I started this post last Thursday when Telstra dipped to $3.21. Due to a sore neck and a new Carl Hiaasen novel I didn’t make much progress, but the share price sure did. An upgrade to outperform from Credit Suisse, a buy from RBS Australia and a stupidly low price was enough to attract buyers back into Telstra. Its shares closed at $3.32 on Friday after hitting a high of $3.34.

Telstra Corporation Limited (TLS) is the dominate telco in Australia. It owns the network that most voice and data travels down and half the main cable TV provider, plus directory listings and some other small businesses.

I see little point in over thinking an investment in Telstra, so will try to keep this simple.

Telecommunications is a large and growing necessity in our lives. The only way is up for data movement and Telstra are the biggest toll collector on the digital communication and entertainment highway. More bits will travel down Telstra’s pipes and as they complete their transformation from wires to wireless and ubiquitous broadband they will grow their slice of consumer’s dollars. Telstra business is highly capital intensive so it will take excellent management to control costs and produce excellent returns, fortunately Sol set Telstra on the right  path there and team Thodey and Stanhope are well equipped to manage the business.

The current price of $3.21 is low. Telstra are a slow growing utility and thus it’s appropriate I back that low price call up with the dividend discount model as a valuation approach. I’ll get to that in a moment, but first let’s keep it really simple. The current 28 cent dividend provides a net annual return 32.2 cents to SMSFs, with Telstra trading at $3.21 yesterday that’s a 10% annual net return before even looking for upside. The holy grail for many dividend investors is a potential 10% dividend yield at some future point, with Telstra it’s not potential, it’s right here right now.

Back in June I worked through an example of using the Dividend Discount Model. In summary, Price = dividends one year from now/(discount rate-growth).

As with all models the danger is garbage in garbage out, so I’ll do my best to limit the garbage in.

Current Dividend is 28 cents annually, the same as it’s been for four years if we exclude special dividends. Payout ratio is 85% or 80% on a free cash flow basis.

Growth Rate.The dividend has doubled over the last 10 years. While it has not moved over the last four years, there were three special six cent dividends in 2005 and 1H 2006. Plus the massive restructuring and investment for the move from fixed line to wireless and broadband consumed a lot of cash, which stymied any dividend increases. I’ll use a range of growth rates, all below the past decades.

Discount Rate: I’m going to stick to 10%. Though, I am left concerned that the discount rate has such a large impact on the DDM output, see the chart below for an example. I could use CAPM to determine the rate as Aswath Damodaran does in this dividend discount method spreadsheet. In CAPM the discount rate is the risk-free rate plus the risk premium (difference between market and risk-free returns) multiplied by the stock’s beta. My bias is there has to be something better than beta to measure risk. I view Telstra as less risky than the overall market.

The Results

If you’ve skipped ahead you may have noticed Roger Montgomery came up with the very exact valuation of $4.01.

I prefer to work with ranges or ball-park figures. The chart to the right shows Telstra valuations with differing growth rates using 10% and 11% discount rates. My range within this chart is $3.60 – $4.90, but like Roger I view Telstra as fairly valued right now in the low $4 range.

The next chart shows what the dividends would be out til 2016 at those growth rates.

I see 3% – 4% growth rates as achievable, but as Roger points out below Telstra haven’t grown their earnings in a decade so perhaps it is ambitious to see them growing over the next decade. I’ll look at growth in the forward looking section, but in summary, Telstra have been repositioning their business model over the last decade and low growth will now be delivered.

Telstra’s Dividend

Is the dividend sustainable? The current 85% earnings and 80% free cash payout ratio is sustainable. However, Telstra will need to grow earnings to enable increases in the dividend.

As the Telstra Dividend Payout chart below shows Telstra now comfortably cover the dividend. Telstra earnt 32.9 cps this year, up 9.8% on 2008, continuing the recent pattern of 2008 up 13.3% and 2007 up 2.9%. There was only one year, 2007, when Telstra were guilty of paying out more in dividends than their free cash flow.

Looking Forward

Up to now I’ve been looking in the rear view mirror, so let’s take a few minutes to consider the future.

Telstra is transitioning from a heavy reliance on their fixed wire, PSTN, network to the future drivers of wireless and broadband for ubiquitous communications and data. Mobiles are now Telstra’s largest contributor in sales and while some commentators are stuck in 2007 and can only see the decline in PSTN, the reality is that mobile revenue grew 10% in 2009 while PSTN declined half that amount. Telstra now have 10.2M mobile customers and those subscribers are a large part of the future of this business.

Telstra are targeting a massive $6B in free cash flow this year, 35% year on year growth.  While that is mainly due to cost and capital control they still predict low single digit growth in revenue and earnings. With those cash flows it would be no surprise to see a dividend increase this year.

In the words of Sol, Telstra have rewired and unwired. Telstra is not the company they were a decade ago, their future is more assured and their price is only 40% of what it was then trading for. Its financial ratios have compressed while earnings and cash flow in particular are growing. Show me a safer investment with a shot at 30%+ returns and I’ll be all ears. Seriously if you know one, leave a comment, as I’m very interested.

The thrust of this post is Telstra’s long term story and dividend stream. However, there is also a capital gain story. If, or I should say when investors re-rate Telstra and it trades at its usual dividend yield of 7% the shares will be worth north of $4.00. The sooner that happens the greater the annual capital capital. Buying Telstra at current prices gives SMSF investors a relatively safe 10% yield while they wait for a respectable capital gain. The total return within a year could be 37% or higher with exretemly low chance of a permanent risk of capital.

A Bearish View

Here’s a bearish perspecitve by By Roger Montgomery from the excellent Eureka report.

“Telstra shares do look cheap and I have a valuation of $4.01 but this is a business that is currently earning the same profit that is was earning at the turn of the century, whose return on equity is still not back to where it was a decade ago and whose rising return on equity is due to equity falling rather than profit growth. This latter fact stems from the policy of paying dividends far in excess of profits. Moreover, the company is a capital-intensive one – just look at the $24 billion of property, plant and equipment on the balance sheet. Further, borrowings of $17 billion are well in excess of the $12 billion in equity, which in turn is boosted by $8.4 billion of intangibles, a combination I simply prefer to avoid. ”

Buying Telstra at $3.21

It’s Monday afternoon now and Telstra has fallen back to $3.26. I wouldn’t be surprised to see Telstra change hands for $3.21 or lower over the coming weeks, heck maybe even tomorrow. So buying Telstra at $3.21 may be as simple as waiting patiently. For those not willing to wait, there are other options. Here’s two that spring to mind.

1. Buy Stock and Short Straddle. I saw this strategy referred to the other day as The Money Tree, which is a lot more catchy than what I call it, but money does not grow on trees, so I’ll stick to Covered Straddle. In summary you buy half the stock you want and then sell at the money calls and puts. Here’s an example with Telstra.
   Imagine you want to own 10,000 shares of Telstra. Here’s what to do:
   - Buy 5,000 shares at $3.26
   - Sell 5 $3.36 October Calls and 5 Puts. (To keep the maths simple, I’ll ignore that these Telstra options are for 1040 shares,  and round to the standard 1,000 shares for Australian options)
   - At current prices that will give a cost basis on the shares of $3.01, ($3.26-.17-.08).

   Come October if Telstra is:
   - above $3.36, shares will be called away and you’ll net (ignoring transaction costs) 11.6% or 35 cents, an annualised return of 94%. Annualised costs generally glorify reality so it’s best to cut that figure in half. Rinse and repeat the process.
   - below $3.36. You’ll be put the 5,000 at $3.36 and will now have the full 10,000 shares with a cost basis of $3.19, ($3.01+$3.36)/2.
   - exactly $3.36, get a grip the chances of that happening are slim, but for completeness you’ll be left with half your shares at $3.01 and you repeat the straddle the following month.

2. While the above may sound a little tricky to those not familiar with options, it is easy to do. Though I understand you may want something even easier. Selling puts are like placing buy limit orders, except you get paid to do so. While that may sound great the downside is that you’re taking all the downside risk without the potential of upside gain. The October $3.36 is currently trading at 17 cents, if you sell that then the following can happen if Telstra is:
   - above $3.36 you’ll walk away with your $0.17
   - below $3.36  you’ll be put and will have to buy the shares at $3.36 no matter what they are currently trading for, you cost basis will be $3.19

One of the slight tricks with options is comparing apples to apples. As I often say you can’t buy a latte with percentages (yeah I know I really must work on my saying), so let’s concentrate on the cash. In general there is no such thing as a better option strategy, as it all depends on what you’re trying to achieve. However, if you want to profit from taking ownership risk on Telstra which of the above strategies would you choose?

Picked one? Did you opt for strategy one with the the higher profit if called, though higher cost basis if put? I hope not as if you look at the strategy again you’ll see the higher profit if called is actually a mirage. In strategy one you’re only selling half as many options, 5, instead of the 10 in strategy 2. So the two strategies have almost the same gain if called, 5*.35*1000 and 10*.17*1000 and the same cost basis if Put. In this case I’d opt for the simpler strategy. My point is ignore percentages, convert everything to dollars on a like for like basis.

My real reason for running through these two strategies is that I saw the first strategy extolled as an excellent strategy on an investing discussion board. I’ve tried to explain several times on that board that a put is equivalent to a covered call, but it appears the message has not got through. If you break down the ‘money tree’ strategy, you have a put and a covered call. As a put and a covered call are equivalent you really have two puts. Thus strategies one and two are the same, except strategy one is more complicated.

Can we do better? The great thing about options is there is always another option, but that’s enough for now.

If you’re a sucker for confirmation bias then Christina over at SMSF Investment Strategies recently posted about her exploits selling Telstra put options.

Disclosure: I own Telstra in various accounts and may open option positions in the near future. Telstra closed Monday at $3.25.

[Update] Crikey, blow me down, the Telecommunications Regulatory Reform release today has knocked Telstra for six, it trades at $3.16 as I write this. It look like the market doesn’t like structural separation. I said Telstra could trade under $3.21 today or within weeks, but sure didn’t think it would be within hours of posting this.

My main issue with the structural separation is it will distract management focus. My main interest in the story is one of opportunity. Telstra is now $3.10 with fear is in control.

Related posts:

1. Telstra looks like a great buy
2. Telstra Looks Like a Strong Buy
3. Telstra – Stock Market Returns Inverted
4. Telstra Corporation Analysis
5. The Alternative Telstra Media Release
6. Telstra out of National Broadband Network