Description

It may be obvious to state that the hunger for yield occasionally drives investors into riskier assets, but a more subtle (and frequent) manifestation of this problem involves the overpaying for assets that are generally attractive, but whose risk/reward profile has recently shifted against investors.  Add to that a pro-competition regulatory environment, a new and well-capitalized competitor, the possibility of a price war, and a dividend at moderate risk and the stage is set for a lot of disappointment if and when something goes wrong.

Such a drama is currently unfolding in Canadian Telecom land, starring Telus Corp.  Recommendation: Short.

Company Background -

Telus is one of Canada's "Big 3" national Telcos (along with Rogers and BCE).  Telus's wireless service comprises 55% of revenues but 66% of EBITDA.  The rest of their business (referred to with the catchall "wireline") comprises traditional landline telephones, broadband internet, Telus TV (an IPTV offering), and Telus Health (an electronic medical and health records service).  All in, Telus serves roughly 12.5B customers.

Recent Industry Dynamics -

Under Harper's Conservative government, Canadian federal regulators adopted pro-Consumer policies designed to increase competition.  One of these policies included the subsidizing of wireless spectrum to smaller players by limiting the ability of the Big 3 to participate in auctions.  And while the government blocked Telus's acqusition of Mobilicity in 2013, it approved Shaw's acquisition of WindMobile earlier this year, establishing a strong "4th player" in Canada's wireless market.  While Harper's Conservative government is no longer in power, investors have been given no reasons to believe the Trudeau government will be any friendlier to the Big 3, though a big test will come later this year when the government has to decide whether to allow the recently announced acquisition of Manitoba Telecom by Telus's competitor, BCE.

Telus particularly vulnerable -

With an unfriendly industry backdrop for the Big 3, why is Telus in particular at risk?  The Shaw / WindMobile deal poses a direct threat to Telus because of Shaw / WindMobile's geographical footprint.  Wind's customers are heavily concentrated in Western Canada (British Columbia, Alberta, Ontario), where Telus has historically dominated.  While Wind's cellular network is not currently an LTE network, a network upgrade is currently underway.  In addition, to help fund the deal, Shaw announced the sale of its media division to Corus Entertainment, a further signal of Shaw's intention to compete directly with Telus.  The presence of a new, motivated competitor in Telus's key markets will likely result in increased downward pressure on subs and ARPU once Shaw has completed its network upgrade to LTE.  The purchase of low-band spectrum in a future auction (600MHz auction likely to take place in 2018) would then complete Shaw's arsenal and enable it to compete effectively with Telus in the West.

Dividend Risk -

While Telus has a track record of consistently raising its dividend, and is therefore held primarily by income-oriented investors, the dividend payout is currently ~120% of LTM FCF.  Note that management's 2016 guidance implies a decline in FCF.  Management does not give explicit FCF guidance, but gives guidance for EBITDA, CAPEX, and cash taxes.   This guidance implies FCF will decline by roughly 20% in 2016, primarily on account of increased capex and cash taxes.

On the Q4 earnings call, Telus's CEO was asked about management's 10% dividend growth guidance and said investors could "take that to the bank."  Only one quarter later, management adjusted this guidance to 7-10% dividend growth.

The essense of the dividend risk at Telus is that management has promised investors dividend growth in the middle of an intensive capex cycle.  Management is open about its intentions to continue to upgrade its LTE wireless network, as well as its fiber-optic network and other broadband infrastructure.  While existing liquidity amply covers near-term dividend requirements, should any of the aforementioned industry dynamics start to affect subs or ARPU growth at Telus, continued FCF declines will force Telus either to borrow more to cover the dividend or cut dividend growth guidance further.  This is all to say nothing of any capital needed to participate in any upcoming spectrum auctions.

Finally, though I am not a macro guy, I'm comfortable making the statement that we are in an interest rate bubble, and when that finally pops and rates rise, defensive yield companies will go out of favor.  For this reason, one can also think of Telus as a way to hedge a rise in interest rates in the interim.

Valuation -

Telus trades basically in line with the other two national Telcos on both and EBITDA basis and a dividend yield basis (~8x 16Y EBITDA, ~4% yield), and it is difficult to argue that one deserves a material premium/discount to the others.  I struggle with the question of what the "right" multiple should be, but the multiple parity today suggests the market is not fully discounting the potential threats to Telus's wireless business over the next 12-24 months.  The contrarian view here is that you are fighting a tidal wave of yield seeking capital globally in a negative/zero interest rate environment.

Summary -

To summarize, Telus is facing increased downward pressure on wireless subs/ARPU on a ccount of a new wireless competitor in Western Canada, a pro-consumer and pro-competition regulatory environment in Canada, and a dividend commitment that is ~120% of LTM FCF amid a large capex cycle and an interest rate bubble, all in an environment in which investors are starved for yield/income.

Risks -

- Long-term pension look through the cycle and won't care about the near-term FCF headwinds and moderate dividend risk

- Will take some time for Shaw to acquire the low-band spectrum that could pose a real threat to Telus

- Interest rates impossible to predict

Disclaimer: The views expressed in this note are only the opinion of the author.  This report is not a recommendation to purchase or sell any securities mentioned.  The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein.  Readers should conduct their own verification of any information or analyses contained in this report.  The author undertakes no obligation to update this report based on any future events or information.  Please do your own work.

Catalyst

- Interest rates rise as inflation picks up

- A wireless price war erupts

- Shaw starts taking share in the West

- Further reductions in dividend growth guidance