Tougher road ahead for telecoms

Telecommunications companies have long been outperformers in Canada, compared to the broader TSX. But, going forward, that sector’s growth is expected to slow.

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So says Craig Jerusalim, portfolio manager at CIBC Asset Management, who adds, “Over the past decade, the telecom sector has [grown] over 150% on a dividend-adjusted basis, versus about 50% for the TSX. In fact, 2016 was only the second year in the past decade where telecom stocks underperformed the broader index on a total return basis.”

Jerusalim, who co-manages the Renaissance Diversified Income Fund, says the main reason telecoms have outperformed is because of the oligopoly that existed in the Canadian marketplace, with BCE, Telus and Rogers dominating. In the U.S., there was a wider mix of strong players and new disrupters over the last decade.

Until recently, adds Jerusalim, the three Canadian giants weren’t “willing to sacrifice profitability for short-term market share gains.” And, when new companies tried to enter the space, they were either acquired or squeezed out, he adds.

“These [Canadian] telecom providers were able to constantly adapt to changing wants and needs, while continuously generating excess free cash, maintaining some of the best networks in the world and consistently grow[ing] dividends,” he notes.

Increasing dividends regularly was a tactic all three of the companies used to grow share price and expand valuation multiples, says Jerusalim, who points out, “Some of the best buying opportunities for the telecom sector occurred when fear and uncertainty were at peak levels — specifically, when Verizon was threatening to enter the Canadian market [and] when regulatory pressures were elevated.”

What to expect in 2017

Today’s market environment is less promising for Canadian telecoms, says Jerusalim. “Valuations are at a richer starting point, interest rates are unlikely to fall further, the wireless and wireline markets are much more mature today, and the wireless sector now has a viable, well-capitalized fourth entrant in all major regions.”

Takeaway: Focus on telecoms that are investing in and building out their networks to meet customer demand.

So, investors looking at telecom companies need to determine which providers can continue to generate excess free cash flow, while also investing in and building out networks to satisfy customer and investor demand, he adds.

Jerusalim identifies these three key themes going forward:

• Coaxial versus copper. Because of their established coaxial networks, traditional cable companies like Rogers, Shaw and Quebecor have an advantage over telecom companies like Bell and Telus, says Jerusalim. This lets them provide high speeds at lower prices, he explains, adding, “[Companies] need to lay fiber directly into a home to compete with the speeds of cable networks, but the cost to do so is about $1,000 per home more than an existing coaxial network—thus lowering ROI.”
• Buildout of digital ecosystems. Companies are already building out their ecosystems. Take Telus, says Jerusalim, which aims to “become the backbone of the healthcare network in Canada [by] connecting doctors, hospitals and pharmacists, and facilitating patient care with electronic medical records.” He’s watching for companies that seek out niche markets.
• Impact of deregulation. If U.S. President Trump’s proposed deregulation policies succeed, says Jerusalim, a similar trend north of the border could occur, in regards to foreign ownership. “That would likely result in some big M&A activity,” he adds. He suggests Rogers could acquire Shaw, and Verizon could snap up Telus. Jerusalim says the result would be “a heightened level of volatility that the sector hasn’t experienced in a very long time.”

What about media innovation?

Media is a shrinking piece of the telecom pie, says portfolio manager Craig Jerusalim of CIBC Asset Management. Still, key content is what drives performance, he adds, noting, “For companies like Rogers and BCE, sports [coverage] is still a sought-after entity. However, it’s hard to compete against some of the really big players like HBO and Netflix” when it comes to television series and movies.

In the years ahead, telecom companies will focus on top-tier content rather than directly compete with these big players, he says. Consider Rogers and Shaw’s pullback on Shomi after the offering failed to gain market share.

Disclosure: Advisor.ca was owned by Rogers Communications until December 1, 2016.