Telstra Corporation: Constructing growth

About the author:

Author name:

By Nick Harris

Job title:

Senior Analyst

Date posted:

03 February 2022, 8:00 AM

Sectors Covered:

Telecommunications, Technology

• Telstra (ASX:TLS) has announced it will increase its capex budget over the next ~5 years as it invests ~$1.5bn of capex into two material infrastructure projects.
• Project #1 is building ground based infrastructure (satellite base stations) and the fibre network/backhaul connecting those base stations across Australia. This is for global satellite company Viasat and secured with a 16.5-year contract.
• Project #2 is a ~6x upgrade to TLS’s extensive but arguably outdated inter-capital fibre network. This new build should bring net new earnings but is also more speculative. TLS noted returns from project #2 are expected from a combination of BAU and net new cornerstone deals. We also think there is a reasonable interdependency between the two projects.

Event: bulging their backhaul

These two projects are largely around expanding TLS’s already extensive fibre network to increase coverage and capacity across Australia. Both projects are, to some extent, fibre backhaul upgrades across the country and have, in our view, some duplicate uses (eg base stations may need inter-capital fibre).

Project#1 (satellite base stations) is a net new project. Project#2 (inter-capital network upgrades) is a 6x increase in fibre capacity between major cities on a new dual fibre network. It can be argued that much of Project#2 is business as usual as TLS needed to upgrade its legacy inter-capital networks to meet growing data requirements from customers.

Offsetting this, management expects to derive net new business (incremental earnings streams) from Project#2.

Project #2 should help TLS keep up with growing customer demand for data (and lower operating costs on some legacy networks). On the net new side, it allows TLS to sell strands of inter-capital dark fibre to sophisticated customers including Cloud Service Providers.

Until recently TLS has not sold dark fibre services and this should open a new wholesale market for bandwidth-hungry customers.

The financial details and industrial logic

TLS has effectively increased its capex guidance for the next 5 years as it has committed to ~$1.5bn of capex to build two major infrastructure projects.

The bulk of the capex (~$350m pa in addition to BAU) is expected to be deployed from FY23-FY25. The build should be largely complete by FY26 when TLS expects the project to add ~$200m to EBITDA.

TLS points to a 9-year payback and mid-teen IRR on the combined spend.

Management believes TLS has a competitive advantage with respect to its build plans and this should provide some pricing power/protection. However, other carriers are also aggressively pursuing similar projects, and these projects have significant fixed cost leverage.

In our view, competition has the potential to crimp return expectations, if not all players remain economically rational.

Forecast and valuation update

We have updated our forecasts to reflect the project, noting that the spend/capex commences from FY23 but returns/EBITDA is not meaningful until FY26.

We have also updated our model following reclassifications/changes to TLS’s business segment reporting. The net result is immaterial changes to our EPS forecasts in FY22-24 and our price target edging 1cps higher to (login to view).

Investment view

Add retained. Sector dynamics look positive and value realisation is possible.

Price catalyst

• More details following the release of TLS’s result on Thursday 17 February.
• Proof points supporting industry rationality (ARPU rises sticking and FCF growing).
• SOTP realisation (new business units track record, partial divestments, and full divestments of small holdings eg the potential IPO of Foxtel).

Risks

Key risks relate to industry pricing remaining rational and realisation of value drivers.

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