Description

I am pitching Bell Canada (BCE.TO / NYSE: BCE) as a short. There are four legs to the thesis:

1. The Canadian telecom industry is facing a structural transition from 3 to 4 players, where the new entrant has a government-mandated cost advantage and is driving substantial price deflation. Bell’s existing customers on average pay 25-30% more for their older plans than what that same plan costs on the market today. This has already driven, and in my view will continue to drive, significantly greater competition and ARPU declines within the industry than street is appreciating

2 Bell is the worst-off player across Canadian telcos due to its highest exposure to secularly declining segments (business wireline, copper internet, satellite video, voice, media) which together comprises ~40% of total revenue. Its only growing business (wireless) have decelerated rapidly as it has ceded the most share thus far to the new entrant

3. Bell’s financials are horribly misunderstood owing to IFRS accounting. There is roughly CAD 1bn (~30% of headline “free cash flow”) in annual, recurring lease payments that is not included in any of the Company’s reporting nor in forward consensus numbers. Inclusive of this $1bn cash use, Bell’s dividend payout ratio on its real cash generation is >170%. Bell has levered up ~0.2x per year in each of the past 4 years to sustain its dividend. This strategy is clearly unsustainable, and current leverage, inclusive of a debt-like preferred securities, is already highly elevated at 3.8x IFRS EBITDA, or 4.2x “GAAP” EBITDA

4. The Canadian market is expected to see a marked slowdown in population growth (the key industry growth driver), as unsustainably high levels of immigration over the past 2 years, specifically temporary migrants, reverse. Projections from the Bank of Canada would suggest a ~2pt deceleration in the market beginning next year (which in telco is often the difference between positive and negative growth). To clarify, this headwind to growth is separate from the impacts of greater competitive intensity, which I believe will an even larger negative impact.

Altogether, I am significantly lower vs. the street on revenue , EBITDA, and free cash flow growth. I have a $31 CAD / $23 USD price target, which represents -30% downside to today’s stock price. The immediate reaction if you pull up the stock chart is “darn, I missed the trade”, but because the Company has issued so much more debt to go to paying its dividend, BCE’s TEV has actually declined by much less than what the chart suggests.

To that point on valuation, BCE remains mind-blowingly expensive, trading at ~7.5x IFRS EBITDA (~8.2x GAAP EBITDA) and ~24x NTM (lease payment included) FCF, for a company that I believe will show negative EBITDA growth in and beyond 2025. For context, BCE’s U.S. peers (VZ, T, CMCSA, CHTR) trade for 6-6.5x GAAP EBITDA / ~10x FCF, and are all expected to show positive EBITDA growth.

My price target implies a re-rate of BCE down to ~6.7x GAAP EBITDA / ~16x FCF, which I believe will be catalyzed by a combination of 1) continued negative financial performance that misses street as my thesis points materialize, including an inflection to negative EBITDA growth beginning in 25, and 2) a cut of the unsustainable dividend.

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1. INDUSTRY DETERIORATION: GOING FROM 3 TO 4
In Apr-23, Rogers Communications (along with Bell, one of Canada’s 3 incumbent wireless players as well as its largest cable company) acquired Canada’s second largest cable company, Shaw. Prior to the acquisition, Shaw owned a small, fledgling wireless provider called Freedom. Freedom was a smaller/worse version of the old Sprint in the US: bad network that was largely confined to the inner-metros, and a small, lower-end customer base.

As part of regulatory approval for the merger, Rogers was forced by the Canadian government to do two things: the first was to sell Freedom at a bargain price to Quebecor (QBR.TO - I will discuss these guys in a bit), and the second was to give Freedom the right to ride Rogers’ own (high-quality) wireless network in areas where Freedom itself had inferior service or had simply not yet built out. Effectively overnight, service quality on Freedom went from extremely bad to on-par with the incumbents.

How much would Freedom (Quebecor) pay Rogers for that right to use their network? Well, it was up to those two to negotiate a fair rate. Except they couldn’t. And because this was a government-mandated requirement, Quebecor and Rogers went into baseball-style arbitration (they each propose a rate, and the government regulators choose one or the other - there is no compromise). Importantly, regulators in Canada HATE the incumbent telcos. Canada has some of the highest wireless prices in the world and it is a big sore spot. They also hate it when telcos fire people, which they tend to do quite often. Here’s Bell’s CEO getting hauled in front of Canada’s Parliament 3 months ago (https://www.youtube.com/watch?v=5pTTIMVRYGA). It should come as no shocker that the government sided with the rate Quebecor proposed, for a term length of 7 years with another 3-year option to extend. I discuss this decision in greater detail a few paragraphs down.

But first, who is Quebecor? Quebecor is both a wireless and cable company in Quebec (~20% of Canada’s population). This makes the headline on my thesis not entirely true: wireless was always an effective 3-player market (Freedom was so small and bad it didn’t really count) in all of the country, except Quebec. In Quebec, Videotron had ~25% market share, making it an even 4-player market. Not-so-coincidentally, Quebec’s wireless prices were always ~20% lower than the rest of the country’s (to spell it out, 4 player market = 20% lower prices).

The best analogy I have for Quebecor is it’s like T-Mobile when John Legere was there. Except, Quebecor’s CEO, Pierre Karl Péladeau (“PKP”), is even more insane. I won’t dive into all of his bio here, but the important things to know are he is a billionaire whose father founded Quebecor, whose “lifelong dream” has been described as expanding Quebecor into a national footprint. He is known to despise the big-3 incumbent telcos, who have competed tooth-and-nail against him in both the wireless and cable segments in Quebec. Read QBR’s transcripts, and it will be quite evident that he is treating the Freedom acquisition as his shot to 1) fulfill his dream of expanding nationally, and 2) get his revenge on the the big-3 incumbents, including and in particular Bell, who overlap the most with them in Quebec.

But can Quebecor afford this? The short answer is: yes. Unlike the big-3, Quebecor is de-levering with its debt recently upgraded to IG. It generates significant positive FCF after dividends and has strong M-HSD underlying EBITDA growth. And very importantly, not only did the government side with Quebecor/Freedom, they also published a long note justifying the decision, which gives significant color on just how low the rate they are paying Rogers is. This note has not been brought up by anyone covering the Canadian telcos to my knowledge, but there are some bombshell lines in here:

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Verbatim Quotes from Decision (https://crtc.gc.ca/eng/archive/2023/2023-217.htm):

“QMI (Quebecor) added that the rates it proposed would enable it to cover its retail costs, react to commercial strategies from incumbent carriers (Bell Mobility Inc., RCCI, and TELUS Communications Inc.) that hold market power, earn a modest profit margin, and reinvest in the expansion of its network.”

“QMI also submitted that its offer is the maximum rate at which it can compensate RCCI while still honouring its binding commitments to the Minister of Innovation, Science and Industry (Minister of Industry) and to Innovation, Science and Economic Development Canada (ISED) as part of the Freedom Mobile purchase while absorbing all of the deployment costs associated with Videotron’s entry into new markets.”

And what was the “binding commitment” referenced in the last quote? It was a commitment to lower wireless pricing in Canada by 20% (https://www.quebecor.com/en/-/qu-c3-a9becor-compl-c3-a8te-l-acquisition-de-freedom-mobile)
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So to summarize those quotes: the wholesale rates that Quebecor proposed, which were the rates the arbitrators ended up mandating, allows Quebecor to offer 20% lower prices than the rest of the industry, reinvest in its network, absorb deployment costs, react to competitor strategies, and “earn a modest profit margin.” All the while not having to put up more capex upfront, because they can now supplement Freedom’s existing spotty network with Roger’s very good network. If that’s not a cost advantage, I don’t know what is.

And Quebecor’s numbers have backed everything up thus far. Their wireless service margins (including Freedom) stands at ~60%. Their net adds are industry-leading, and their churn is now lower than the incumbents, something that has never happened before. And on the last earnings call, when Quebecor’s CEO was asked how aggressive he’ll be on wireless pricing, he referenced a French provider that offered services for as cheap as 2 euro (2 single euros) a month. This is not a joke.

That’s the buildup. What’s actually happened? A refreshed Freedom hard-launched nationwide in Q4-23. Since that point, industry churn (including Bell’s) is at RECORD highs, up a completely unheard-of 40bps yoy. Freedom’s price point, true to practice, have been 30% below incumbents’ prior price plans on an apples-to-apples basis. Incumbents have had to lower their offering prices to compete. Despite that, Freedom’s net adds led the industry last quarter, showing significant customer traction. Bell’s came in dead last (25k vs. others at 40-60k). And ARPUs at Bell have flipped from slightly positive to negative and worsening. Bell had to change the ARPU commentary on its guidance MD&A last quarter due to this.

Despite this, consensus still has Bell returning to slightly positive ARPU growth in 2025 and is building in a re-acceleration in its wireless business, which I view as completely backward. I believe Bell’s wireless revenues will continue to decelerate and bottom in the ~0-1% range (vs. 3.4% today and street at >3% LT), comprised of -2 to - 1% ARPU declines offset by +2% sub growth.

The justification for my forecast is as follows: in abstract terms, telcos are glacially slow-moving, but it is extremely difficult once they do start heading one direction (in this case, more negatively) to reverse momentum. Against the backdrop of headwinds that are highly unlikely to abate (and likely only worsens as market growth slows and Freedom’s quality improvement and superior value prop becomes more well-understood by customers), I would characterize a re-acceleration as extremely improbable.

In more technical terms: Bell’s biggest issue with its wireless business today is that it now has a book of subscribers on old phone plans that were priced when the industry was a rational 3-player market. These plans are now ~30% more expensive than what those same customers could get on the open market today. As these plans churn out, and the current low-priced plans build into the base, there is a massive negative ARPU impact to Bell. Bell’s single biggest focus has been basically hiding this fact from their customers (and not only that, but also raising prices on those already-elevated plans), but that only worsens the pain to come. Given how relatively slow-moving the replacement cycle of these subs are (only ~15% of subs turn over in a year), I expect this to be a multi-year, but highly significant detractor to ARPU because of just how wide current prices have fallen vs. historic prices.

So that’s this leg of the thesis. We haven’t even talked about the non-wireless business yet, which believe it or not is even worse - but I the explanation there is much shorter.

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2. BELL HAS THE HIGHEST MIX OF SECULARLY DECLINING SEGMENTS
The wireless business discussed above is the biggest (and really only) growth driver at Bell, but it is only ~45% of contribution. The remaining ~60% is comprised of wireline (~45%) and media (<10%), which are even worse businesses.

In wireline, there is zero helpful disclosure. I will caveat by saying these mix estimates are rough, but ones I have confidence in directionally. By a combination of sell-side estimates and past management commentary, roughly 30-40% of the segment is business wireline (LUMN is the closest comp). Business wireline is secularly declining, price-deflationary, highly competitive, and generally just not good. Another ~10% of the business is voice (exclusive of the business wireline estimated mix). Also secularly declining and worsening. From there, another ~10% of the business is satellite video (i.e. a DISH or DirecTV).

The remainder of the business is residential payTV and internet. But fiber internet, the one real growth avenue in this segment, is actually much smaller (est. ~25% of segment revs) than the amount of airtime it gets on Bell’s earnings calls. And I believe growth even in this segment will decelerate as Bell has been slashed new fiber builds / upgrades by over 60% in order to conserve cash flows (which instead go to the dividend).

As a whole, the wireline business has decelerated tremendously driven by secular declines across its exposures which are only expected to worsen. Last quarter, wireline revenues worsened to -1% declines. I think these declines should steepen, but consensus has again modeled a return to growth in the business which we view as highly unlikely based on the mix of Bell’s revenues and end-markets.

Media is small but is facing similar secular challenges - this is a media network/broadcast business, so comparable to FOXA / PARA / NXST in US.

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3. BELL’S FINANCIALS ARE MISUNDERSTOOD AND LEASE PAYMENTS, WHICH IS A THIRD OF FREE CASH FLOW, ARE NOT BEING MODELED

Bell accounts for leases under IFRS. This means that normal-way principal payments for leases are not included in EBITDA, nor company-defined free cash flow. For most IFRS-reporting companies, principal lease payments are a separate line item in that company’s CFS in the financing section, and investors will simply deduct that line from IFRS EBITDA / FCF to get to a true view of that Company’s cash generation.

Bell does not do this. Instead, Bell groups its lease payments under “Repayment of long-term debt”. The only place Bell discloses its lease payments is once a year, deep within its annual report - p. 200 of its 2023 report (202 on the PDF), to be exact. It is a one-line, text disclosure:

“Total cash outflow related to leases was $1,455 million and $1,272 million for the year ended December 31, 2023 and December 31, 2022, respectively.”

Of the $1.46bn in outflows, a little over $1bn was principal payments that were not included in the Company’s free cash flow definition. Importantly, these payments are used for normal-way business uses (land leases, equipment leases, etc.) that would otherwise belong in capex or opex.

So why is this important? Last year in 2023, Bell reported $3.1bn in free cash flow. That free cash flow does not include this $1bn in lease payments. Net of this $1bn payment, Bell’s free cash flow would have only been $2.1bn, against a $3.6bn dividend obligation. That math (i.e. a 170%+ dividend payout ratio) doesn’t work especially as we expect free cash flows to decline in ’24.

To verify this, you can simply look at Bell’s leverage over the past several years. If a company’s true free cash flows roughly matches dividend obligations (with no material M&A and slight EBITDA growth), then leverage levels should remain relatively stable, and perhaps slowly decline driven by EBITDA growth. Instead, leverage, as defined by BCE (which haircuts the pref by 50% for no good reason), has increased from 2.9x in 2020 to 3.2x in 2021 to 3.3x in 2022 to 3.5x in 2023 to 3.6x in Q1-24. True leverage (not haircutting the pref) has increased commensurately and now stands at 3.8x, and this still on IFRS EBITDA. On GAAP EBITDA (i.e. removing the lease payments from EBITDA as is done for US companies), leverage stands at 4.2x. If Bell keeps going at the rate it is at now, leverage will continue to shoot up and equity markets, debt markets, and the ratings agencies will have to take notice.

The only long-term solution in my view for Bell to return to a sustainable capital return program is to cut its dividend, and I believe that will be an extremely big negative catalyst for the stock as the dividend is the #1 reason investors own BCE.

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4. CANADA IMMIGRATION IS PROJECTED TO REVERSE, HURTING MARKET GROWTH

The Bank of Canada and StatCan have both published reports (p.8 of this https://www.bankofcanada.ca/2024/04/mpr-2024-04-10/) expecting Canada’s population growth to decelerate by 2pp in ’25, driven by a reversal of the unprecedented levels of temporary workers that immigrated to Canada in ’21 and ’22. Those 2pp of lower growth should directly impact both the wireless and consumer wireline segments, and likely further worsens the competitive backdrop as there are now fewer new subs to fight for.

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NUMBERS SUMMARY

I think Bell’s revenue growth will decelerate from 2% in ’23 to 0% in ’24 and -2% moving forward, whereas street thinks Bell can still sustain ~1-2% revenue growth.

Similarly on EBITDA, I think Bell’s EBITDA will begin declining by -1% y/y beginning in ’25 vs. street expecting ~2% growth. If my views on the number materialize, I think it would be likely to see a material de-rate of Bell’s multiple down, to a level more fitting for its growth profile and risks (which is how we arrive at our price target).

And finally, people don’t seem to understand that Bell is only able to pay its dividend by raising more and more debt every year (because they don’t realize FCF is overstated by 50%). At some point, that mathematically needs to break (i.e. the dividend needs to be cut) especially if EBITDA inflects negative, which would be the best and most severe catalyst for this thesis.

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RISKS

Quebecor raises prices. Mitigant: unlikely, and in any case will not be enough to change the massive ARPU headwinds that incumbents with overpriced current plans should face

Bell reduces headcount even further. Mitigant: Bell announced a massive round of layoffs that is benefitting current period results, and despite this they are still missing expectations.

Interest rates: if rates fall, that will benefit all telco stocks including Bell

Catalyst

Continued revenue deceleration in wireless
Inflection to negative EBITDA growth beginning in 2025
Dividend cut, driven by unsustainably of current payout (>170% payout ratio on real free cash flow)