The Outlook for Canadian Telecoms

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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Greg Zdzienicki, client portfolio manager of equities, at CIBC Asset Management.  

In terms of Canadian telcos, if we go back over the last couple of years, they’ve generally underperformed the broader benchmark. And I think there’s not just one individual reason for their sort of lackluster performance. I think it’s a matter that they’ve received pressure from a combination of different reasons.  

First of all, rising interest rates. Secondly would be, I think, a worsening regulatory environment, and also increased competition. And to be honest, at the current valuation, the industry is reflecting some, some fairly pessimistic viewpoints, and I think it represents an opportunity to buy some quality dividend paying companies at attractive prices. You know, as we think about sort of the pressure from interest rates. For about 10 years after the global financial crisis, you know, we continued to see record low interest rates, and for teleco companies in particular, this low interest rate environment is especially attractive because of the high and stable dividend yields that the sector provides for investors, as well as the requirement for them to fund very large capital expenditures.  

So, you know, these factors, I think, reached their peak during Covid, when the spread between the 10-year Bank of Canada yield and the teleco dividend hit almost four and a half per cent, was about 4.4 or 5 per cent in 2020. But once the Bank of Canada started raising interest rates, this spread quickly declined, hitting sort of its lowest point of about 1.36%. That’s in June of 2022, which was a low over the last 10 years.  

The spread has improved, you know, so it’s currently at about 3.2%. So, this is sort of at the end of May, approximately. Some other factors have come into play, which have kept the share prices muted in recent quarters, if you will. And, you know, we anticipate that interest rates will continue to be lowered in the second half of 2024, turning what has been a headwind into probably a positive tailwind for them going forward.  

For the past several years leading up into the Covid-19 pandemic, telcos were in a relatively benign regulatory environment, they kept investing in their infrastructure in Canada, they deployed billions of dollars into fibre networks. That was mainly Bell and Telus. And they invested heavily in 5G infrastructure. You know, one of the biggest investments came in the purchase of the 5G spectrum auction in 2021 and that cost the industry a record $8.9 billion. However, we did see a bit of a change in the regulatory environment as the Rogers-Shaw merger dragged on for a couple of years, going through a number of legal battles, with Rogers finally receiving approval for the purchase of them in the first quarter of 2023.  

Now, this approval did come with a number of conditions, and the chief amongst them was the divestment of Freedom Mobile, which was sold to Quebecor. And Quebecor is expanding their footprint across Canada, going from what primarily was a company serving the province of Quebec.  

So, the introduction of a fourth national player would allow the government really to deliver on a promise of reducing wireless pricing in Canada, which was really another factor, I think, for the underperformance of the sector. And more recently, regulators have started turning their eye towards access to fibre networks. Now, we’re still waiting for a decision on rates and the mechanics of who can get access to the network. While we see a free for all access scenario to fibre being highly unlikely, this certainly has put some pressure on the stocks. And you know, in terms of wireless, the three incumbents — Quebecor coming into play now — have shared a very healthy wireless market over the last several years amongst themselves. I know Canada’s population was growing at a record pace, there was record wireless ads with rational competitive action between the three and all of that changed last year when Quebecor entered the market, Freedom Mobile. Then, the wireless market saw monthly plans drop from $60 a month on average plus roaming charges to under $40 a month plans on certain brands. And so, this competitive environment has also spilled into the wireline market where we’re seeing some increased products and new geographies, further increasing some of the competitive intensity.  

The industry has experienced these periods of heightened competition in the past, and over time, market share and pricing trends tend to become a little bit more rational. 

The sector has really gone through a number of changes over the last couple of years. We still remain cautious, but we believe that some factors tend to be priced in to the stocks. You know, the sector is currently trading less than one standard deviation below its 10-year average of 7.2 times versus 7.8 times forward EV to EBITDA, while paying an average yield of 6.7%. The telecommunication sector, I think, remains one of the pillars of Canadian infrastructure with only four major players servicing the entire country.  

We believe in the investment potential of the sector and anticipate a turnaround once some of the uncertainties are laid to rest in the near to medium term. There’s recently also been some speculation on the sustainability of that dividend. And that’s understandable given the lower top line growth expectations for the sector, higher than average leverage and the high interest expense. But, you know, we still believe that companies will continue to service their dividend commitments going forward, with certain companies continuing to even grow their dividends annually.  

In management meetings during Q2, executives had reiterated to us their plans to continue to pay out dividends and reminded investors of their commitment to the dividend. Now, we do see a prolonged payout ratio of above 100% to be unsustainable. We should see the overall sector payout ratios start to come down sometime towards the end of this year.  

And, you know, keep in mind, the sector has a very long history of growing their dividends, and they’re aware of the reliance of the shareholder on these set dividends. Think about a company like Bell Canada, I mean, they’ve been paying a dividend since 1949 and they have not cut their dividend, with the small exception of 2008 when there was a buyout offer for them. So instead of cutting dividends, we believe companies will sooner sell non-core assets and cut costs in order to increase their free cash flow and to reduce their payout ratios. And in fact, you know, we did see June 10, BCE sold Northwestel that serves some of the communities in the Yukon, Northwest Territories, Nunavut, Northern B.C. and Alberta.  

You know, with that transaction, BCE is going to be losing about 31,000 internet subscribers and about eight and a half thousand TV subscribers. Overall, in return, BCE will get a cash injection of about $1 billion. So, this will reduce net debt by about 0.1 times and potentially increase our price target on the stock.  

So, if I take a look at Canadian versus U.S. telecom valuations, the premium valuation of the Canadian telecom group relative to the U.S. peers has really compressed to about the lowest levels we’ve seen over the past 10 years. However, unlike Canada that is experiencing some temporary competitive pressures, the U.S. market is structurally much more competitive given the makeup of the incumbents and the disruptors in the particular space.  

Furthermore, the population growth and the further penetration potential of the Canadian wireless market puts the Canadian group in, I would say, an enviable position relative to the more mature U.S. market and warrants actually a return to the premium multiple.  

As for some more ammunition to alleviate dividend concerns, the Canadian telecom group continues to be rich in hidden assets that can always be monetized if needed, like we saw with Bell Canada, there on June 10. On top of that, many of the incumbents still own prime real estate that can be sold. They also own sports and media assets, as well as some really invaluable communication broadcast towers that trade at multiples far above that of the telco.