Delivering on dividends

Most clients know Canada’s telecoms. There’s the monthly billing exercise, of course, but also the marketing blitzes, where the big providers play chicken with monthly plans as they fight for market share.

December 2017 was one such period, and an especially fierce one. When the dust had settled, BCE Inc. had added 175,000 new wireless customers, compared to Telus Corp.’s 121,000 and Rogers Communications Inc.’s 72,000.

But how do these promotional battles affect shareholders? And after the intense consolidation of the past few years (Bell bought Astral, Bell Aliant and Manitoba Telecom; Telus acquired Public Mobile and a chunk of Manitoba’s subscribers in the Bell deal; Rogers bought Mobilicity; and Shaw acquired Wind Mobile, now Freedom), how are the dominant players positioned to compete?

There’s also the question of how to approach dividend stocks like telecoms in this late cycle. As interest rates rise, pushing up bond yields, how should investors view the sector known for its reliable dividends but also for its large capital expenditures?

Current dividend yield:

BCE 5.42%

Telus 4.41%

Rogers 3.13%

Shaw 4.39%

Source: Morningstar, on April 24, 2018

“For each of those companies, it’s a balancing act between pushing subscribers and near-term financials, and there is a discipline currently shared across the industry as the largest players balance dividend growth expectations and deleveraging expectations with financial momentum,” says Rob Goff, managing director and head of research at Echelon Wealth Partners.

We examine this balancing act through Telus’s 2017 Q4 report, with the help of Goff and Guardian Capital’s Michele Robitaille.

Dividends and capital expenditures

Telus is known for its solid dividend growth. In the Feb. 8 release accompanying the quarterly, CEO and president Darren Entwistle boasted that his company had returned $1.1 billion to shareholders in 2017, building on the $15 billion, or $25 per share, returned since 2004.

For Q4, its dividend grew 5.2%, bringing it to 7.1% growth for the year. That’s in line with the 7% to 10% dividend growth target the company is maintaining for 2018.

“Clearly the value returned to shareholders by way of dividend growth and by way of share repurchase is a critical foundation upon which to consider the investment,” Goff says.

Michele Robitaille, managing director at Guardian Capital, looks at operating revenues and expenses, and earnings per share, in relation to dividends.

Consolidated highlights

	Fourth quarters ended Dec. 31			Years ended Dec. 31
	2017	2016	Change	2017	2016	Change
Basic earnings per share (EPS) ($)	0.47	0.14	n/a	2.46	2.06	19.4%
Dividends declared per common share ($)	0.5050	0.48	5.2%	1.97	1.84	7.1%
Free cash flow ($ millions)	274	(191)	n/a	966	141	n/a

“What you want to make sure is that earnings are going up in support of that dividend growth,” she says—in this case, annual EPS gains of 19.4% go along with the 7.1% dividend growth.

The same table also shows improved free cash flow for the quarter and for the year. This is an important number as interest rates rise, says Robitaille, who co-manages two Canadian dividend funds. Telus makes up just over 3% of the asset mix in each.

“We like to see companies that can grow their cash flow and can grow their dividend at a pace that more than offsets the impact of interest rate increases. I would say Telus fits much more cleanly into that camp than other telco[s],” she says.

She points to the manner in which Telus has expanded its free cash flow. While BCE has boosted its dividend yield to 5.4% (compared to Telus’s 4.4%), Robitaille says BCE used acquisitions “to fuel growth in cash flow in order to support its 5% dividend growth target.” BCE’s rate has been “artificially supported,” she says, and without acquisitions she expects it to fall.

Telus had maintained six consecutive years of dividend growth around 10%, Entwistle said in the release. Yet some have criticized the company’s dividend growth target, especially as Telus incurred debt to finance it.

“The knock against Telus over the last couple of years has been that their outsized spending on capex is resulting in a negative free cash flow profile at a time when they’re continuing to grow their dividends,” Robitaille says.

That capex program took several years as Telus built out its fibre network in Western Canada, required for its high-speed internet product. “They front-end loaded their capex at a time of low interest rates and very attractive wireless growth,” Goff says.

It also came during a lull in the competitive environment, Robitaille says, as Shaw was “on its back feet” developing Comcast TV.

Telus stressed in its call with analysts that 2017 marked the peak of its capex program, Goff says, in terms of both absolute dollars and capital intensity (which is capex divided by revenue). Its 2018 financial targets show capex down to $2.85 billion from $3.094 billion in 2017.

The Q4 statement shows the decline had already started, although 2017 saw an overall 4.2% increase in consolidated capex.

Capital expenditure measures

($ millions)	Fourth quarters ended Dec. 31			Years ended Dec. 31
	2017	2016	Change	2017	2016	Change
Capital expenditures (excluding spectrum licences and non-monetary transactions)
Wireless segment	233	249	(6.4)%	978	982	(0.4)%
Wireline segment	506	545	(7.2)%	2,116	1,986	6.5%
Consolidated	739	794	(6.9)%	3,094	2,968	4.2%

“They’re definitely investing in the network,” Robitaille says. “But what you’re seeing in Q4, and even in 2017 over 2016, is that they’re less cash-flow negative. Over time we want to see that trend continuing because, as the capex deployment of fibre slows down, [and] as the pricing becomes less competitive on some of their wireline products, that cash margin should start to grow and you should start to see those numbers normalizing.”

The unaudited Supplemental Investor Information for Q4 shows how high the capex intensity was for wireline, due to the fibre expansion: EBITDA less capex (“essentially your cash flow,” Robitaille says) was in the negatives.

In 2017, Telus invested 35% of its wireline revenues in wireline capex. Goff predicts that number will drop to 30% this year and to 27% by 2020. Now that the “generational upgrade in their infrastructure” is maturing, he says, they’ve turned a corner.

Capital expenditure intensity (Q4 Supplemental Investor Information)

	Quarter 4			Dec. YTD
	2017	2016	Change	2017	2016	Change
Wireless	12%	13%	(1) pts.	13%	14%	(1) pts.
Wireline	33%	36%	(3) pts.	35%	34%	1 pts.
Consolidated	21%	24%	(3) pts.	23%	23%	—

Robitaille also says the company’s debt-to-EBITDA ratio shows it isn’t overleveraged. Telus managed to stay competitive in this measure during several years of high capex, she says, and she projects the ratio to decline further in 2018.

New customers versus old customers

On the wireless side, Goff looks at the balance between financial growth and subscriber growth. “Financial results are a near-term benchmark while subscriber growth foretells longer-term prospects,” he says.

Telus’s network revenue increased 5.4% in Q4 ( 6.5% for the year), while it added 121,000 post-paid subscribers (up 39.1% over Q4 2016), thanks largely to the holiday promotional frenzy in December 2017.

Wireless operating indicators

	Fourth quarters ended Dec. 31			Years ended Dec. 31
	2017	2016	Change	2017	2016	Change
Subscriber net additions (000s)
Postpaid	121	87	39.1%	379	243	56.0%
Blended ARPU, per month ($)	67.27	66.24	1.6%	67.05	65.10	3.0%
Churn, per month (%)
Postpaid	0.99	0.98	0.01 pts.	0.90	0.95	(0.05) pts.
Operating revenues—wireless segment
Network revenue	1,772	1,681	5.4%	6,964	6,541	6.5%

For Robitaille, the wireless business requires a balance between three key numbers: subscriber net additions, blended ARPU (average revenue per user) and churn. After a promotional season like December’s, this balance can be skewed toward subscriber additions at the expense of ARPU.

“What you want to make sure is that you’re not adding subscribers by being overly aggressive on price and therefore compromising the long-term value,” Robitaille says. “You want to make sure that there’s a decent balance.”

Telus pulled this off, increasing blended ARPU by 1.6% in the quarter while adding subscribers. ARPU growth for the year was 3%.

Churn, the customer turnover rate, is equally important. Telus is the industry leader at 0.90 for 2017, which makes adding subscribers less important: with promotions and subsidies, adding customers typically costs more than maintaining current ones.

Customer appetite for data continues to grow, raising ARPU as well as the number of devices on the market, Goff says. “We’re all moving to bigger and bigger buckets. If you give us 2-3% ARPU growth supported by the increased video consumption, I think the consumer will see the value gains, and I think that you’ll see device penetration exceed expectations.”

That’s why wireless is where companies are turning for growth. Among the big three, Telus and Rogers are best positioned with roughly two-thirds of their business on the wireless side, he says; for Bell, that ratio is reversed.

Playing defence with fibre

On the wireline side, the balance is between the broadband product and the declining TV offering, (though this distinction is not completely black and white for Telus, whose IPTV product is a hybrid that requires the internet to view TV services.) While subscriber additions for both declined in Q4, high-speed internet additions were up 19.1% for the year, while TV was down 35.2%.

That TV drop isn’t as alarming as it looks, Robitaille says. While Telus was “initially quite aggressive” in rolling out its ITV product, there’s been “a rebalancing of the market” now that Shaw has introduced its Comcast product.

Wireline operating indicators

	Fourth quarters ended Dec. 31			Years ended Dec. 31
	2017	2016	Change	2017	2016	Change
Subscriber connection net additions (losses):
High-speed internet	21	24	(12.5)%	81	68	19.1%
TV	14	16	(12.5)%	35	54	(35.2)%
Operating revenues —Wireline segment
Wireline operating revenues	1,546	1,515	2.0%	5,975	5,878	1.7%

“That’s why you’re seeing those net addition numbers come down,” she says. “That’s a positive because, frankly, it means there’s more of a rational focus on bottom-line profitability as opposed to growing market share.”

The more profitable high-speed internet connections are continuing to grow, which is the payoff from all the capital expenditures on the fibre network, she says. As the TV product declines, with competition from Netflix and similar services leading to cord-cutting, all the major companies are focusing on growing their internet businesses. For Telus, the growth “more than offsets the general decline you see in television,” she says.

The wireline business has less cyclical volatility than the wireless side, Goff says, and 2% growth on wireline would provide a stable base for the higher growth on wireless.

Summary

Telecom stocks are known as a reliable, defensive play, especially for retirees looking for a stable dividend payout. Rising interest rates put some pressure on that position.

At this stage in the cycle, Robitaille says it’s still early to be adding to telecoms and other interest-rate sensitive sectors to portfolios.

“Right now I think that sort of anti-interest rate trade is probably still paramount over the defensive trade,” she says. “With continued volatility and concerns over a U.S.-China trade war, this shift is looking closer and closer.”

Most of the economic and earnings data are still positive, she says, leaving “a bit more room for this market to run.” One caveat is a trade war, Robitaille says, which “could derail the global and U.S. expansion and create significant uncertainty in the market.”

She will be looking to move more defensively this year, though. While the increase in market volatility moves that shift forward, she says, “it will still be a gradual shift.”

Goff and Robitaille still like Telus. With the peak capex spending on fibre “maturing,” the company won’t be as affected by rising rates and will have the cash flow to continue to fund its dividend growth.

Goff says he differentiates more and more on longer-term growth prospects, “which are the greater determinant in shareholder returns. Telus offering higher growth and a lower dividend would see less of a negative headwind from rising rates than would BCE shares,” he says.

Robitaille also like Telus’s asset mix compared to its competitors’, with wireless making up two-thirds of the business and positioning it for greater long-term growth. BCE is at a disadvantage because of its higher percentage of wireline assets, she says, while Rogers isn’t promising the same dividend growth, instead keeping its powder dry for more capital expenditures.

“If Telus can continue to grow their dividend at 7% to 10%, it really helps to offset the increases in interest rates that we’re seeing,” she says.