Shareholders in Telstra should get used to the fact that they are now on the slippery slide toward lower earnings per share and potentially lower dividend payments as the company gets hit by the impact of the roll-out of the NBN.
The company warned last year that it would take a $2 billion to $3 billion annual hit to its earnings in the longer term from the transition in Australia to a wholesale broadband market.
To put this impact in context, the company has earnings before interest, tax, depreciation and amortisation of about $10 billion a year. So, it must make up for the loss of about a quarter of its earnings over the next five years.
Telstra chief executive Andy Penn told analysts on Thursday that about 20 per cent of the transition to the NBN was already complete which means Telstra has already dealt with a $600 million drag on earnings.
In the NBN broadband world retail providers, including Telstra, compete with each other to provide services on the NBN wholesale network.
The profit margins earned as a retail reseller are about a third to a quarter of the amount earned by Telstra and its competitors using their own fixed line infrastructure.
The looming long term hit to profit margins from the NBN transition has seen shares in TPG Telecom fall 47 per cent since July last year and Vocus Communications slump 54 per cent in the past 12 months.
Telstra's diversified business mix and market leading mobile network have cushioned the negative impact on Telstra's share price from the shift to lower broadband profits.
But the stock fell 4 per cent on Thursday morning after the release of disappointing results and the release of guidance at the lower end of the already published range.
Calculating the impact of the NBN on Telstra is complicated because of several moving parts.
On the one hand Telstra will receive $11 billion in one off payments for giving up its broadband dominance in favour of the government's nationlisation of broadband infrastructure. The net payment is actually about $9 billion because it costs Telstra $2 billion to shift its customers over to the NBN.
That $9 billion is already baked into Telstra's profit guidance which is mid to high-single digit income growth and low to mid-single digit EBITDA growth. Free cash flow is expected to be in the range of $3.5 billion to $4 billion and capital expenditure is expected to be approximately 18 per cent of sales.
The second leg of the NBN benefit to Telstra is the $1 billion in annual payments from the federal government for 35 years from the date of completion of the NBN in 2020. This AAA rated, government guaranteed income stream has a value which is not easy to quantify.
Is it already reflected in the Telstra share price? Can it be monetised and a lump sum brought forward for distribution to shareholders?
This is the wild card that could support the Telstra share price in the second half of this year. The company is considering dividends, buybacks and other forms of returns.
Whatever happens in relation to the monetisation of the $1 billion a year government payment schedule, Penn and his chief financial officer made clear on Thursday that Telstra's shareholders want the company to maintain a strong A rated balance sheet.
The latest half year was hit by increased competition in mobile, some negative impacts from regulatory decisions, restructuring costs and amortisation of software.
There were bright spots in the half year earnings including strong growth in bundling packages to 2.8 million customers, 51 per cent market share among NBN users and an 18 per cent rise in the profits from NAS.
But Telstra's brand took a big hit during the half year because of high profile outages of its services. This was reflected in the poor net promoter scores, which measure customer advocacy.
Telstra's earnings per share are headed backwards over the next three years, according to the consensus among the 17 analysts monitored by S&P; Capital IQ.
However, the EPS remains higher than the annual dividend which suggests the company will be able to maintain its annual dividend at the current level of 31¢ a share or 15.5¢ a share each half year.
The sugar hit coming from capital management will not deal with the longer term structural problem caused by the shift to lower profit margins on fixed line broadband services.
Penn told Chanticleer that those who claimed the NBN deal was great for Telstra need to think again.
"Giving up $2 billion to $3 billion in EBITDA every year in return for a net $9 billion is not a good deal," he said.
This comment ignores the second leg of the NBN equation, which is the $1 billion a year in government payments indexed to inflation.
Penn told the analysts he has several different priorities for boosting profits in the longer term including expanding the number of mobile and fixed line customers, cutting costs by $1 billion over several years, growing profits from is NAS business and improving its internet streaming product, Telstra TV.
Disclosure: The author's super fund owns shares in Telstra.
