Jeff Bezos of Amazon famously made the following quote:
“I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time.
And that is what Bezos has done at Amazon. He has built a multi billion dollar business with the idea that consumers will always want low prices, vast selection and great customer service.
In our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, ‘Jeff I love Amazon; I just wish the prices were a little higher,’ [or] ‘I love Amazon; I just wish you’d deliver a little more slowly.’ Impossible.
He did not make a bold prediction about the world and how it would change in 10 years. He just backed things that have always worked.
BNSF and Buffett
This had me thinking about the deal Warren Buffett of Berkshire Hathaway (BRK) did in 2009 to buy out the remaining 77.4% of Burlington North Santa Fe Corp (BNSF) they did not own for around $27 billion.
BNSF owns and operates a large rail network in the US and Canada.
When Warren Buffet was asked why he bought a high capital intensive cyclical business he gave the following reasons:
Well, I felt it was an opportunity to buy a business that is going to be around for 100 or 200 years, that’s interwoven with the American economy in a way that if the American economy prospers, the business will prosper. It is the most efficient way of moving goods in the country. It is the most environmentally friendly way of moving goods, and both those things are going to be very important.
But the biggest thing is the U.S. is going to do well. I mean, we can’t move the railroad to China or India. They haven’t figured out how to do that.
Buffet is betting the way we move freight around is not going to change in the next 10, 20 or 100 years. He is investing in things that are going to be here for a long time. Like Bezos.
But that is only part of the equation. Price matters and no one knows this better than Buffett.
He bought BNSF equity at a total valuation of $35 billion. With BNSF came $10 billion in debt so the total Enterprise value (EV) he paid was $45 billion. At the time of the deal 12 month trailing net earnings were $2.1 billion. A P/E multiple of 16.6x. On a EV/EBITDA basis he paid around 8.7x trailing earnings.
BNSF earned $3.5 billion in 2016 and since the acquisition was completed, BRK has received around $23 billion in dividends. In this time BNSF has spend over $27 billion in capital expenditures. A pretty decent investment.
So with that in mind what would Buffett think about Telstra (TLS)?
Telstra originated in 1901 when the Australian government set up the Post Master Generals Department to be in charge of domestic telephone, telegraph and postal services.
TLS had a regulated domestic monopoly on communication in Australia. It was privatised and now has to compete against other Telco’s. It still maintains a dominant market share position with an estimated 50% of fixed line, mobile and internet communications. It is a cash generating machine with little reinvestment opportunities.
Humans are a social species. We all want to communicate. We want to talk to our friends and family, we need to do business. And the platform of choice is more and more on mobile.
I think communication, like transporting goods, will still be needed in 10, 20 and 100 years. I would not bet against this change.
TLS has been the market leader in communications from telegraph to mobile for over 100 years in Australia. And it has maintained this leadership in an unregulated environment.
The odds suggest that TLS will play a key role in how we communicate in Australia for the foreseeable future.
This does not mean that TLS is a great investment. This is a function of the price you pay.
So what does TLS earn?
TLS last year earned $3.832 billion in after tax profit. Of this it distributed $3.783 billion in dividends. TLS has struggled to reinvest its earnings at a high rate of return, so it has chosen to pay the majority of earnings in dividends. And it has been like this for a long time, since 2006 the annual dividend has been in a range of 28-31 cents per share per year.
Like BNSF, TLS requires substantial capital to maintain its network. TLS is currently spending around $5 billion a year. And if 5G is a viable option they may have to spend a lot more to build out this new network.
In FY 2017 TLS is forecast to earn $3.8 billion in after tax earnings, EBITDA of $10.6 billion and have a net debt position (debt – cash) of $16.5 billion. The current equity market capitalisation of TLS is $48.6 billion at share price of $4.09.
TLS total enterprise value is $65.1 billion with an EV/EBITDA of 6.1x. Compare that to the BNSF deal of 8.7x in 2009.
However the benefit that BNSF had over TLS is earnings almost doubled between 2009 ($1.8 billion) and 2016 ($3.5 billion). Unfortunately I don’t think TLS can double its earnings of its existing capital base in 7 years.
Currently there is uncertainty as the effect of the NBN on TLS earnings from 2020 when the NBN roll out is complete.
This uncertainty is caused by the migration of TLS’s current high margin fixed line internet to a lower margin NBN business. Estimates are this could result in a 20% fall in EBITDA by 2021.
There is also more competition coming in mobile with TPG committing to building a mobile network.
So if TLS EBITDA does fall to 20% to $8 billion by 2021 then on an EV/EBITDA basis you are paying 8x at the current share price.
Something else to consider is what would it cost to replicate TLS asset base?
When Buffet was asked about what it would cost to replicate the BNSF network he responded by saying it would take $100 billion or so and to do that they would have to be a real sport, it would take years. Remember he paid a total enterprise valuation of $45 billion for BNSF.
Would it cost more than $65 billion to replicate the TLS network? Probably and by a wide margin. And it would take years.
So do I think Buffett would buy TLS at $4? Maybe not but I think at around $3.50 he might be tempted to pay $40 billion in equity for an asset that over the cycle would pay $3-4 billion in dividends per year for the next 10-20 years that would grow with real GDP of 2-3% over time. Sounds like a pretty nice deal if you are long term enough.
But what would I know, I do not have Warren’s number to ask.