This was the week Andy Penn finally confronted a bitter reality. Penn is a little more than two years into one of the biggest jobs in corporate Australia and insists his vision for Telstra – to become a world-class technology company – remains intact.
But while it is on that journey Telstra simply can't keep paying out the generous dividends for which it's known to its shareholders.
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Telstra announces new dividend policy
Chief executive Andrew Penn warns investors of "material" cuts to dividends at Telstra's 2017 full year results presentation.
"I'm not suggesting we are going to be the next Netflix or Facebook or Amazon," Penn, the chief executive of the monolithic telecom carrier, told Fairfax Media this week.
"I'm recognising our world is changing, we are shifting from being just a pure telco to something else. In that world we can't be a company that pays out 100 per cent of its profits".
This is especially so when Telstra's underlying businesses aren't growing. In fact, Telstra's is not just stagnating, its' at serious risk of shrinkage. It has gotten about as big as it can in Australia.
At the same time its shareholders don't want, and won't let, it expand overseas. Its core businesses of mobile phone connectivity and internet access in this country are facing more competitive threats than perhaps ever before.
The somewhat brutal response to those pressures was laid out at the company's annual results day in Melbourne.
Penn announced Telstra would slash dividends next year by 30 per cent to 22¢ cents per share. It was the first time Telstra has reduced its dividend – cherished by so many of its 1.4 million retail shareholders – since 1998.
![The dividend cut was the kind of decision Andy Penn eventually needed to make if Telstra is ever going to escape from ...](http://web.archive.org./web/20170821040011im_/https://www.fairfaxstatic.com.au/content/dam/images/g/x/y/9/t/c/image.related.articleLeadwide.620x349.gxz1y2.png/1503093729883.jpg)
The move was widely anticipated – chairman John Mullen recently flagged it, and some analysts were openly calling for it – but few expected the cut to be so deep and the share price plunged.
"The bears had the dividend at 25¢ for next year," says Arnhem Investment Management portfolio manager Theo Maas, who holds some Telstra shares on behalf of clients, "so it coming in at 22¢ is quite a shock".
Importantly, this was not the only piece of housekeeping Telstra was involved in this week.
![Telstra chairman John Mullen (left) flagged the dividend cut.](http://web.archive.org./web/20170821040011im_/http://www.smh.com.au/content/dam/images/g/r/z/i/k/i/image.imgtype.articleLeadwide.620x349.png/1499029524363.png)
Telstra chairman John Mullen (left) flagged the dividend cut. Photo: Nic Walker
Foxtel float
Telstra announced on Thursday night it had struck a deal with News Corporation to merge Fox Sports Australia (heretofore owned entirely by News) into Foxtel.
Under the deal, Telstra's stake in (a bigger) Foxtel will decline from 50 per cent to 35 per cent. The merger sets the stage for an even more interesting deal, a Foxtel IPO on the ASX, in the next couple of years.
Penn flagged on Friday that float could be an opportunity for Telstra to sell down its stake in Foxtel.
As well, Telstra confirmed it might proceed with a plan to package up payments it will receive from the NBN into a security that could be on-sold to debt investors. Telstra would use the proceeds, which could total up to $5.5 billion, to pay down debt and buy back shares.
This week's developments offer striking evidence of how Telstra has utterly failed to transform itself from its monopoly past.
For years, Telstra lapped up the revenue from a fixed network that everyone else had to pay to use if they wanted to supply telephony or internet services (Optus had its own cable network, but only in certain areas, and it did not provide genuine infrastructure competition).
Telstra did invest heavily to build a world-class mobile network that has 17.5 million customers today and delivers about $10 billion in revenue every year.
But the company has also for years pursued a policy of returning 100 per cent of its profits to shareholders in dividends.
Unsustainable policy
Telstra's dividends have been considered untouchable to the extent that, when its earnings haven't been enough to fund them, it has even borrowed money to cover the shortfall.
This week, Telstra bowed to the inevitable and changed its dividend policy. It said going forward it would limit shareholder payouts to between 70Â per cent and 90 per cent of its profits.
That brings it into line with other big dividend payers on the ASX such as the big four banks, and provides the company with flexibility to invest to shore up its core businesses, which are under siege from competitors.
![Illustration: Simon Bosch](http://web.archive.org./web/20170821040011im_/http://www.smh.com.au/content/dam/images/g/x/z/q/n/v/image.imgtype.articleLeadwide.620x349.png/1503052896920.png)
Illustration: Simon Bosch
For some perspective, in 2011 when Telstra's total income was $25.3 billion the fixed network delivered revenue of $9.5 billion ($10.4 billion in today's dollars). It had a staggering 60 per cent profit margin on $5.3 billion worth of phone calls made over the copper network.
The year 2011 is important because landline use was already declining in favour of mobiles, but the NBN had not yet started to bite into Telstra's fixed network.
Yet six years later, rival internet service providers operating on the NBN have taken 2.5 million fixed line connections away from Telstra – and this is finally starting to hurt.
Telstra's revenue for the full year was $28.5 billion but the contribution from fixed products was $6.4 billion for 2016-17, a 33 per cent decline on the 2011 figure.
That fat profit margin on phone calls was down to 48 per cent, reflecting the fact some of these calls are now occurring on NBN-owned infrastructure that Telstra has to pay the same price as everyone else to use.
"The underlying core business is going backwards, that is pretty clear," says Maas.
Wrong tactic?
Of course, Telstra has been compensated for the loss of its fixed line monopoly, through billions of dollars of payments from NBN (estimated to be worth $11 billion in 2014) to access its infrastructure.
But again, Telstra has so far preferred to return excess funds to its shareholders, rather than use it to bolster its core business ahead of an onslaught of competition. Let alone invest for long-term growth. Telstra hiked its dividend in 2014 and 2015. That is what shareholders wanted but in hindsight looks like a misstep.
The underlying message from management on Thursday was that Telstra, and its shareholders, need to learn how to feed themselves from now on.
Analysts estimate the one-off payments from NBN Co will last about four more years. It remains to be seen if Telstra is smart enough and nimble enough to transform within that period.
In the short term there is still lots of money to be made from contracts designing and building the NBN, which were not even included in the $11 billion deal.
For example, much of the 30 per cent growth Telstra's network applications and services division (NAS), up 30 per cent to $3.4 billion, was thanks to commercial works it has been contracted to do for NBN Co.
Eventually the NBN roll-out will taper off and the contracting opportunities will dry up as NBN moves into the maintain-and-operate phase.
Macquarie's telecommunications analysts predict it will be a hard few years for Telstra.
"In addition to NBN headwinds, management flagged increasing competition and more demanding customer expectations around service offerings as reasons to accelerate its transformation " they wrote in a note to clients.
"Going forward, the dividend looks set to stay at 22¢ over the medium-term, where underlying earnings are likely to remain under pressure."
They estimate Telstra has a "buffer" of about 25¢ per share from the NBN one-off receipts to use over the next four years as special dividends. After that, Telstra will need to establish whether it can sustain the dividend from underlying earnings alone.
Priorities correct
Morgan Stanley's Andrew McLeod called the dividend change painful in the short term but correct.
"One lesson we have learnt from the other side of our stock coverage universe – media – is that when a business is facing significant structural change from new technologies and new competitors ... it is strategically wise to make a strong balance sheet a priority," he wrote in a note to clients.
Citi analyst David Kaynes, who called on Telstra to cut its dividend before the fact, endorsed the decision.
"In our view [Telstra] has made the right move in cutting the dividend to allow for further investment into the core [mostly mobile] and put earnings onto a sustainable post-NBN growth path".
Telstra has signalled aggressive investment in its mobile network, as it faces increased competition. TPG Telecom, led by reclusive billionaire David Teoh and known for extremely low prices, is building its own mobile network, a move that could reshape the industry.
By mid-2019 Telstra expects to have spent $15 billion on capital investments, including at government auctions for spectrum – the wireless airspace needed to operate a mobile network.
This figure also includes the $3 billion to be spent expanding and upgrading mobile networks that was put on hold while the competition watchdog conducted a review that could have seen Telstra forced to share its regional mobile network with rivals (The interim decision was in Telstra's favour, but it has been challenged in the courts by Vodafone. A final decision is expected in coming months).
Telstra has to plug a $3 billion gap in earnings from not owning the fixed network. It expects investments in mobile to lead to an earnings benefit of at least $500 million by 2021. It also plans to cut $1.5 billion from its cost base by 2022.
That is a lot of running to just stand still. How Telstra actually grows remains the eternal question.
The company's track record with overseas expansion is mixed. In recent years it booked significant profits on the sale of Chinese internet assets such as car sales website Autohome and real estate portal SouFun.
But it also wrote off billions of dollars on investment in Hong Kong infrastructure assets. It last year explored investing $1 billion into a Philippines mobile joint venture, but walked away after shareholder anger.
As one long-time adviser to the company put it: "They've got a bit of a problem. After years of rhetoric about growth, they are playing defence, when they should be playing offence."
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