Canada’s big 3 telecoms poised for comeback

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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. 

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Craig Jerusalim, senior portfolio manager, Canadian equities at CIBC Asset Management 

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The telecom sector has always held a soft spot in my heart, not because I started out at CIBC as CIBC Asset Management’s telecom analyst — a position I held for well over a decade — or because I actually started out my career working onsite at Rogers Communications, programming their billing software for them. But really, it’s because the telecom sector had a phenomenal track record of consistently outperforming the TSX over the long term. 

From the time I started at CIBC in 2006, the telecom sector outperformed the S&P/TSX 10 out of 13 years, with a cumulative total return exceeding the TSX by over 160% from late 2005 to the end of 2018. 

However, the communications sector in Canada — which is effectively made up of the two big telcos, TELUS and BCE, and the two big cablecos, Rogers and Quebecor — they hit a wall in 2019, and including year-to-date returns, has underperformed the S&P/TSX in six out of the past seven years. 

So what happened? What changed? And what can we learn from the U.S. telecom experience over the past decade to gain insight into the future prospects for the sector? 

For much of those early years, the Canadian telecom space benefited from a very cozy and typical Canadian oligopoly. There was the normal fight for market share, and the goal of being the best operator with the fastest network. But the wireless and internet market was growing quite robustly with enough subscriber gains and ARPU — which is industry jargon for average revenue per user — for all the players to enjoy. As a result, most of the competition was battled in the media and at discrete periods like back to school and Boxing Day, as opposed to for any longer periods of time. 

As a result, Canadian pricing was amongst the highest in the world and garnered the ire of the CRTC regulatory body. 

There was also the scare that Verizon may enter the Canadian market in 2008, but that quickly died down, and the cozy oligopoly continued unabated until regional cable operator Shaw Communications bought Freedom Mobile in 2016. Things really turned more competitive when Rogers bought Shaw and was forced to divest their wireless business to Quebecor, creating a true well-capitalized fourth national wireless player. 

During this time, the regulatory environment took a turn for the worse, as populist governments love to extract value from the much-bemoaned sector. No voter in the history of politics has ever said that they paid too little for their wireless internet or TV packages! 

Additional headwinds of late have been the slowdown in Canada’s population growth from the lack of new immigrants and curbs on foreign students, as well as the use of eSIMs and Canadians’ overall infuriation with the U.S., limiting cross-border U.S. travel. 

There was a contrasting dynamic playing out south of the border over the past decade plus. The U.S. had a highly competitive four-player market through the 2010s, and then, even though it consolidated down to three major players once T-Mobile purchased Sprint in 2020, the U.S. market was left with a major disrupter in T-Mobile. Verizon and AT&T were slow, sleepy, expensive incumbents that T-Mobile targeted via price and a differentiated value-proposition offering. 

In Canada, the situation appears similar, but with some important differences. 

Once Quebecor took control of Freedom Mobile, they were able to and have been driving down prices, given they didn’t have the incumbent base to worry about repricing lower. However, unlike T-Mobile, Quebecor was and is the incumbent operator in the province of Quebec. And, therefore, if they stay too irrational in price in order to win too much market share, then Telus, Rogers and especially BCE can target Quebecor’s whole region of Quebec. 

Even though the sector has lost 40% over the past three years, there seems to be a thawing of the competitive intensity in wireless, which could be positive for all players — effectively seeing a rising tide lift all ships. 

In fact, after many false starts over the past few months, we’ve seen prices lifted and hold about three times, including a $10 increase in the highly important 60-gigabit plus packages. 

We haven’t seen Canadian packages move entirely to unlimited and differentiate themselves on service like the U.S. has, but that’s a future catalyst, given what we’ve seen in the U.S. telecom valuations. 

On the competitive front, we do know the current back-to-school period is always incredibly competitive, and we’d expect targeted campaigns to win new student entrants. But as long as prices revert back to the higher levels after those targeted campaigns, we’ll know that the worst of the industry underperformance is likely behind us. 

Additionally, the sector is lapping some very ugly quarters nine and 12 months ago, so the initial year-over-year improvement should also be cheered by investors. 

The culmination could be that ARPU — that was the average revenue per user — could actually show increases for the first time in two-and-a-half years, a clear directional change in momentum for the downtrodden sector. 

While there are no real prospects for immigration to ramp up any time soon, Canada’s wireless penetration level remains about 25% behind U.S. penetration, leaving ample room for additional subscriber gains. We are even seeing green shoots on the regulatory front. For example, on the fibre-to-the-home file, the government chose not to impose draconian prices on the incumbents to rent out their pipes, but instead settled on a more manageable $70 per megabit that will likely limit significant reselling activity. 

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Each of the incumbents also have individual catalysts, potentially attracting investor interest. 

Rogers is working on uncovering untapped value in a consolidated Maple Leaf Sports and Entertainment property, and certainly isn’t being hurt by the recent success of the Toronto Blue Jays. 

Telus has a payout ratio that has been too high for investor liking. However, they also have the best growth prospects and a capital intensity profile that will result in rapidly increasing excess free cash flows. Telus also just announced an accretive tower monetization with La Caisse that quickly improves their balance sheet, edging them towards three-and-a-half time leverage by the end of the year. They also have an interesting call option on healthcare at some point down the road, and the highest dividend yield of the group that is still growing around 7% per year. 

BCE’s dividend yield is now sustainable after their dividend cut. But they are most likely going to have to invest heavily in their U.S. fibre operations, a strategy that I think will pay off over the long term, but will take a lot of trust and time to play out. 

Valuation-wise, the Canadian telecom sector is trading at a rare discount to their U.S. peers, as the average premium for the Canadian group has been approximately 15% to 20% over the past 20 years when measured on an enterprise-value-to-EBITDA basis, a metric that incorporates both earnings and balance sheet leverage. Today, that premium has completely evaporated and is trading at a discount to the U.S. peers. 

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So, reflecting back over the past two decades of the telecom sector, recall some key, sustainable highlights and some disappointing, self-inflicted low lights. 

While the industry hasn’t done itself any favours with respect to competitive intensity, there is a good possibility that the worst of the sector’s malaise is behind them. As key catalysts kick in and oligopolistic behaviour resumes, free cash flow and dividends that Canadian investors love so much should come back to the forefront, leading to improved performance. 

If the overall equity market does take a turn for the worse and gives back some of the 24% rally we’ve seen since those April lows, then the telecom sector, which is a traditional low-volatility sleepy sector, should outperform on a relative basis as well. So you have a little bit of a defensive angle, as well as a potential catch-up trade if things do normalize like I’m expecting they will. 

But most importantly, I have to reiterate, if you had any billing errors from a Rogers cell phone bill in the years 2000 to 2003, I sincerely apologize and hope that I’ve made some strong, long-term fund outperformance to make up for it.

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