Typically, after earnings season has ended, I release a Value Call.
The Value Call is a company that I feel presents an attractive opportunity from a valuation standpoint for investors to consider adding. These are comprehensive newsletters that dive into the individual company and explain the thesis as to why I believe the company is, at its current point, undervalued.
Before we start, however, I want to make a pretty big announcement.
Our brand-new stock screener is close to completion
A few months ago, I set out to develop an entirely new Stock Screener here at Stocktrades. I aim to provide the most user-friendly, comprehensive screener on the market.
Months of hard work are finally looking like they will pay off, and we should have our new screener live for beta testing by the end of next week, barring any delays.
This screener will highlight over 90 data points on over 5000 equities in North America.
In addition to the data points being available for members, I have created a comprehensive grading system that considers all 90 metrics. Stocks will have particular grades relative to their growth, profitability, dividend, valuation, debt, and more.
I will reach out in a week or two to collect members who’d like to test this screener in beta. But, to say I am excited about what we will bring to the table is an understatement.
Stay tuned!
Our September Value Call – Telus (TSE:T)
I’ll first dig into my central thesis with Telus and then dive into particular details.
Full disclosure also: I plan to aggressively add to my Telus position over the next while here, as I believe shares are discounted at this price. Telus has always remained a relatively low allocation position in my portfolio, primarily because of the stiff competition in the industry today.
Over the next while, my additions will be purely from a valuation basis, understanding that there are plenty of potential continued headwinds. But I believe even with the headwinds today, there is the possibility of multiple expansion from a valuation basis.
If my aggressive buys become profitable, I will likely lower my position to my 2-2.5% target allocation.
My central thesis behind the Telus Value Call
Telecoms have been beaten up over the last few years. While many telecoms feasted on cheap capital for many years post-financial crisis, rapidly rising rates during the inflationary environment we witnessed in 2022 created a gigantic headwind that impacted telecom companies and most high-debt blue-chip Canadian stocks.
That headwind was interest expenses. Below is a chart of Telus’s interest expenses on a quarterly basis. As we can see, expenses have more than doubled since the third quarter of 2022.
Not surprisingly, the third quarter of 2022 was when rates started accelerating at some of the fastest pace in history.
Not only did these interest expenses have a large impact on earnings, but they also reduced the valuation multiple the market was willing to pay for these companies.
The environment is certainly changing at this point, with the Bank of Canada cutting rates by 75 basis points this year and a rumoured 75 basis points more to come by the end of the year.
In a nutshell, my main thesis behind aggressive additions of the company and its place as a Value Call is the fact that declining rates should provide some relief in terms of its floating rate debt, along with the fact its reduction in capital expenditures should result in improved cash flow generation from the company.
But let’s dig into some numbers for Telus overall.
The debt
As mentioned, the main thing holding Telus down at this point in time is elevated debt levels, resulting in higher interest expenses from both the renewal of its fixed-rate debt and its floating-rate debt.
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The company currently carries around $29B in debt on the balance sheet, with a slight reduction on a quarter-over-quarter basis. 13% or around $3.8B of this debt is floating rate, which should be seeing some immediate improvements on an interest expenses basis.
The remaining debt carries an average interest rate of around 4.33%. Over the next year, the company needs to refinance about $4.3B of this debt. It is unclear what rate this debt is at. However, if we go off just the average debt profile of the company at this point in time, it should not be refinanced at much higher rates than are offered right now.
If the Bank of Canada continues to aggressively lower rates, the refinancing could come in at lower amounts. I don’t think by anything material, but it could be lower.
The difficulty from a debt perspective was the debt issuances over the last year or so, which carry rates of nearly 5%. However, this should be offset by lower refinances and, if needed, lower debt issuances over the next year.
The company’s net leverage ratio, which measures the company’s net debt to its EBITDA, sits at 3.85x. Ultimately, we want this ratio lower.
The bad news is that it is above Telus’s historical targets. The good news is that these targets are hard to achieve in our current environment, and the company’s ratio has improved on a QoQ basis.
I do expect this leverage ratio to improve in quarters moving forward.
Free cash flow
Free cash flow is a key metric for telecom companies. Although earnings per share are also helpful, with the amount of depreciation and amortization on the balance sheet for these companies due to their capital-intensive business models, free cash flow is king.
For many years, particularly during the COVID-19 pandemic, companies like Telus were running a free cash flow deficit, meaning their free cash flow didn’t cover their overall dividend payments.
However, because debt was so cheap, this was a necessity. Locking up dirt-cheap debt during the pandemic allows these companies to achieve a higher internal rate of return on their investments. If they can build infrastructure and finance it at a 2% rate (just ballparking numbers), they don’t mind sacrificing short-term free cash flow generation. Ultimately, down the line, those assets they’re financing at those rates will achieve positive returns for them.
Now that rates are higher, we can expect these companies to scale back spending in a big way. Case in point: the company spent $5.2B~ on capital expenditures in 2022 and is guiding towards $2.6B in 2024. I expect this number to come in even lower in their 2025 guidance when they issue it.
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I expect cash flows to improve meaningfully in both 2024 and 2025. The company generated around $1.2B in free cash flow in 2023 and is guiding to around $2.1B in 2024. I would not be surprised if they guide to free cash flows north of $2.5B in 2025.
This will come as a result of declining interest expenses, lower capital expenditures, and growing EBITDA through its higher growth verticals.
The dividend
It wouldn’t be a Canadian telecom stock overview if I didn’t speak on the dividend. For many years, Canadian telecoms were some of the best dividend growth stocks in the country. Growing cash flows due to a low interest rate environment and virtually no competition in the industry allowed them to make consistent raises, all while providing outstanding yields to go along with market-beating returns.
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In the case of Telus, there is zero doubt the dividend is attractive at this point from a yield standpoint. Currently yielding just shy of 7%, this is significantly higher than the company has ever yielded historically.
The yield is high because share prices are in the tank, and the overall safety of the dividends is in question.
Telus pays out around $2.3B annually in terms of dividends, and with expected cash flows to come in around $2.1B, there is zero question that the company does not generate enough money to afford the dividend.
However, the company is not in as tricky of a situation as a company such as BCE, which is still reporting declining free cash flows and a $700M shortfall in dividend payments. So, I do not believe we will be in a situation where we will see a dividend cut.
It should be fairly easy for Telus to come up with the $200M needed in Fiscal 2025 to cover the dividend with the current acceleration in free cash flow generation.
For this reason, I don’t think the company is particularly concerned. If they’re confident in their free cash flow targets in 2025, it is likely they continue raising the dividend at a mid-single-digit pace.
The growth
The key area I’ve spoken about with Telus over the years has been its exposure to higher growth verticals like Telus Health, Agriculture, International, Security, and more.
The key difference between a company like Telus and BCE is that BCE has exposure to numerous assets that used to be highly profitable for the company but are not so much anymore. We’ve witnessed this over the last year or so as the company has been selling off unprofitable legacy assets in one of the largest restructurings in its history.
With Telus, these higher growth verticals, which it bundles up in what it calls its “TTech” segment, are currently driving most of the company’s growth as telecommunications revenue. This allows it to maintain higher margins and offset some of the stagnant growth in the telecom sector resulting from stricter regulations, more competition, and many consumers simply demanding lower prices.
The company is growing its TTech Adjusted EBITDA by around 5%~ annually and should continue to do so in the future.
Make no mistake about it, these telecom companies will not grow fast over the long-term. The main element for growth here will primarily be added cash flows and reduced pressure related to interest expenses. This should drive double-digit earnings growth over the short term.
As you can see by the charts below, the company is expected to post a small single-digit increase to earnings in 2024 before returning to double-digit growth in both 2025 and 2026.
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The valuation
This is arguably the most important segment of the Value Call, as it is one of the main reasons I am aggressively adding to my Telus position today, and that is the valuation.
If the company successfully hits its Fiscal ’24 free cash flow targets, it is trading at 15.7X its expected free cash flow generation.
If we make some simple assumptions that cash flows will improve meaningfully in 2025 based on lower interest rates and a reduction in capital expenditures, $2.5B in FCF is not out of the question. This situation would put the company at a market capitalization of around $39B, representing 16% growth from today’s share prices. This would not include any dividend payments made to investors. Those would be over and above that share price expansion.
However, there is also the chance that the company could see stabilized interest expenses and capital flooding back into these higher-yielding, higher debt-load companies in light of falling interest rates.
In this situation, we could see Telus’s free cash flows expand, as well as the multiple the market is willing to pay for those cash flows.
In this situation, there would be more upside than simply the 16% price increase I mentioned above.
Historically, investors have been willing to pay much higher than 15.75X the company’s free cash flow. Although it is a bit unreasonable to think they would head back to their pre-pandemic price to free cash flow multiples (around 30) just because of the current rate environment, it is certainly not unreasonable to believe that at some point investors will be willing to pay more than 15.75X.
As mentioned, this is one of the main reasons I’m aggressively adding to the company.
The bear side of things
I like to close out every Value Call email with the bearish end of things. Every single investment you make on the markets today comes with risk, and it is not reasonable to believe that 100% of your overall investment theses will come to fruition.
The first would be the fact that there is no guarantee interest rates will continue to come down. The company’s current debt structure requires rates to come down. If they don’t, it is highly likely the company would be in a position where it needed to completely stop dividend growth or, even worse, cut the dividend.
Second would be the strict regulatory requirements being placed on many telecom companies in Canada. These companies got away with a lot for a long time, and they were able to gouge Canadians in terms of mobile and television costs. This simply isn’t the case anymore, and many Canadians are bouncing around from provider to provider to save money. In addition, there are always risks that regulators force these telecom companies to share infrastructure with competition, which would reduce barriers to entry and significantly impact their market share.
Third would be the Canadian telecom company’s reliance on immigration. The Canadian population, primarily due to skyrocketing living costs, is not growing all that fast organically. People simply cannot afford to have many children anymore. For this reason, many of these telecom providers rely a ton on immigration, which is a sensitive subject from a political standpoint.
If regulatory bodies were to change the current immigration situation, it could knee-cap the telecom companies’ main avenue for customer growth, which wouldn’t be good.
All that said, I believe the risk/reward tradeoff is promising right now
I do believe that at some point, we will see money flowing back into telecom companies as the economic environment improves, and many Canadians who were hoarding money in high-interest savings accounts exit those accounts as rates fall.
For this reason, plus all of the reasons I mentioned above, I’m bullish on Telus, which will be one of the main additions to my portfolio on a weekly basis for the short term.
As always, if you have any questions, feel free to utilize the Q&A to ask.
