There’s been some commotion and significant price movement in a stock that typically doesn’t experience this kind of volatility: Foundational Stock TELUS (TSE:T).
The main driver of the drawdown in TELUS is due to its recent spinoff and underlying company TELUS International (TSE:TIXT).
These are two heavily featured stocks here, and considering TELUS is arguably one of the most popular stocks in the country, we figured a dedicated newsletter speaking on the two companies was the best route to go. We just needed a week to digest the information.
Along with this, we’ll dig into a small amount of earnings that were reported among stocks featured here this week.
TELUS and TELUS International
In early 2021, TELUS decided to spin off one of its underlying business segments, TELUS International. The company was growing rapidly, and TELUS no doubt wanted to take advantage of a hot market in 2021 and get the company trading publicly on the TSX.
This was not your traditional IPO, like a fresh company coming to market. TELUS International had been around for a long time. In fact, the company is nearly two decades old, with a long history of strong operating results.
As a result, when the company IPOed, it became the largest Canadian tech IPO in history, rising 30% in a single day.
The optimism around this cash flow-positive company being a standalone investment with TELUS, the parent corporation, still holding the majority of voting power, was certainly enticing.
However, the tech drawdown in late 2021 and the bear market of 2022 were not kind to TELUS International, as it would fall from nearly $50 a share to the $13 it sits at right now.
We’ll speak more on TELUS International later. We want to talk about the current headwinds impacting TELUS itself.
A combination of headwinds impacting TELUS
With interest rates rising, there is no doubt that a high debt, high capital expenditure company like TELUS would witness some sort of drawdown in price. However, the drawdown has been amplified as of late due to many factors.
Exposure to TELUS International
TELUS is still the controlling shareholder of TELUS International. The company owns a large chunk of TELUS International (~60%). As a result, a recent reduction in guidance by the company will no doubt impact TELUS’s own results.
Somewhat out of left field, TELUS International sent a press release issuing preliminary results for the second quarter. Considering this company does not typically report prelim results, you can almost guarantee the release will be bad when something like this happens. It’s a bit of damage control that helps reduce any shock when the company files earnings.
Once expected to grow in the 10-14% range in revenue and earnings, the company has guided down to revenue growth of 9%-11%. Now, this doesn’t seem like much of a revision downwards. However, when we remove the contributions from its most recent acquisition WillowTree, that growth shrinks to 1-2%.
In terms of earnings per share, the company guided down from $1.25 per share to $0.97 per share. This is a significant downgrade to earnings and is likely the one that shocked the market the most. Although it still represents strong growth from Fiscal 2022, that large of a downgrade is not something you want to see.
The company’s Q1 2023 report reiterated full-year guidance for double-digit revenue and earnings growth. To issue preliminary results just a few months later, downgrading guidance by large numbers certainly has the market concerned.
As a result, shares took a 30% nosedive on the release day.
Over the last while, TELUS has been actively buying shares of TELUS International. So, the 30% nosedive on issued guidance not only hurt the share purchases of TELUS, but questions started to pop up regarding the company’s ability to allocate capital.
TELUS forced to revise guidance downwards
Because TELUS International makes up a reasonable chunk of TELUS’s EBITDA (about 10%), TELUS was forced to lower their own guidance.
Operating revenue is expected to grow by 9.5%-11% and Adjusted EBITDA by 7%-8%. Previously, the company had guided to 11%-14% revenue growth and 9.5%-11% in adjusted EBITDA growth.
TELUS has historically commanded a growth premium in relation to the other two big telecoms in the industry. It is well known the company targets more aggressive, higher-growth verticals. In contrast, telecoms like Rogers and Bell are more directed towards traditional telecom business operations, like media outlets.
Higher growth verticals often come at higher risk, and when growth guidance takes a hit, the growth premium TELUS has commanded for a long time will no doubt shrink.
We must remember that the core of TELUS’s business is a slow-growing, traditional telecom play. The company depends heavily on its higher-growth subsidiaries to drive earnings and revenue growth.
More on this in a bit, however.
Lead cable controversy
Regardless of whether it is justified, stocks tend to move in groups. Last week, when bombshell news of the U.S. telecom companies having an extensive amount of abandoned lead cables buried in the United States, Canadian telecoms took some collateral damage.
U.S. telecoms like AT&T and Verizon hit 31-year and 13-year lows, respectively.
The potential impact of this from a financial standpoint could be significant, so there is some cause for concern among Canadian telecoms.
However, the Canadian Radio Television and Telecommunications Commission have had regulations regarding the use of lead cables for longer than the United States.
There is no doubt some exposure here, but if we were to guess, it wouldn’t be in the same ballpark as the U.S. telcos.
This is a problematic headwind to provide guidance on, as we attempted to research the area extensively and came up blank.
High interest rates
As a company that needs to invest heavily in new infrastructure to expand, it’s hard to have the cash to do so. For a telecom like TELUS, debt is essential. And in times of rising interest rates, debt is frowned upon.
The current state of the company’s debt structure is strong, however. The average cost of the company’s long-term debt sits at 4.18%, with an average maturity date of 11.8 years. If we rewind back to 2020, the company’s average rate on its long-term debt sat at 3.9%.
So, despite much higher interest rates, the company has only witnessed its long-term cost of debt, on average, increase by 0.28%. This is likely because although debt is much more expensive now, it was able to offset a lot of this by taking advantage of ultra-low rates during the pandemic.
Interest charges are on the rise and will impact earnings moving forward. However, by the numbers, the company is still well within the realm of managing its debt.
What about the dividend?
With all these headwinds, this will often be the first thing most investors ask. TELUS has a nice pipeline of growth incentives that have caused it to put up exceptional returns over the last decade before this most recent drawdown.
However, now that rates are rising and economic growth is slowing, many are wondering about the state of the dividend.
When it comes to a company like TELUS, traditional payout ratios simply won’t do. In fact, these types of payout ratios, particularly the misinterpretation of them, scare people away from companies like TELUS in the first place when there isn’t much to worry about.
We won’t get into it too much in this e-mail. However, significant depreciation and amortization costs on the income statement drive down earnings per share when they don’t cost the company any money during that year.
Don’t get us wrong, depreciation and amortization are expenses. But from a cash flow perspective, they do not impact the company’s ability to pay cash outflows like dividends.
To judge the safety of the dividend, we must look to something like free cash flow, which adds back these non-cash expenses to give us an accurate picture of the company’s ability to pay the dividend.
Before the revision in TELUS’s guidance, the company expected to produce free cash flow of $2B in Fiscal 2023. This would be a 140% increase from Fiscal 2022 and is a prime example of a company like TELUS’s ability to simply dial back capital expenditures when spending may not be wise.
Looking at the company’s expected dividend payouts for Fiscal 2023, we get just shy of $2B.
If we utilize a free cash flow payout ratio to judge the safety of the dividend at this point, we’re getting to the tighter range of things, with the dividend expected to come in at 95% of its free cash flow expectations for 2023.
However, we haven’t yet factored in the reduction in guidance. The company trimmed back revenue and EBITDA guidance by 3-4% each, so it’s safe to say that unless the company initiates some cost savings and reduces capital expenditures even further, free cash flow would fall by this amount, at minimum.
In this situation, the company is spending nearly all its available cash flow toward dividend payments, which isn’t necessarily a healthy business practice over the long term.
However, before we know anything definitively, we would need to see the company report earnings and hopefully provide an update to its Fiscal 2023 guidance regarding free cash flow.
In short, do we think TELUS could cut the dividend? At this point, it’s unlikely.
The one area we could see impacted by the revision in guidance due to TELUS International’s struggles is dividend growth. The company has historically put up the best dividend growth rates out of the Big 3 telecoms.
It could scale back dividend growth quite a ways and still maintain its status as a leader in this area.
TELUS and TELUS International, are they still strong options in our eyes?
A sharp and unpredictable reduction in guidance is going to spook the market. This is evident by the 30% thrashing TELUS International took when it did just that. With a significant ownership stake, there was no question that TELUS would face some drawdowns in price as well.
For the most part, we view both drawdowns as short-sighted and overblown.
One could argue that TELUS International overpaid for WillowTree at a bad time, considering the acquisition was funded mainly with debt. In addition, the softening of demand for its products from tech companies certainly doesn’t help.
However, over the long term, we feel this company can return to double-digit growth and provide strong returns for shareholders. Mat and I are long TELUS International, with zero plans to sell.
As the saying goes, buy when there is blood in the streets. With the company trading at only 10 times its expected revised earnings, we feel it is firmly in value territory now.
When we look to TELUS, there seems to be a perfect cocktail of headwinds impacting the company. However, it’s proven time and time again to be the best Canadian telecom over multiple decades, and we have little doubt that the company will be able to navigate the current environment it is in.
Could we see a slowing of dividend growth? We could. In fact, we’d expect it. However, it still should be able to maintain the fastest level of dividend growth out of the major telcos.
All eyes will be on the company’s next quarterly report. We will be checking in to see if the company decides to scale back capex even further to offset the inevitable decline in cash flow from TELUS International’s struggles or if it will simply go full steam ahead and maintain tight but manageable payout ratios and slash dividend growth.
