The Stock

What to Buy: Telstra Corp (Australia: TLS, OTC: TTRAF, TLSYY) @ AUD2.80, USD13

Why Now? Shares of Australia’s largest full-service provider of telecommunications services have been under pressure in recent weeks, as a long-simmering dispute with the country’s regulators has appeared to boil over. The stock is now only a few points above its all-time low touched on Mar. 20, 2009. But much of the potential harm has already been mitigated by constructive negotiations with Australia’s government. And the CEO has put his word behind the dividend, usually a sign that the regular payment to shareholders will hold up.

The Story

Roger and David have had a long infatuation with the Land Down Under. Their fascination is based in large part on the wonderful experience they’ve had covering investment opportunities in Canada, like Australia a former Commonwealth country.

Australia is also rich in resources and benefits from its close proximity to China. It’s an investor-friendly country–in fact, more Australians own stocks, as a percentage of the overall domestic population, than citizens of any other country.

Of course, a robust trading relationship with emerging Asia and an equity culture don’t necessarily mean all Australia-based stocks will be wealth-builders over the long term. There is one publicly traded company–what was once the most dominant telecommunications monopoly on the planet–that’s been beaten up by the Australian government and the market of late.

David: Before we hit the Southern Hemisphere let me ask you about New Flyer Industries (TSX: NFI-U, OTC: NFYIF), our August pick. New Flyer reported third-quarter results on Monday, and as I guess you and everyone else noticed the stock gapped down and shed more than 4 percent on Tuesday.

The things I noticed were a year-over-year uptick in the payout ratio to 69.8 percent from 64.9 percent in the third quarter of 2009–it’s still in a really good range–and that the company’s backlog rose to 9,011 TEUs from 8,492 TEUs. (“TEU” is “truck-equivalent unit.”)

So what’s the deal? Certainly a 15.9 percent revenue decrease isn’t good news.

And “reduced industry demand” is another obvious problem. But give me some additional context for this selloff. And–bottom line–is the dividend in jeopardy?

Roger: Did you see what happened to Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF) this month, the day they announced earnings? Their numbers were somewhat more disappointing than New Flyer’s, but neither is their dividend in the least bit of danger now. And that’s the only thing I can think of to remotely justify a 10-point top-to-bottom intra-day drop, even if half of it was recovered by the end of the day.

David: From where I’m sitting, this looks like an opportunity for people to get into New Flyer under our USD11 buy target.

Roger: I agree. This company is still making sales and earning more than enough cash flow to cover their distribution. The revenue shortfall last quarter was basically because they sold lower priced buses but masked a number of more positive developments, such as an increase in the company’s share of the aftermarket in the US, even as that market on the whole was contracting. Order backlog was actually up almost 7 percent sequentially in the summer quarter in both dollar value and units.

This is still a company dependent on largely government orders for its buses. And it’s made its niche in clean fuels, which may be less popular after the November elections. Management expects demand to fall roughly 10 percent next year and for the US market not to recover until 2012. But it’s also built its business plan around these gloomy projections, as the payout ratio of less than 70 percent in a down quarter shows.

Readers should remember that we’re hunting for big yields here, which means taking on some risk. But this looks like a second chance to get in on New Flyer at a monthly yield of 10.5 percent–with a lot of upside. Our October pick, Otelco (NYSE: OTT), just made a new 52-week high this week–which is justified by what I thought were strong third-quarter results–but it no longer fits our 10 percent rule for big yields. If you’re not in on Otelco, wait until it comes back below 16.

David: Speaking of getting in cheaply, I’ve been looking at another name that’s been beaten up. This one’s been down so long it’s starting to look like up to me, but I have a couple of concerns.

Telstra Corp (Australia: TLS, OTC: TLSYY)–which is yielding 10.9 percent right now–dominates the Australian fixed-line market and is the No. 1 Internet service provider in Australia. But it’s got serious regulatory problems, and customers seem to be unhappy with the company. I looked at it back in 2009, when I took a look Down Under for a Canadian Currents article for Canadian Edge. At the time it had just basically self-sabotaged its role in Australia’s state-mandated build-out of the National Broadband Network. Telstra’s back in. But legislation just passed the lower house and is likely to cruise through the Senate after a couple Independent Party legislators signaled their support.

Is the customer satisfaction issue simply a matter of Aussies not wanting to root for the favorite–the big, bad giant–or is what seems a concerted state effort to undermine its dominant role in the Australian telecom market reflected in popular attitudes? I like that management confirmed it can cover the AUD0.28 (USD0.27) per share dividend, but these are a lot of hurdles, even for a market player as dominant as Telstra.

Roger: I think all English-speaking countries have an inbred paranoia about big, dominant communications companies. Ever seen the Theodore Flicker/James Coburn classic “The President’s Analyst”? Over the past decade, both British Telecom (NYSE: BT) and Telecom New Zealand (NYSE: NZT) have literally seen their business models destroyed by regulators, who were supposedly acting in the interest of consumers. Can you imagine that happening in France or Japan?

Anyway, the regulatory burden is why I wouldn’t recommend Telecom New Zealand to my worst enemy, or even BT. The question is, is the state a potential killer for Telstra? We know it’s a solid company on the numbers. But can management navigate a tough environment well enough to keep generating the cash flow they need to keep paying the dividend?

It looks to me that if they can–and I do mean if–this stock is going to go a lot higher over the next year or so. This is a stock that under normal circumstances yields about half this much. Getting back to normal if Telstra holds the current dividend means a double in the share price, in addition to the 10 percent plus yield.

David: Well, the “legislation” I referred to blankly has to do with splitting Telstra in two. That’s actually similar to what regulators did require of BT and are forcing down Telecom New Zealand’s throat now.

Roger: So the key is can Telstra adapt better and faster than BT and Telecom New Zealand have. What are the differences as you see them?

David: Like you I’ve been impressed by Telstra’s ability to weather everything the Aussie government has thrown at it over the years. But aside from that, this bill is actually a real compromise. By separating its functions willingly, Telstra will actually be freed of rules on how much wireless spectrum it can acquire. A government spokesman said the bill provides Telstra with “sufficient regulatory certainty” so shareholders have a clear understanding of separation and its implications. And Telstra has basically been on board with the NBN/separation plan since June 2010.

Roger: What’s NBN ?

David: Like many nations, Australia wants to make broadband communications ubiquitous. NBN is a separate entity that will spin out of Telstra to roll out new broadband infrastructure nationwide. Telstra estimates the deal has a total value of AUD16 billion, while the government has set it at AUD11 billion. This is important, because the value will determine the cash payment Telstra will receive for spinning out NBN.

This is really the crux of how this deal will either benefit or hurt the company and I suspect like all regulatory matters that it will drag on for a long time before it’s fully resolved. There’s also a range of other disagreements, such as the terms of interconnections for ISPs (Internet service providers).

The bill just passed the lower house of the Australian Parliament this week. The key was independent MPs supporting the government’s position against the opposition, which had threatened to derail the process over concerns that NBN is being unfairly protected against potential private sector rivals. Interestingly, that may play to Telstra’s advantage, as they have a piece of the action now.

Roger: What else is potentially positive for Telstra?

David: For one thing, expectations are at rock bottom with the stock trading at a 52-week low and only a couple points off the early 2009 low. But the separation itself might have some positive implications. Telstra will no longer have its current burden of having to provide fixed-line access to all Australians, a legacy of the days when it was a sanctioned monopoly. It also means a clearer path to participation in the NBN.

Right now there are 18 research houses listed globally as following Telstra. At this point, seven have buys on the stock, six holds and five sells. Every single one of them, however, has a 52-week target price that’s above Telstra’s current level–even the bears. I think a lot of the recent selling, too, has to do with one of Australia’s state pension/(sovereign wealth) funds diversifying. Australia’s “Future Fund,” in fact, might have some more selling to do to get its portfolio to match the ASX 200.

Roger: Based on what I’ve been reading, the buzz in the analyst community has been that Telstra management is hoarding cash in the event that its deal with NBN falls apart. As it is, it looks like the passage of legislation pretty much rules that out. In fact, the special payout–even if it’s more like AUD11 billion than AUD16 billion–is almost an incentive for Telstra to get this done. That’s something that neither Telecom New Zealand nor BT had when their respective governments were busting them up.

What is a little more concerning to me is management’s apparent telegraphing of a drop in sales next year. It’s combating that with a more aggressive push into wireless communications–including lobbying the Australian government to auction more spectrum. And in fact, there’s some evidence of success here as its two main rivals, Singtel Optus and Vodafone Hutchison, have seen subscriber growth slow a bit. Keeping that going will be key, as the traditional phone business is bound to keep shrinking.

The other question is Telstra’s credit rating. As you know, my view about the raters is they’re more likely to pile on when a company is down, rather than actually spot trouble before it starts. But if Moody’s does cut Telstra’s rating from A2, it may be more difficult to borrow money in the long term.

David: I guess it’s like you’ve said before: It’s all about expectations. I’d argue that all of this is priced in and then some. And isn’t this the kind of story BIG is all about: a risky turnaround story that pays you while you wait?

Anyway, Telstra reports two times a year, in February and August. The most recent report covered fiscal 2010. The payout ratio is below 90, and cash flow coverage is pretty solid. I don’t know if they’ll actually make their target of 50 percent of the Australian smart phone market by late 2011. But if they come anywhere close, that’s going to make up a lot of the revenue lost from the broadband spinoff.

As for the money to execute, barring some sort of catastrophe, even a cash payoff of AUD11 billion is going to be huge. And keep in mind the company just had an extremely successful bond auction that it managed to upsize.

Roger: It’s interesting how they’re trying to increase the debt denominated in Australian dollars. That’s good for financial security, as they’re making all their money in that currency. It also makes sense from a currency point of view, given the steep run up in the Australian dollar, which if I’m not mistaken has just hit its highest level versus the US dollar since the early 1980s.

That’s quite a run already. But what a lot of people forget is that unlike the Canadian dollar the Aussie can literally go to the moon against the US dollar, as it tends to do during commodity bull markets. And this is certainly one with China and India sucking down everything from natural gas to iron ore the country produces. Telstra pays dividends and is priced in Australian dollars, so this could be a real bonus for buying this stock.

What should we look for now as a catalyst?

David: The Telecommunications Legislation Amendment Bill is now before the Australian Senate, where it’s likely to pass. The government will establish a new monopoly to assume responsibility for most of Telstra’s “universal service obligations” for the delivery of standard telephone services, payphones and emergency call handling from July 1, 2012. The government will also provide AUD100 million to Telstra to assist in the retraining and redeployment of staff affected by the changes. NBN Co will become the wholesale supplier of last resort for fiber connections in greenfield developments as of Jan. 1, 2011.

For months there was a lot of discussion–including Telstra reps and the federal government– about working based on self interest: NBN’s mission is much more achievable and more financially sustainable with Telstra inside the tent. The government’s “fiber-to-the-house” dream is going to be a whole lot easier if NBN has access to Telstra’s national network of trenches and ducts. Government will benefit from reduced costs for the national broadband rollout.

Getting that final legislation passed is the first hurdle. Then there’s the matter of the cash payment to Telstra and the resolution of several other matters concerning how NBN will compete with private companies. Assuming these establish an acceptable playing field for the company, the next test will be Feb. 10, 2011, when the company will announce its first-half fiscal 2011 earnings.

Roger: I’ll be looking for evidence wireless growth is picking up for Telstra, as well as how well cash flow is or isn’t covering the distribution. Apparently contrary to popular belief, management of these major telecoms has a tremendous amount of flexibility to maintain distributions when they want to. I’ll take Telstra’s at its word, with the caveat that no one should be betting the farm on this one–just as no one should any Big Yield Hunting recommendation. We’re playing for gains here and we’re taking some risk to do it, obviously.

How do we buy?

David: If you don’t want to buy on the Australian Stock Exchange–which is actually pretty easy with many brokerages–there are two choices in the US. I would go with TLSYY, which is the American Depositary Receipt and represents five ordinary Telstra shares. As of Nov. 17 the ADR was changing hands at a 0.22 percent discount to the Australian Stock Exchange-traded share. That’s actually a reversal of how things generally are–and another reason to buy now. A buy price under USD13 will ensure a yield well over 10 percent and a great deal of potential upside as well.

Roger: Agreed.

David: Here we go, Big Yield Hunters: Buy Telstra Corp up to AUD2.80 on the Australian Stock Exchange or buy the ADR on the US over-the-counter exchange–symbol TLSYY–up to USD13.

Open Positions

New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–Buy @ USD11

Avenir Diversified Income Trust (TSX: AVF-U, OTC: AVNDF)–Buy @ USD6