Is the market Under-Valuing Telkom South Africa?

Mergers, Acquisitions and Financial Results

The annual results for Telkom for the year ended March 31, published on June 8, were, at best, described as flat. Diluted headline earnings a share were 1706c, 7,7% lower than the 1719,2c the previous financial year. Kudos should perhaps be given to the Forecast Factory experts. Their consensus back in late October, when Telkom was reviewed in this column, was 1721c in financial year 2007 -- a fractional improvement on the 2006 figure.

But there was egg on this writer's face who expected Telkom to be able to improve 20%. The fundamentals seemed right at the time. There was good reason to expect an increase in operating revenue of about 10%. This would have taken the 2007 operating revenue to R52,38bn from R47,62bn. On the assumption that operating margin would maintain at 30,8%, its 2007 operating profit would have been R15,9bn. Its profit for the year would, after tax, have been about R1bn, and diluted headline earnings a share would have been about 1870c . This would still have fallen short of the column's forecast of 2072c but not quite so much egg would have been splattered in my face.

The interesting things is that, had the Forecast Factory consensus been used to rate the company, at its October share price of R140, its forward earnings yield would have been 12,29% and its forward price-earnings ratio would have been 8,1. The conclusion that the share price was under-valued would have been the same, notwithstanding that the respective forecasts in the column were 14,8% and 7 respectively.

The share price forecast over a year would still have been about R170, as the forward investment fundamental ratings shouted that the share price was under-valued. A share price of R170, especially in this market, was attainable.

Well, the share price did, indeed move to R170. In June it nearly peaked R185, although it's now dithering at R163,50. The down-flip in the share price has much to do with the Competition Tribunal's decision, reported on June 29, that Telkom could not buy Business Connexion. You can bet on one thing, though -- Telkom is taking advantage of the share price weakness to continue its current share buy-back programme of R2,4bn. This, no doubt, explains the part of the underlying demand for the shares mentioned in the comment on the accompanying chart.

Telkom, is a cash-cow operation. As its cash-flow statement shows, in the financial year 2007, its cash-flow from operating activities was R9,35bn. Its actual cash generated from operations -- the difference between cash received from customers and cash supplied to suppliers and employees -- was R20,52bn. The tax-bite from this cash was R5,69bn and dividends took another chunk of R4,78bn. Its capital investment in the year amounted to R10,04bn and its net loan decrease was R1,3bn. At the end of the year it still had net cash and cash equivalents of R308m.

Agreed, this cash pile looks tiny compared to the mountain of R4,25bn at the end of the 2006 financial year. The important point, though, is that the cash flow shows that it can easily meet its future capital investment and continue to improve its return on assets through acquisitions and also by reducing its capital through its share buy-back programme. It also has scope to gear its equity. At year-end its net debt:equity was 30,9% and its reported target range is 50% to 70%.

According to the return on assets managed model, its return on assets in the financial year 2007 was 24,38%. This was achieved on a return on sales of 28% and a ratio of 1,86 on assets to equity. Reducing equity will improve the ratio of assets to equity, and improve its already historical return on equity of more than 45%. Its actual performance, over time, will depend on how well it manages its assets as they expand and diversify organically. It's worth making this last comment, although it appears all too obvious, as the possibility of a major acquisition, especially in SA, seems less likely as time goes on. Don't expect scintillating results next year. The published prospects focus on competitive and regulatory price pressures as well as increasing costs.

The Forecast Factory consensus, recommending hold +, is diluted headline earnings a share of 1746,80c for the financial year 2008. Given Telkom's published prospects, this consensus seems fair. At the current share price of R163,50, the forward earnings yield is 10,68%, the forward price-earnings ratio is 9,3 and the projected dividend yield is about 5,5%.

The share price is under-valued, even taking into account expected diluted earnings a share growth of less than 5%. The share price may well move fairly soon to R170 and could well be again over R180 and heading towards R200 within a year from now.

The  weekly bar chart of Telkom since its listing in 2003 shows how the share price has quadrupled, and, with the addition of moving averages, has mostly remained in a long-term bull trend. The bull trend was lost in June last year when the shorter-term moving average moved down from top position. However, it moved back to top position in December .

What the price plotting has not yet done is to move back into the upper segment of the speed resistance line formation. On three occasions it has pushed upwards into the top one-third of the formation, but has been unable to sustain that level.

The latest pull-back in price, which was accompanied by high volume, has positioned the share in oversold territory and, at what appears, fairly close to its equilibrium level.

Its Cycle Trend chart indicates that at the bottom of a cycle it is likely to move strongly upwards in the short term. Telkom's next count is to R219, but it's doubtful that it will reach this level in its current upward move.

From December until mid-April/May the share the share was in an accumulation phase. Distribution took over and lasted until mid-May. From end-May to date, despite the recent dip, accumulation has been dominant.

(Source: Business Day)