Application Services (“NAS”) and Media divisions are much less capital intensive (and lower margin) than the rest of its businesses. As such, it is probably more appropriate to compare Telstra’s capex to its non-fixed line, non-NAS and non-Media businesses over this period.
Source: Company Accounts, Merlon Capital Partners
From this perspective, the company’s current capex budget appears historically high, although the 2020 guidance of 14% of sales is slightly lower than the experience over the past decade when excluding “capital light” segments.
What is clear to us is that Telstra is and will remain a highly capital intensive business with its core mobile and corporate/wholesale businesses historically absorbing between 30 and 40% of revenues in capital expenditure.
Portfolio positioning
It is clear to us that despite the recent share price fall Telstra is no bargain, even if management achieve what we believe are potentially optimistic targets. Poor earnings quality, headwinds related to the NBN, potentially unsustainable mobile margins and high capital intensity lead us to conclude there is probably downside to these targets and our base case valuation. As such, Telstra is not a core holding in the portfolio.
