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Sector Scan: Hold the phone! Why cord-cutting won’t kill the telcos

Posted Sep 29, 2017, 10:56 AM | By Edward Golding

Every month, we examine one stock market sector’s role in the economy and how investors can benefit from it. This month, MD Portfolio Manager, Edward Golding takes a closer look at telcos, where profit is driven by wireless and internet growth. Here’s why no investor should cut the cord on this sector.        

I got hooked on a Blackberry device about a decade ago when I worked as an analyst covering the telecom sector for a Bay Street brokerage firm. At the time, in 2006, about 19 million Canadians subscribed to a wireless phone service.

Today, here at MD, my always-on accessory is an iPhone. And the number of wireless subscribers in Canada now exceeds 30 million.

As wireless usage has skyrocketed, Canadians have steadily abandoned their landlines. Ten years ago, 94% of Canadian households had a landline. Today it’s just over 75% and falling, according to the Canadian Wireless Telecommunications Association (CWTA). The same trend is beginning for cable, with an estimated 247,000 households cancelling TV subscriptions this year1, as we flock to services such as Netflix, Amazon Prime or DAZN, to name a few.

So, in this disrupted landscape, why do we still invest in telcos?

Their growth is going mobile

Even as we’ve been cutting the cords, the skyrocketing growth of wireless and internet data usage has led to outsized performance of the telecom sector over the past five years. This growth has more than offset the decline of telephony as well as subscriber losses reported in TV distribution by traditional cable and satellite providers.

The sector continues to generate strong profitability, with close to 40% margins2, and delivered a five year annualized return of 12.5%—outperforming the broad S&P/TSX Composite by over 4.3% as of the end of August.3

Even with these exceptional returns, the valuations of the sector remain very reasonable at about 17 times expected 2018 earnings—a slight premium above the benchmark, given the performance.

All telcos are not alike: how we look at industry metrics

The Big Three names in Canada’s telecom industry are Rogers, TELUS and Bell—Rogers is the largest in wireless business, with approximately 10.4 million subscribers at the end of the second quarter of 2017.  Next up are Quebecor, Shaw and SaskTel, rounding out the top facilities-based service providers, meaning they own and operate the transmission equipment required to provide telecommunication services. The vast majority of alternative providers are resellers, who acquire services from these incumbents on a wholesale basis.

When analysts assess a telecom company, one key metric is Average Revenue Per User—how much individual customers spend—which tells which products or services generate the most revenue.

A second metric followed closely is churn: the percentage of people who discontinue subscriptions in a given time period—It’s good for a company to gain customers faster than it loses them. In addition, Cost per Gross Addition measures the cost of acquiring one new customer to a business; many wireless providers subsidize the purchase of the hardware (such as an iPhone) to lock customers into long-term contracts. 

Compared to other sectors, capital expenditures by telecom companies are high. The industry is expected to incur costs north of $12 billion in 2018 as industry players need to maintain and develop wireline and wireless infrastructure as well as acquire licenses for spectrum positions—the right to use airwaves to carry signals to and from customers.

This heavy investment takes its toll on free cash flow, which is the primary source in determining the valuation of a company.

We seek dividends over the long-term

Thanks to that monthly internet or cable bill, one trait of the telco sector is an ability to pay healthy dividends, with the industry average yield above 4%.

From that perspective, our MD Dividend Growth Fund and MDPIM Dividend Pool continue to be overweight in the sector due to the yields it can provide.

Our sub-advisor Montrusco Bolton applies a process that seeks stocks with elevated dividend yield and low risk relative to the broader market. As such, it favours telco operators that have relatively higher exposure to wireless and internet, and that carry less exposure to TV distribution and media, such as publishing and radio stations.

“Looking at the Big Three, we believe that TELUS has the most favourable asset mix,” say our Montrusco Bolton analysts.

“It generates ~65% of earnings EBITDA (earnings before interest, tax, depreciation and amortization) from wireless which is in line with Rogers but well ahead of BCE’s ~36%. With respect to internet, the contributions aren’t typically disclosed but we estimate the mix is similar across the Big Three at 9–11% of revenue. Turning to TV Distribution, it accounts for about 6% of TELUS revenue compared to 12% for BCE and 11% for Rogers. Finally, TELUS doesn’t have any exposure to legacy media assets.”

More importantly, our analysts say, aggressive investments in its fibre-to-the-home footprint positions TELUS well to capitalize on the next generation of wireless technology.

Hand me my tricorder, will you?

Ten years from now, my super smart iPhone might well seem like a quaint relic—who remembers the RIM Pager, circa 1999?

By then, it’s more than likely we will be in a world connected by the so-called Internet of Things (IoT), relying on a data network to increasingly regulate my home and appliances, connect my car to traffic management systems, or even monitor my vital stats to alert my physician if something goes awry.

We expect the telecom industry to play a vital role in shaping our lives in the future and see continued growth from wireless and internet services over the medium-term and playing a contributing role to strong future returns in MD portfolios.

About Edward Golding

Edward Golding, CFA, MBA, is a Portfolio Manager with the Investment Management team at MD Financial Management. He oversees the Canadian, Dividend and U.S. equity mutual funds and investment pools at the firm.