Executive Summary The headline numbers deceived. Netprofit growth of 3.6%, earnings per share growth of 37.4% and abuyback of $1.5bn all gave the impression of a growing, stable business (seeTable 1) but that impression isn’t quite right.

The numbers were flattered by the saleof the Autohome business, which generated a profit of $1.8bn.Without that sale, Telstra’s performancewasn’t as riveting with EBITDA up just 2.6% and revenue less than 2% higher. Inits key divisions – mobile and broadband – operating profit was slightlynegative or flat, depending on how you measure it. This was a result thatdisplayed weakness rather than strength.Linked Data: Ø  https://www.

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telstra.com.au/content/dam/tcom/about-us/investors/pdf-e/FY16-Annual-Report.pdf Ø https://www.telstra.com.au/content/dam/tcom/about-us/investors/pdf%20D/telstra-annual-report-2015.pdf   Profitability Thepinch isn’t just from the NBN; it is also evident in the mobile business.

Although customer growth was strong – Telstra added 560,000 new customersto its network therefore revenue actually fell.Howcan that be?Operating Profit Margin Thereare two reasons. Firstly, the average revenue per user fell about 1% to (astill astonishing) $68.40 a month, the highest in the market.

More importantwas the impact of competition.Tomaintain subscribers, Telstra is being forced to offer more inclusions,particularly higher data limits across all plans. It has also joined the restof the industry in introducing fixed charges for additional data.Thishas eliminated hundreds of millions of dollars the business once earned fromcharging customers usurious penalty rates for exceeding data caps. That profitwill not return.

This highlights Telstra’s plight and illustrates why thenegative on the stock.Telstraadded half a million customer accounts but, because the market is more competitive,it still made less money. There is no clearer proof that the mobile businesshas been overearning for years and returns are now falling.EBITDAmargins of 42% offer plenty of room for returns to slide further.Internationally, these margins are unmatched outside monopoly providers. 2015-06 2016-06 Revenue AUD Mil 25,119 25,845 Gross Margin % 74.

1 73.4 Operating Income AUD Mil 6,008 6,000 Operating Margin % 23.9 23.

2 Net Income AUD Mil 4,275 4,231 Earnings Per Share AUD 0.34 0.34 Dividends AUD 0.28 0.36 Payout Ratio % * 102.2 79.5 Shares Mil 12,464 12,264 Book Value Per Share * USD 0.97 0.

84 Operating Cash Flow AUD Mil 8,613 8,311 Cap Spending AUD Mil -3,762 -5,102 Free Cash Flow AUD Mil 4,851 3,209 Free Cash Flow Per Share * USD 0.32 0.23 Working Capital AUD Mil 1,754 -1,159  Return on Equity Withmobile generating 40% of all revenue and a similar proportion of profit,falling returns is a problem that isn’t easy to fix. Management’s solution isto pour billions of dollars into the division. Over the past few years,Telstra has spent an average of 15% of revenue on capital expenditure. That sumwill now climb to 18% for at least the next three years to defenddeclining margins.Ifcash were pouring into the fast growing parts of the business, we would be morecomfortable that the spending would ultimately lead to higher earnings.Instead, capex is being used as a competitive weapon to shore up margins thatare too high and, in my view, bound to fall.

Balance Sheet Items (in %) 2015-06 2016-06 Cash & Short-Term Investments 3.47 8.34 Accounts Receivable 11.67 10.94 Inventory 1.21 1.

29 Other Current Assets 0.88 1.00 Total Current Assets 17.23 21.58 Net PP 50.56 47.

55 Intangibles 23.07 21.32 Other Long-Term Assets 9.

13 9.56 Total Assets 100.00 100.00 Accounts Payable 3.11 3.38 Short-Term Debt 3.47 5.

86 Taxes Payable — — Accrued Liabilities — — Other Short-Term Liabilities 13.52 11.98 Total Current Liabilities 20.10 21.

23 Long-Term Debt 34.34 33.22 Other Long-Term Liabilities 10.70 8.89 Total Liabilities 65.

13 63.33 Total Stockholders’ Equity 34.87 36.67 Total Liabilities & Equity 100.00 100.00   Debt/Equity 1.00 0.

92   Return on AssetsTelstramay not have much growth but it does have plenty of cash and it isn’t shy aboutspending it.Operatingcash flow of $7bn (I had to adjust operating cash flow line for interestcharges which Telstra doesn’t include) was enough to cover capital expenditureof $4.4bn, but generous dividends and a $1.5bn buyback requires proceeds fromAutohome and continuing payments from NBN.  TheNBN deal, celebrated at the time of its announcement, will ultimately cost thebusiness between $2–3bn per year in EBITDA, cash that will be hard to replace.Telstra is slowly shrinking.Efficiency Asset Turnover 2015-06 2016-06 Days Sales Outstanding 62.

80 66.81 Payables Period 64.29 68.52 Cash Conversion Cycle 21.17 24.68 Receivables Turnover 5.81 5.

46 Fixed Assets Turnover 1.28 1.26 Asset Turnover 0.65 0.62       Debtorshave been drawn out 6.39% from 2015, therefore the payables period has increasedand cashflow is weaker in 2016.

Inventory Turnover 2015-06 2016-06 Days Inventory 22.66 26.39 Inventory Turnover 16.11 13.83 Considering the inclusion of 560,000 new customers in 2016, inventoryturnover has increased by 16.49% compared to 2015. Liquidity and Solvency Current Ratio 2015-06 2016-06 Current Ratio 0.

86 1.02 Quick Ratio 0.75 0.91 Due tothe buy back and selling of assets in 2016, the current ratio has increased. Withoutthis income, the current ratio would be weaker as compared to 2015.Gearing Ratio 2015-06 2016-06 Financial Leverage 2.87 2.73 Debt/Equity 1.

00 0.92 FinancialLeverage has decreased due to the payables period increasing in 2016 as comparedto 2015, therefore cashflow is weaker in 2016.Acid TestTelstra’sscore card is one of the best in the world among incumbent telecommunicationscompanies. It is also well-positioned to increase its business in the emergingdigital, sharing and networking economy.

It is successfully transforming itselfinto a full services ICT company.Telstra’smobile network is, and will continue to be, well-positioned to offer superiorservices to those offered by the NBN company. Their aggressive pursuit of 4G,and next on the list 5G, will guarantee this. While these mobile networks willnot cater for all of the ‘big iron’ broadband services, because of thecompany’s superior and most likely competitive offering, a large number ofmobile-based access services will be used in this way. The ongoing delays inthe actual availability of the NBN are also playing in Telstra’s favour.Furthermore, through its national Wi-Fi and fibre backbone networks it canrapidly offload any heavy broadband traffic from its mobile network onto itsfibre backbone.Companiescovered in this synopsis:Telstra,Vodafone, FOXTEL, SingTel Optus, Sensis.

 Share Market PerformanceDividend Payout ratio   2015-06 2016-06 Dividends AUD 0.28 0.36 Payout Ratio % * 102.2 79.5 Dividendpayout ratio decreased due to NBN investments in 2016. Earning Per Share 2015-06 2016-06 Earnings Per Share AUD 0.

34 0.34 Earningsper share remained steady due to the $1.8b profit on sale of Autohome shares   Conclusion Notall of Telstra is stagnant. There are parts of the business that are growingrapidly. The network application business, for example, has performedsplendidly but it generates less than 2% of profit. Despite efforts at diversification,Telstra remains a mobile and broadband business. Any change to than mix willinvolve a large risky acquisition.

Revenueand profits from key divisions is falling without remedy and more money isbeing ploughed into maintaining returns I think are unsustainable. There is achance the business can buy a terrific asset to replace lost earnings but thisis a risk as much as it is an opportunity.Yeteven with those problems, this is a powerful cash generator yielding 5.6%,fully franked. Telstra’s payout ratio, at 98%, is already maxed out and,after NBN payments cease in 3–4 years, dividends will fall unless growth cangenerate additional cash flows.

Idon’t recommend chasing yields but this one, for the next few years at least,is large and sustainable. And it’s better than just about any other blue chipyield available right now. For that reason alone, Telstra earns a “HOLD”.    KeyFinancial Data 12 month price range $3.38 – $5.22 Market cap (m) 42,340 Total shares (m) 11,893 Franking 100% Industry Telecommunication Services  Per Share  Year to Jun Earnings Dividends Book Value 2016 $0.35 $0.31 $1.30 2015 $0.35 $0.31 $1.15  Capital Structure Total Debt Interest Long Term Debt Percent Debt Preferred Stock Share Equity Percent Equity $17,284,000 $729,000 $14,808,000 50% $0 $14,541,000 0.5%  Key Ratios Year Operating Margin (%) Income Tax Rate (%) Employees ($T) Return on Capital (%) Return on Equity (%) Payout Ratio (%) 2016 42.4 31.6 0 16 26.8 89 2015 41.3 29.4 36 17 30 88  Profit & Loss    2016 2015 Revenue ($M)   25,834 26,061 Net Profit Before Abs ($M) 4,245 4,229 Net Profit After Abs ($M)   5,780 4,231  Cashflow   2016 2015 Customer Receipts ($M) $31,163 $29,521 Net Operating Cashflow ($M) $8,133 $8,311 Net Investing Cashflow ($M) $-2,207 $-5,692 Net Financing Cashflow ($M) $-3,777 $-6,882  Market and Earnings   2016 2015 Market Cap ($M) $67,975 $75,066 Dividend Yield (%) 5.6% 5%   Balance Sheet   2016 2015 Cash ($M) 3,550 1,396 Total Current Assets ($M) 9,340 6,970 Total Non-Current Assets ($M)   33,946 33,475 Total Assets ($M) 43,286 40,445 Total Current Liabilities ($M) 9,188 8,129 Total Non-Current Liabilities ($M) 18,191 17,806 Total Liabilities ($M) 27,379 25,935 Total Shareholders Equity ($M) 15,907 14,510