In a mid-week Flash Alert to Australian Edge subscribers I reported that management of AE Portfolio Conservative Holding Telstra Corp Ltd (ASX: TLS, OTC: TTRAF, ADR: TLSYY) on Apr. 19 announced its plan for the estimated AUD11 billion it will receive to transfer its copper-wire network and the customers who currently use it to Australia’s National Broadband Network (NBN).

Rather than announce a specific action, management instead detailed a “capital management strategy” focused on maximizing shareholder returns through both dividends and capital growth, maintaining financial strength and retaining financial flexibility.

The market had hotly anticipated a share buyback in recent weeks, though some held out hope for a special dividend or a payout increase. But, as I noted in a Feb. 28, 2012, Down Under Digest, management’s clearly stated preference has been preserving balance-sheet strength and financial flexibility as it continues to invest in its wireless network and adds customers and services.

And this will remain the priority.

Standard & Poor’s is the first credit rating agency to speak on Telstra’s decision. S&P reiterated an “A” rating on the company, describing Telstra’s capital-management framework as “consistent with” such a long-term mark and also expressed the view that management’s plan “should offset the additional medium-term business risks arising from the NBN transaction.” S&P also revised its outlook upward to “stable” from “negative.”

Telstra’s deal with the NBN will result in the progressive transfer its fixed-line access network customers to the government-owned high-speed network and disconnect its copper access network in exchange for a series of compensation payments.

Much of this cash will flow from long-term lease rental income from the NBN for access to Telstra’s pipes, ducts, “dark fiber” (unused optical fiber, available for use in fiber-optic communication) and exchange racks. According to S&P’s estimates these lease payments could approach AUD1 billion by the end of the NBN build-out. Telstra will also receive significant one-off disconnection payments that will also support long-term growth.

Build-out of the NBN is expected to take a decade. It’s governed by several arrangements between Telstra and the NBN as well as between Telstra and the Australian government. These agreements include:

• Implementation and Interpretation Deed: This agreement between Telstra and the NBN sets out “Conditions Precedent” and various interim arrangements. It also contains common provisions applicable across the entire package of agreements that will give life to the NBN.
• Subscriber Agreement: This deals with the disconnection of copper services and broadband services within the NBN footprint as well as Telstra’s commitment, subject to some exceptions, to use the NBN exclusively to provide fixed-line access to these premises.
• Infrastructure Services Agreement: This sets out the terms according to which Telstra will provide access to infrastructure and related services to the NBN.
• Access Deed: This describes the NBN’s commitments to Telstra regarding terms of supply of the NBN’s basic services and charges for certain wholesale services.
• TUSMA: This is an acronym for the Telecommunications Universal Service Management Agency, which was created Mar. 21, 2012, with Australian Parliament’s passage of universal service reform legislation. It sets out terms according to which Telstra perform and be paid for performing services in the public interest, including meeting Australia’s Universal Service Obligation.
• Retraining Fund Deed: This sets out arrangements according to which the Australian government will fund the retraining of Telstra employees.
• Information Campaign and Migration Deed: This agreement describes key residual commitments and payments to be satisfied directly by the Australian government, including a commitment to arrange for the NBN to conduct a “public education campaign” to inform end-users about the migration to the NBN.
• Commonwealth Guarantee: This is lynchpin. It is what it says it is, a guarantee by the Australian government to Telstra to cover the NBN’s payment and performance obligations described in the first four items in this list.

At the end of the day Telstra will retain leading market positions in mobile, fixed-line and pay television, primarily through its 50 percent stake in FOXTEL. It will maintain its strong market position as the incumbent provider of telecommunications products and services in Australia; its strong market shares and cash flow generation; and its balance-sheet capacity, which will enable it to meet basically any competitive threat and maintain its technological advantage.

At the same time, however, this is the start of a long-term and massive structural change for the Australian telecommunications industry. Telstra’s revenue mix will shift to more competitive products and services. But management has negotiated extremely favorable terms with both the NBN and the Australian government that do away with its legacy monopoly but provide it a significant “head start,” if you will, as it’s joined by new competitors.

As of Dec. 31, 2011, Telstra had about AUD3.3 billion in short-term debt, which was adequately covered by AUD3 billion in cash and cash equivalents, significant ongoing cash generation and about AUD750 million in undrawn credit facilities. Telstra has also significantly reduced its exposure to the commercial paper markets in the past two years, with only AUD500 million outstanding at the end of 2011.

Telstra aims for a balance sheet worthy of a single-A credit rating. The longer-term objective remains to grow dividends–and to make sure these dividends are fully franked for its broad Australian shareholder base. Management has declared its intention to pay AUD0.28 per share per year for fiscal 2012 and fiscal 2013.

Management is working with the following guidelines: a debt servicing ratio between 1.5 and 1.9 times; “gearing,” or net debt-to-capital ratio, between 50 percent and 70 percent; and an interest cover of greater than seven times.

As of Dec. 31, 2011, Telstra is at the lower end of these ranges–the debt servicing ratio was 1.48, gearing 54.9 percent–though management expects modest increases over the next 18 months as it funds its share of 50 percent owned FOXTEL’s acquisition of rival cable TV company Austar United Communications Ltd (ASX: AUN) and spectrum payments due in late 2013.

Payments from the NBN transaction are expected to help offset a reduction in free cash flow Telstra will suffer as it gives up its fixed-line business. But the timing of the NBN payments will result in “excess free cash flow” of AUD2 billion to AUD3 billion over the next three years and an “excess capital position” of AUD500 million to AUD1 billion by the end of fiscal 2012.

Management stated in its presentation today a “preference for returning capital to shareholders is via growth in franked dividends.” As things stand, however, Telstra doesn’t expect to have the franking capacity to increase the dividend before 2014.

(Australia-based companies accumulate “franking credits” as they pay tax to the Australian Tax Office [ATO].  A specific company’s “franking account” is only a record of what was paid; it doesn’t contain actual money. The company’s ability to frank its dividend will depend on the balance of this franking account. If the franking credit contains a surplus, the company may declare a fully franked–or 100 percent franked–dividend. If the franking account isn’t large enough, perhaps because it pays tax overseas, then the company may declare a partially franked dividend.)

Management determined as well that a share buyback at this time would not be “efficient.”

Although this announcement didn’t pack the immediate gratification many shareholders were hoping for, it does set the stage for Telstra to further cement its dominance in Australian telecommunications. The NBN will also play a part in growing two of Telstra’s growth portfolios, primarily its Network Applications and Services (NAS) segment, where the company’s “cloud” initiatives take shape, and its media businesses, including the combined FOXTEL-Austar.

In the first half of fiscal 2012 (ended Dec. 31, 2011) Telstra realized AUD579 million in revenue from “strategic growth driver” NAS, 19.4 percent above the prior corresponding period. Offerings within Telstra’s NAS segment include cloud computing, unified communications and intelligent networks, which allow numerous services to be offered across its networks. Managed network services revenue grew by 24 percent, or AUD75 million, to AUD387 million, on strong video conferencing demand. The March 2011 acquistion of iVision drove this growth; it contributed AUD34 million to revenue.

Some analysts have forecast Telstra will be able to generate AUD2 billion in revenue from NAS within five years; it’s already on a better than AUD1 billion annualized pace. Last June CEO David Thodey unveiled an AUD800 million spending plan to build out Telstra’s cloud capabilities even further, the first major step of which is construction of a 2,000 square meter data center in Melbourne that will come on line in 2013. The center will boost Telstra’s data capacity by about 40 percent.

The company inked new deals with AE Portfolio Aggressive Holding Origin Energy Ltd (ASX: ORG, OTC: OGFGF, ADR: OGFGY) and South Australia Health, a government agency, during the period. The new contracts were significant contributors, as was rising business demand for video conferencing and managed data networks. As of early February Mr. Thodey saw about AUD1 billion in potential contracted services available in the market, business for which Telstra will be very competitive.

Right now Telstra is a wireless company: Domestic Mobile delivered revenue growth of 10.9 percent in the half of 2012 to $4.4 billion. But NAS was its fastest-growing segment, and the company is making it a priority.

Management didn’t rule any ideas out over the last several months while it considered its options. A dividend increase, which would have been the company’s first since 2004, never seemed likely, while even a one-time buyback or special payout to shareholders didn’t really square with management’s priority of winning market share based on its leading technology and infrastructure position.

As I wrote in February, “We like Telstra because of its dominant position, its attention to weak spots such as customer service and proven ability to fix same, and the prudence management has shown in focusing on preserving that which makes it a compelling long-term wealth-building story: its scale advantage. A robust network will keep Telstra’s wireless subscriber rolls growing and its data revenue share expanding.”

We will have to wait for a dividend increase. But, with the NBN agreements finalized, Telstra is in great position to grow.

The Roundup

Following are dates (confirmed, tentative or estimate) for each AE Portfolio Holding’s next earnings announcement.

Conservative Holdings

• AGL Energy Ltd (ASX: AGK, OTC: AGLNF, ADR: AGLNY)–Aug. 22, 2012 (estimate, FY 2012, end Jun. 30, 2012)
• APA Group (ASX: APA, OTC: APAJF)–Aug. 21, 2012 (estimate, FY 2012, end Jun. 30, 2012)
• Australand Property Group Ltd (ASX: ALZ, OTC: AUAOF)–Jul. 26, 2012 (confirmed, CY/FY 2012 1H, end Jun. 30, 2012)
• Australia & New Zealand Banking Group Ltd (ASX: ANZ, OTC: ANEWF, ADR: ANZBY)–May 2, 2012 (confirmed, FY 2012 1H, end Mar. 30, 2012)
• Cardno Ltd (ASX: CDD, OTC: COLDF)–Aug. 16, 2012 (estimate, FY 2012, end Jun. 30, 2012)
• CSL Ltd (ASX: CSL, OTC: CMXHF, ADR: CMXHY)–Aug. 21, 2012 (confirmed, FY 2012, end Jun. 30, 2012)
• Envestra Ltd (ASX: ENV, OTC: EVSRF)–Aug. 27, 2012 (estimate, FY 2012, end Jun. 30, 2012)
• M2 Telecommunications Group Ltd (ASX: MTU, OTC: MTCZF)–Aug. 29, 2012 (estimate, FY 2012, end Jun. 30, 2012)
• Telstra Corp Ltd (ASX: TLS, OTC: TTRAF, ADR: TLSYY)–Aug. 9, 2012 (confirmed, FY 2012, end Jun. 30, 2012)
• Transurban Group (ASX: TCL, OTC: TRAUF)–Aug. 2, 2012 (confirmed, FY 2012, end Jun. 30, 2012)

Aggressive Holdings

• BHP Billiton Ltd (ASX: BHP, NYSE: BHP)–Aug. 22, 2012 (confirmed, FY 2012, end Jun. 30, 2012)
• GrainCorp Ltd (ASX: GNC, OTC: GRCLF)–May 22, 2012 (confirmed, FY 2012 1H, end Mar. 30, 2012)
• Iluka Resources Ltd (ASX: ILU, OTC: ILKAF, ADR: ILKAY)–Aug. 23, 2012 (confirmed, FY 2012 1H, end Jun. 30, 2012)
• Mineral Resources Ltd (ASX: MIN, OTC: MALRF)–Aug. 20, 2012 (estimate, FY 2012, end Jun. 30, 2012)
• Newcrest Mining Ltd (ASX: NCM, OTC: NCMGF, ADR: NCMGY)–Aug. 13, 2012 (confirmed, FY 2012, end Jun. 30, 2012)
• New Hope Corp Ltd (ASX: NHC, OTC: NHPEF)–Sept. 20, 2012 (estimate, FY 2012, end Jul. 31, 2012)
• Oil Search Ltd (ASX: OSH, OTC: OISHF, ADR: OISHY)–Jul. 24, 2012 (confirmed, FY 2012 1H, end Jun. 30, 2012)
• Origin Energy Ltd (ASX: ORG, OTC: OGFGF, ADR: OGFGY)–Aug. 23, 2012 (estimate, FY 2012, end Jun. 30, 2012)
• Rio Tinto Ltd (ASX: RIO, NYSE: RIO)–Aug. 8, 2012 (confirmed, FY 2012 1H, end Jun. 30, 2012)
• WorleyParsons Ltd (ASX: WOR, OTC: WYGPF, ADR: WYGPY)–Aug. 29, 2012 (estimate, FY 2012, end Jun. 30, 2012)