Author: Nelson Smith

Emboldened by higher interest rates, high capex expenses, and weak share prices, many critics say Canada’s telecom stocks – and their generous dividends – are at risk. I examine TELUS Corporation (TSX:T:CA) (NYSE:TU) and its succulent 6.9% dividend to see if the payout can weather today’s storm.

Introduction

TELUS Corporation can trace its history way back to 1906. Its predecessor company, Alberta Government Telephones (AGT) was formed after the Alberta government acquired various telephone assets in the province. AGT grew to eventually serve virtually all citizens of Alberta outside of the Edmonton area, where telephone service was provided by an arm of the municipal government.

AGT continued to provide telephone service to Albertans until 1990, when the ruling Progressive Conservative government decided to privatize the government entity. It formed TELUS Corporation as a vehicle to facilitate the transfer. By 1991, the province sold its remaining stake to TELUS, and it was officially a standalone company without any government backing.

TELUS then acquired Edmonton’s telephone operations in 1995, paying $467M for Edmonton Telephones (ED TEL). With this acquisition, TELUS now had a virtual monopoly in telephone operations in the province.

TELUS continued to grow in 1999. Dubbed as a “merger of equals”, TELUS merged with BC Tel in 1999, a privately-held telecom which held a virtual monopoly on the British Columbia market. TELUS moved its headquarters from Edmonton to Burnaby, and BC Tel’s operations were quickly rebranded under the TELUS name.

After a series of smaller acquisitions and billions invested in building a wireless network across Canada, today TELUS is firmly entrenched as one of Canada’s top telecoms. As of December 31st, 2023, it boasted more than 10M mobile phone subscribers, 2.6M internet subscribers, 1.39M television subscribers, as well as robust security, agricultural, health, and technology subsidiaries. Its wireline assets are still clustered in Canada’s two westernmost provinces, but its wireless network spans all the way across Canada.

Unlike its competitors, BCE (BCE) and Rogers Communications (RCI) – which own substantial stakes in media assets like television channels and professional sports franchises – TELUS diversified into other areas that leverage its existing networks.

For instance, TELUS Health is a global health and wellbeing provider dedicated to solving pressing issues facing citizens, healthcare professionals, employers, and employees, around the world. It provides various technological solutions to healthcare providers, including virtual care platforms. TELUS Health generated $1.7B in revenue in 2023.

TELUS also has a robust Agriculture and Consumer Goods division, which is focused on improving food management solutions and outcomes. Products from this division include tools to make farms both more efficient and safer, as well as inventory management software for both food producers and retailers. This part of the company generated $347M in revenue in 2023, which was slightly lower than 2022.

The company also owns a majority stake of TELUS International (TIXT) (TIXT:CA), which was partially spun off in 2021. TELUS International provides digitally-led customer experiences like AI services and content moderation. It has struggled since its IPO and the stock has fallen nearly 80% since its peak in 2022 as growth expectations have slowed.

Put it all together, and TELUS generated $20B in revenues in 2023, an increase of 9.4% compared to 2022. Adjusted EBITDA came in at $7.1B, a 7.6% improvement versus 2022. Higher interest costs hurt the bottom line in 2023, with adjusted earnings falling 20% from $1.18 to $0.95 per share. Free cash flow increased from $1.3B in 2022 to $1.8B in 2023, mostly due to lower capital expenditures.

Latest Developments

After years of solid returns and steadily increasing dividends, TELUS shares have stumbled over the last 52 weeks. The stock is down more than 23% on the Toronto Stock Exchange, falling from a high of more than $28 per share to today’s level of $21.72.

That’s close to a 52-week and a five-year low. The stock hasn’t traded below $20 since the market chaos of March 2020. It traded as high as $34 per share in 2022.

There are a few reasons the stock is struggling so much. The big one is the state of the Canadian wireless industry today. After years of enjoying a comfortable oligarchy, TELUS and its two main competitors BCE and Rogers are facing more serious competition.

It started when Rogers acquired Shaw Communications, which was first announced in 2021. The Canadian government took a hard look at the proposed transaction and approved it – with one important caveat. Shaw owned Freedom Mobile, an upstart wireless provider with some 2M subscribers. Rogers would need to sell Freedom before it could go ahead and acquire the rest of Shaw.

There was really only one serious potential buyer, and that was Quebecor (OTCPK:QBCRF), a regional telecom with assets in Quebec. Quebecor paid $2.85B for Freedom and quickly got to work expanding its new asset the same way it gained market share against the incumbents in its home province – it undercut the competition. This created a price war across Canada as TELUS and its peers largely matched these aggressive prices to minimize the damage.

To demonstrate the impact of this price war, let’s take a closer look at Canadian inflation data. According to a Statistics Canada analysis, the price of wireless service fell by 26.5% year-over-year in February, although some of that decline can be attributed to faster service for the same price as telecoms roll out recently upgraded 5G networks.

Still, that’s not pretty.

Like any telecom, TELUS has to borrow aggressively to fund expensive investments in both its wireless and wireline networks. This leaves it vulnerable to higher interest rates, like we saw in 2023. TELUS spent $1.27B in net interest costs last year, up some 50% compared to the $847M it spent in 2022.

TELUS shares rallied earlier this year as investors expected aggressive rate cuts in 2024. Heavily indebted telecoms like TELUS would especially welcome any help on this front. Unfortunately, sticky inflation data has tempered any rate-cut expectations. According to CME’s FedWatch Tool, the chances of a June rate cut are now just 18.9% in the United States.

Chances are higher in Canada, with the market predicting an 80% chance of a 25 basis point rate cut in June and a 58% chance of an additional 25 basis point rate cut in September. So relief might be coming, but judging by the price action, investors seem skeptical.

Combine higher interest rates and the overall weak telecom market, and it’s not surprising TELUS shares have been weak. In fact, some investors have even taken this a step further and predicted that TELUS will soon be forced to cut its dividend.

Let’s take a closer look at the viability of that dividend, starting with why it could be in danger.

Why TELUS’ dividend could be in danger

TELUS has been aggressively hiking its dividend for years now, maintaining its original target of 7-10% annual dividend growth first announced in 2011. It extended that guidance in 2013, 2016, 2019, and 2022.

Dig a little further, and there’s a problem. TELUS has a history of not earning enough free cash flow to cover that dividend.

For example, in 2021, TELUS earned $777M in free cash flow. That same year it paid just over $1B in dividends.

The story got a little better in 2022, but it still wasn’t great. Free cash flow improved to $1.27B while the company paid $1.18B in dividends. It covered the dividend, but the payout ratio was 95% of free cash flow once we factor in the impact of dividend reinvestment effects. That’s well above the company’s target payout ratio of 60-75% of free cash flow.

Unfortunately, from 2019 to 2022 the company’s payout ratio was only in the desired range once, with a payout ratio in 2020 of 67% of free cash flow.

It’s easy to argue TELUS’ outlook has gotten worse since 2022, too. Interest rates are far higher, which has had a significant impact on profitability. Combine that with a price war in the wireless sector in Canada, and it’s little wonder why investors are bearish.

In addition, TELUS currently has a debt-to-EBITDA ratio of greater than 4x. That’s a lot of debt, especially considering the uncertainty of future rate cuts.

Why TELUS’ dividend not only survive, it’ll grow

Despite what you read above, this analyst isn’t nearly as bearish as the rest of the market. I believe that TELUS has a sustainable dividend that it can grow in 2024 and beyond.

First, 2023 saw the company make substantial progress on its dividend payout ratio. It earned $1.759B in free cash flow, a 38% improvement versus 2022. This improvement was largely driven by an 18.7% decline in capital expenditures.

Most importantly, this improved the payout ratio to 77% of free cash flow. That’s a little above the company’s desired payout range, but not hugely so.

Free cash flow is expected to improve in 2024 as well. TELUS released 2024’s guidance in February, when it reported 2023’s full-year earnings. It told investors to expect $2.3B in free cash flow in 2024, a 30% improvement compared to 2023.

Seeking Alpha doesn’t track analyst estimates for 2025’s free cash flow. However, analysts do expect earnings per share to grow by 16% in 2025 and an additional 15% in 2026. Based on the earnings increase, expected lower interest rates, and continued discipline on the capital expenditure side, and it isn’t hard to envision even higher free cash flow in 2025.

There are a couple of other bullish factors working for TELUS going forward. Firstly, there’s still robust immigration into Canada. The country’s population increased by 1.27M people in 2023, a pretty large number for a nation with just over 40M people. Most of these people will end up getting wireless packages, with many of them choosing TELUS.

I’ll also argue the price war isn’t quite as bad as it appears at first glance. Many wireless customers are happy to pay the same amount each month in exchange for more data or faster download speeds. Since the incumbent telecoms have already invested in their networks, this extra service costs them virtually zero in continued operating costs while keeping a customer away from the competition.

This phenomenon is further proven by TELUS’ average revenue per user (ARPU), which stayed largely unchanged in 2023 despite the price war. APRU was $58.50 in the fourth quarter of 2023, down ever so slightly from $58.69 in the same quarter of 2022.

The bottom line on TELUS’ dividend

I can understand why investors are worried about Canada’s telecoms. There are some significant headwinds impacting the sector.

I recently wrote about BCE’s dividend safety, and it’s much murkier than TELUS’ I ultimately believe BCE will make it through this rough patch with the dividend intact; however, I’m the first to admit naysayers who say the dividend might not survive have a point.

TELUS’ dividend, meanwhile, is in much better shape. Free cash flow is expected to grow by 30% in 2024, hitting $2.3B. Even if we assume a 10% dividend raise, TELUS would still see its payout ratio fall to the 65% range. That’s comfortably in line with the company’s targets.

As I write this, TELUS has a generous 6.9% dividend yield. Combine that with its strong predicted earnings growth, a reasonable valuation of under 14x forward free cash flow, and its position as part of Canada’s dominant telecom oligarchy, and it combines to make an interesting investment opportunity. This analyst is long.