Telus (TU): One of the Safest and Fastest-Growing Dividends in Telecom

Telus (TU) is one of the telecom companies on our list of the best high dividend stocks with safe, growing payouts.

 

Telecommunication companies have long been a favorite of high-yield income investors thanks to their utility-like recurring cash flows, which typically allow for generous and secure dividends.

 

While blue chips AT&T (T) and Verizon (VZ) are the best known U.S. telecoms, there are some high-quality telecom names north of the border as well.

 

Let’s take a look at Telus, a Canadian blue chip telecom, to see if it appears to be an attractive income stock for our Conservative Retirees dividend portfolio.

 

Business Overview

Founded in 1993 in Vancouver, Canada, Telus is one of Canada’s big telecom providers with rough one-third of the national wireless market and over 40% of the internet market. The company is especially dominant in Western Canada where it serves a total of 12.7 million customers.

 

Telus primarily operates in four businesses:

 

Wireless: 8.6 million customers

Internet: 1.7 million customers

Residential Access Lines: 1.4 million customers (traditional phones)

Cable TV: 1 million customers

 

Telus reports the internet, phone, and cable TV businesses as part of its wireline (physical connection) business segment.

 

The company also operates data centers which offer cloud computing solutions (wireline data), as well a pharmacy, medical records, and medical claims management under its subsidiary Telus Health, which is also listed as part of the wireline segment.

 

 

 

As you can see, Telus’ wireless business is by far the most important in terms of revenue and EBITDA.

 

Meanwhile the company’s internet and cable TV businesses are the fastest-growing units, while its legacy phone business is in secular decline – a trend that most telecoms around the globe are dealing with.

 

Business Analysis

At first glance, Telus’ recent top and bottom line growth appears potentially troubling. However, that’s largely due to currency fluctuations between the U.S. and Canadian dollar.

 

 

Also note that the apparent sharp decline in free cash flow (FCF) per share is largely due to Telus’ recent aggressive investment phase, which saw capital expenditures (i.e. investments in their networks) grow from 1.8 billion CAD in 2007 to an all-time high of 4.6 billion CAD in 2015, according to Morningstar.

 

Metric	2007	2016	CAGR
Revenue	9.074 billion CAD	12.799 billion CAD	3.9%
EPS	1.88 CAD	2.06 CAD	1.0%
FCF per Share	2.10 CAD	0.54 CAD	-14.0%

Source: Morningstar

 

In addition, Telus has been undergoing a long-term corporate restructuring as it pivots away from its legacy phone business and towards faster-growing and more profitable wireless, internet, and pay TV businesses.

 

Telus became Canada’s largest wireless company in 2000 when it agreed to acquire Clearnet Communications for $6.6 billion. The deal transformed Telus from a regional phone company to a blossoming national wireless company while also broadening the range of bundled services it could offer.

 

In other words, acquiring Clearnet positioned Telus to go head-to-head with major rivals Bell Communications and Rogers Communications. The company’s efforts to build out its mobile-phone presence across Canada in the years following the deal have been very successful.

 

This ongoing strategic shift away from traditional phones resulted in ongoing restructuring costs (e.g. $305 million in Q4 2016) that suppress earnings and explain the company’s rather weak EPS growth over the past decade.

 

Factoring out the restructuring costs (assuming they really are transitory in nature) would have resulted in an 18% EPS boost in 2016 to 2.44 CAD and increased the company’s long-term EPS growth rate to 3.0% per year.

 

However, management’s 2017 guidance indicates that this era of mega-spending is likely over, with capital expenditures set to stabilize at a far lower 2.9 billion CAD. In other words, future FCF should grow nicely.

 

The same is true for EPS, which is expected to grow between 2% and 8% this year as the company’s recent restructuring and investments into growth markets such as internet and cable TV finally start bearing fruit.

 

 

In fact, management is confident that its long-term EPS payout target of 65% to 75% will allow it to grow the dividend by 7% to 10% through 2019.

 

Meanwhile Telus’ overall profitability and returns on capital have been far less volatile, which makes sense given the stable nature of its business and its growing economies of scale.

 

 

In fact, Telus already boasts above-average profitability compared to its industry peers. And those results are likely to grow nicely in the coming years as it ramps down its capex spending.

 

Company	Operating Margin	Net Margin	Return On Assets	Return On Equity
Telus	17.1%	9.6%	4.5%	15.7%
Industry Average	13.8%	6.8%	3.2%	11.2%

Source: Morningstar

 

Importantly, Telus’ investments into its wireless network have allowed it to consistently win market share and generate steady subscriber growth (and moderately increase prices) in its most profitable segment.

 

 

The high-quality of its network also gives the company strong enough pricing power to steadily increase average revenue per user (3.9% in 2016) while maintaining a very low and steady churn rate (the best customer retention of any Canadian telecom).

 

In fact, at 5,300 Canadian dollars in lifetime customer revenue, Telus has the best long-term client relationships of any telecom in Canada. That’s thanks in part to its ability to upsell wireless customers to longer, two-year plans at higher rates, driving up average revenue per user and generating more predictable cash flows with which to payout dividends.

 

Key Risks

There are two main risks that .U.S investors in Telus need to know about.

 

On a fundamental level, Telus faces two major challenges in the coming years. First, it operates in a heavily regulated industry, under the close watch of the Canadian Radio-Television and Telecommunications Commission, or CRTC.

 

In recent years, the CRTC has expressed concern that the three dominant telecoms controlling over 90% of the wireless market were threatening competition. As a result, the commission has been cracking down on what it considers oligopolistic practices.

 

This includes the 2015 CRTC ruling that capped wireless contracts at two years. In addition the commission required that Telus, as well as its two major rivals Bell Communications and Rogers Communications (RCI), offer smaller rivals deeply discounted access to their networks in order to allow cheaper roaming charges.

 

A major new entrant could also disrupt the Canadian telecom industry’s favorable structure. In 2012, for example, the industry grew fearful that Verizon was planning to buy wireless company Wind Mobile in an effort to enter Canada and challenge the three major incumbents. Valuation multiples quickly dropped between 7% and 27% for Telus, Bell Communications, and Rogers.

 

While the potential threat from Verizon never materialized, cable operator Shaw Communications (SJR) ended up acquiring spectrum-rich Wind Mobile for $1.6 billion in March 2016, marking its entry into the wireless market in an effort to better compete with Telus’ bundled services (Shaw can now offer television, wireless, and internet in major urban areas such as Ontario, Alberta, and British Columbia).

 

Here’s what Shaw CEO Brad Shaw said in an interview, according to TheTelecomBlog.com:

 

“Wireless was a missing piece. Now we’re on the same page, we’re at the same level … and we’ve improved our competitive position in Western Canada just by doing this deal, let alone the opportunity in the East.”

 

Shaw rebranded the wireless business Freedom Mobile and is positioning it as a lower-priced option compared to the major three operators (driven by its inferior service quality). Freedom Mobile secured the necessary financing to build out its own LTE network by 2017 and is now the fourth telecom company to cover the entire length of Canada.

 

Should Freedom Mobile improve its network coverage and quality enough to experience strong growth, the big three incumbents could face subscriber growth pressure and margin compression over the coming years.

 

Freedom Mobile ended 2016 with 1.05 million total wireless subscribers, meaningfully trailing Bell (8.5 million), Rogers (10.3 million), and Telus (8.6 million). However, the company reported net additions of 112,758 subscribers for the full year (Telus added 173,000 for comparison’s sake) and is motivated to continue increasing its market share.

 

It will be interesting to see if Telus’ superior network quality and customer service will allow it to continue enjoying its industry-leading churn rate and average revenue per user, or if it will ultimately face the greatest pressure to lower prices in an effort to close the gap with lower-priced competition.

 

Here is what management said on the company’s fourth-quarter earnings call:

 

“Customer loyalty remains the best in our industry where we achieved a churn rate of 0.98%, a meaningful 37 and 47 basis points better than our two national peers. Impressively, Telus has now delivered a postpaid churn rate below 1% for three consecutive years. With strong [average revenue per user] and a low churn rate, Telus also continues to deliver the best lifetime revenue per subscriber at 5,300 Canadian dollars, a significant 27% and 36% higher than our two closest competitors.”

 

At the end of the day, I would be surprised if industry pricing is hurt anytime soon by Shaw’s entry. Freedom Mobile largely has outdated technology, which will cost hundreds of millions of dollars to upgrade, and these significant investments likely mean it will need to charge higher prices to pay for its upgrades rather than dramatically undercut its rivals’ prices.

 

While Telus has been able to steadily grow its wireless business in recent years, there is also risk that the saturated nature of the Canadian wireless market continues to result in slower wireless subscriber growth over time. You can see that the country’s smartphone market penetration rate is third highest in the world and even exceeds America’s rate, for example.

 

 

As a result, most of Telus’ subscriber growth is coming from its internet and cable TV businesses. However, the growth rate of these businesses could slow substantially in the future for two reasons.

 

 

First, the Canadian market is of limited size and is pretty much fully mature. Second, Telus’ internet business is part of a regional duopoly in western Canada, competing with Shaw Communications (SJR). The problem for Telus is that Shaw’s cable network is superior to Telus’, especially when it comes to maintenance costs.

 

In other words, it will be far harder to continue winning market share and growing its wireline subscriber base because Telus needs to recoup the large amount it’s spent to build out its fiber optic and cable networks. Getting into a price war to win new customers is something that Telus might not be able to do.

 

Additionally, Telus’ legacy landline phone business has served a major drag on its overall wireline growth. The company’s total residential network access lines (i.e. traditional phones) declined 6.3% in the fourth quarter of 2016, for example, but still account for one-third of Telus’ total wireline subscriber base. As a result, the company’s overall wireline subscriber base grew by just 1.2%.

 

In other words, Telus’ subscriber growth, which drives its revenue and cash flow generation, is likely to remain somewhat constrained in the coming years. That will make cost cutting and margin optimization the primary way management can potentially live up to its goal of around 8.5% annual dividend growth over the next three years.

 

However, that may not be easy as the world gets ready to transition to 5G wireless. This revolutionary and potentially disruptive next gen wireless network will be needed to usher the world into a future filled with smart devices (e.g. the internet of things), as well as autonomous cars.

 

Implementing 5G technology could also cost tens of billions in new capital spending and expensive spectrum auctions that could limit Telus’ dividend growth beyond 2019.

 

Finally, for U.S. investors there are two additional items to consider before investing in Telus.

 

First, as a Canadian company, the stock has a 15% withholding tax on the dividend, which means the effective yield is closer to 3.7% instead of 4.3%. Tax treaties between the U.S. and Canada allow you to potentially recoup this withholding, but it can be a complicated and lengthy amount of paperwork at tax time.

 

Finally, remember that Telus pays all its dividends in Canadian dollars, which means that the amount of money that will actually appear in your bank account can be far more volatile than the company’s steadily-growing dividend would indicate depending on what the USD-CAD currency exchange rate is at the time.

 

While Telus has raised its dividend every year since 2004 in Canadian dollars, you can see that the dividends declared in U.S. dollars have been less predictable and even declined in 2015.

 

 

If the U.S dollar strengthens relative to the Canadian dollar, such as is likely to happen as US interest rates rise, then the effective yield on Telus shares owned by American investors could decline even further.

 

Telus’ Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Telus has a Dividend Safety Score of 85, indicating that its dividend is very secure and dependable.

 

That should come as no surprise given that Telus was able to grow its payout even during the financial crisis, courtesy of its very stable revenue and earnings (most consumers and businesses need telecom services even when economic times are tough).

 

The predictability of Telus’ business has allowed the company to safely maintain an EPS payout ratio between 55% and 75% every year since the financial crisis. Management targets at payout ratio between 65% and 75%, so this isn’t necessarily a surprise.

 

The company’s high Dividend Safety Score is also driven by the strength of Telus’ balance sheet. While the large absolute amount of debt, low current ratio, and apparently steep leverage ratio may appear troubling at first, it’s important to keep things in perspective.

 

 

For example, in a capital-intensive industry such as telecom, high debt levels are to be expected. While it’s true that Telus has above average debt metrics, management expects leverage to decrease in the coming years as its long-term investments pay off and increase profitability.

 

Specifically, Telus expects its Debt / EBITDA ratio will be at 2.5 or below by 2018, even with the planned 7% to 10% dividend growth.

 

Company	Debt / EBITDA	Debt / Capital	Current Ratio	S&P Credit Rating
Telus	3.06	55%	0.50	BBB+
Industry Average	2.36	44%	0.78	NA

Sources: Morningstar, Fastgraphs

 

Given Telus’ growing base of largely recurring cash flows and its investment-grade credit rating, the company is able to not only easily service its existing debts and short-term obligations, but also continue to access very cheap debt, such as 10-year unsecured U.S. bonds at just 2.8% interest and 30-year bonds paying just a 4.4% interest rate.

 

In other words, Telus’ balance sheet remains stable enough to allow for a generous, secure, and growing dividend while still investing in its core business.

 

Telus’ Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Telus’ Dividend Growth Score is 52, which suggests the company’s dividend growth potential is about average (i.e. mid-single-digit growth).

 

Telus has grown its dividend every year since 2004 in Canadian dollars, and its U.S. dividend has increased by 4.8% annually over the past five years.

 

 

Looking ahead, despite management’s optimistic dividend growth guidance of 7% to 10% per year through 2019, Telus’ dividend payout ratio has grown large enough (70% over the last year) that management can’t count on payout ratio expansion to grow the dividend faster than earnings, as they have in the past.

 

However, due to more conservative future investments in wireline, specifically fiber optics, analysts believe Telus should be able to gradually improve its margins over time.

 

Combined with steady revenue growth of about 3% per year, as well as ongoing share buybacks of 1% to 2%, it seems reasonable to believe that Telus can achieve annual earnings growth around 6% to 8% over the medium term.

 

While dividend growth will certainly slow from the relatively blistering (for a telecom) pace of 10.2% per year over the last decade, investors can still reasonably expect at least mid-single-digit payout growth from Telus.

 

Valuation

TU shares trade at a forward P/E multiple of 16.4, a premium to the telecom sector’s forward P/E multiple of 12.9, and offer a dividend yield of 4.3%, which is somewhat higher than the stock’s long-term historical yield of 3.9%.

 

Assuming the company is able to deliver annual earnings growth between 6% and 8% over the coming years, TU’s stock appears to offer annual total return potential of 10% to 12% (4.3% dividend yield plus 6% to 8% earnings growth).

 

Telus’ stock doesn’t look like a bargain today, but it doesn’t seem excessively priced either. Assuming the Canadian telecom industry’s oligopolistic structure remains steady, the company’s stock appears to be a reasonably priced, low-risk, high-yield dividend growth investment.

 

Concluding Thoughts on Telus

Low-risk telecom stocks, especially those with far better yields than the broader market, are understandably a favorite of many income investors, especially ones who rely on dependable dividends to fund retirement.

 

On that front, Telus appears to be a reasonable long-term core holding for most income growth portfolios. That’s especially true compared to slower-growing U.S. rivals AT&T and Verizon, which seem likely to generate far slower income growth in the coming years.

 

The main risk to watch is how the Canadian telecom industry evolves over the coming years. The rise of Shaw’s wireless business could cause some disruption, which could hinder Telus’ premium valuation multiple and long-term earnings power.