Maher Yaghi, telecom, media and technology analyst at Desjardins Securities, recently spoke with The Globe and Mail about three stocks he believes will deliver solid returns to investors.
Before we discuss your stock selections, is there an investment strategy that you believe will result in strong stock selection?
All three companies that we will be discussing are expected to show accelerating free cash flow growth for different reasons but all three are picks that I thought would be good stocks to own going forward as their free cash flow profiles are going to materially improve over the next 12 months.
All three companies that we are discussing today are positioned to show improved year-on-year free cash flow growth. For Telus, it's going to be driven by lower capex [capital expenditure] spending. For CGI, it's going to be driven by margin expansion and for Stingray it's going to be driven by revenue growth and acquisition. All three companies are going to show a nice improvement in free cash flow in 2018.
Let's delve into your first stock recommendation, Telus Corp.
Inside the telco sector in Canada, Telus is expected to show the highest free cash flow growth year-over-year in 2018, 2019 and 2020 and that is going to be driven by EBITDA (earnings before interest, taxes, depreciation and amortization) growth and lower capex. It's going to allow them to grow their dividend faster than most other large cap companies in the telcom sector (management targets annual dividend growth of 7 per cent to 10 per cent).
Telus being a high dividend paying stock is it vulnerable to a rising interest rate environment?
The correlation between the dividend yield of the telecom sector and the 10-year bond rate in Canada is about 70 per cent over the last five years. So increasing interest rates would have an upward bias on yield, which inversely impacts the stock price but because Telus has one of the highest dividend growth rates in the sector, it should be much more protected than other companies.
You have a 'buy' recommendation on the stock and a $49.50 target price. What are the key reasons for your recommendation ?
The No. 1 reason is EBITDA growth. The company has invested significantly in improving their network's technological performance and that is going to drive much better retention and growth in subscribers both on wireless and wireline. The No. 2 reason is free cash flow improvement due to the peak in capex intensity taking place in 2017. The company has been on a very high capital spending mode over the past four years, this is likely to have peaked in 2017. We still expect capex spending to be high but the trend is for it to be declining so that declining capex trajectory is going to amplify the EBITDA growth that the company sees on the free cash flow line. The third reason is when it comes to positioning the company for the long-term, their investment in fibre-to-the-home is going to not only help them increase revenue per customer and gain market share on wireline, it's going to position the company to be a leader, yet again, in wireless. Their investment in wireline, in fibre-to-the-home right now is going position them very favourably to have a very fast network in the future on wireless. It will help them achieve very high wireless data speeds for these data-demanding customers. One of the reasons I like Telus as well is their very high exposure to wireless, close to 65 per cent of earnings is coming from wireless, where all of the growth right now is going in terms of consumer spending and they have the lowest exposure among all the companies in Canada to TV revenues, which is seeing continued pressure as customers move from the traditional TV environment to over-the-top entertainment content like Netflix and the like. So this combination of being positioned in the fastest growing sector and having the least exposure to ... a declining segment like TV should help the product mix of the company outperform other companies.
You have a target price of $49.50 implying modest upside potential, is that a conservative estimate? How did you arrive at it?
Our target price is very conservative. We tend to base our target price on a combination of two methods: a DCF (a discounted cash flow analysis) and an EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation and amortization) valuation, so a NAV (net asset value) valuation. We apply an eight times multiple on EBITDA for the NAV valuation and DCF is driven by the cost of equity and the cost of debt that the company has for its current funding needs right now.
When we look at Telus, we are looking forward one year. So Rogers has benefited in 2017 significantly over Telus and BCE because their free cash flow actually was outperforming as their capex intensity was declining. In 2018, we expect Rogers' capex intensity to start drifting higher and so that advantage that Rogers had over Telus is going to diminish. I think the same reasons why Rogers outperformed in 2017 are going to drive Telus' outperformance in 2018 i.e., free cash flow growth.
What discount is Telus trading at relative to Rogers and how much could that gap potentially narrow?
So Telus is trading at around 7.9 times EV/EBITDA [on 2018 expectations]. The Canadian telecom sector is trading at 8.2 to 8.3 times so it is trading at a discount to both BCE and Rogers. For a company that is expected to outperform in both EBITDA growth and dividend growth in 2018, we see this discount as materially big enough to justify a positive outlook on the stock. Telus should be trading at a premium in our view, not at a discount.
Can you discuss the competitive landscape in Western Canada?
It was a headwind in the past year. So Shaw has been using price promotion to protect its market share in Western Canada against Telus. That strategy has started to affect negatively Shaw with margins under pressure. In the most recent quarter, we saw 10 per cent year-on-year EBITDA declines in Shaw's consumer business due to margin pressure. Management [at Shaw] has said that they are going to start pulling back on these heavy promotions in order to protect their margins and improve growth and profitability. Those are clear signs that the pricing environment in Western Canada is likely to improve going forward. Telus during that period had no choice but to match prices to stay competitive; any kind of reduced price competition in Western Canada is likely to lead to improved profitability for both Shaw and Telus at the end of the day.
And Telus, in Western Canada – what is their exposure?
I can tell you for Alberta specifically ... the oil patch type exposure, is about 30 per cent, I would say, of sales. The company does not segment their results on a geographical basis so it's a pure estimate on my part…. I would say one-third but we have seen great resiliency in consumer behaviour in the last year in Alberta.
The company will be reporting their quarterly results on Nov. 9. Last quarter, the company reported earnings results short of expectations and the share price declined. What are your expectations for this quarter?
If we look at the second quarter, the reasons why Telus had showed lower-than-expected bottom line results is mainly because they added more wireless customers than the Street was expecting, and so that impacted profitability and there were also some strategic reasons. The company signed more customers on two-year plans than we had initially thought, all the subsidy costs weighted on profitability. We think in the third quarter that strategy and the [subscriber additions] are going to be within the norm and so in terms of earnings, our estimates are somewhat higher at the margin, a little bit higher, than the Street. We are looking for 71 cents per share versus 68 cents for consensus but on EBITDA and revenue we're in line.
Within the technology sector, you are recommending CGI Group. Could you tell us what the company does?
CGI is an IT services company. Their business is to take over certain key business processes… [for] their clients and do them cheaper… with new growth in digital investments sourced by the client from these savings.
Is there a particular segment where they are focused on expanding? I know they took a restructuring charge perhaps to shift their focus to a higher margin segment where they see an opportunity. Can you elaborate on this?
What the company has seen great success in is working in the financial sector, trying to help banks digitize their services to consumers and reduce their cost structures. We have seen significant restructuring announcements from companies like Scotia, TD, BMO, National – all these banks are moving a lot of their products to become more consumer friendly and require less hands-on or paper-type transactions to be made. They've seen great growth in the financial sector in Canada and in the U.S. and they are trying to replicate that in other parts of their organization. CGI works with 22 of the top 30 banks in the world helping them deploy new processes areas. Regulation and de-regulation both require IT and the financial industry globally has introduced close to 6,000 new regulations over the last year alone. Also, they are moving away from lower margin type outsourcing contracts to higher margin software-driven IT service contracts, where software (if you own the intellectual property) drives much higher margins closer to the 30 per cent range on EBIT margins compared to the low end outsourcing contracts, which is more in the 10- to 15-per-cent range. So the mix is shifting. That is going to, in my view, drive higher margins closer and closer to what Accenture [PLC] margins look like…
Where are Accenture's margins at?
On an EBIT margin basis, they [CGI] are currently in the 14 to 15 per cent range but IP related services bring in margins closer to 30 per cent. We see the margins at CGI improving over the next couple of years growing to 18, 19 per cent in five years. Accenture's margins are in the high teens. Accenture is a direct competitor, they are a leading IT service provider for consulting and they are kind of the bull that CGI would like to become in the next five years. CGI's stock, however, trades at a discount to Accenture and adds to our positive view.
What are your earnings growth expectations for fiscal 2017 and fiscal 2018?
When we look at 2017, the company was getting rid of lower margin contracts, moving to higher value relationships and contracts…. What is currently happening, we are at the end of that cycle of margin pressure as they retooled their employee base. Now, they are bringing on revenues from higher margin contracts, more so than before, so instead of showing EPS (earnings per share) growth of approximately 5 per cent in [fiscal] 2017, we expect EPS growth to go to 15 per cent in [fiscal] 2018. It is important to note that, despite this transition, they have increased their net headcount in each quarter of the last year and continue to do so.
What is the currency impact?
A rising Canadian dollar is negative because only about 20 per cent of their revenue is from Canada and 80 per cent is coming from the U.S. and Europe (the company reports in Canadian dollars).
Acquisitions are a key part of management's growth strategy. On the most recent earnings call, management indicated that they had a 'very active pipeline' of acquisition opportunities. Are you expecting to see a series of smaller tuck-in acquisitions or larger ones?
Of the $1.4-billion of free cash flow that the company makes every year, that's a significant free cash flow generating company right now, two third of that revenue is recurring so [there is] very high visibility on free cash flow generation. The company has practically no debt any more that they can repay. All free cash flow that is going to be generated over the next year with a very low leverage ratio could be used to undertake acquisitions. In our model, the 15 per cent EPS growth that we forecast for [fiscal] 2018 does not include additional acquisitions. So any acquisitions they do would be accretive to our forecast. When we look at acquisitions, there are potentially a lot of small tuck-in acquisitions like you talked about that could be undertaken, like the one in Finland they are currently completing. They have done three nice tuck-in acquisitions in the U.S. recently. Those kind of tuck-in acquisitions are not significant enough to drive big moves in EPS – more than let's say, 5 per cent per year – because of the size of the company. It has been a while since the company has made a large M&A transaction…. It's an industry that remains highly fragmented. CGI does not own more than 5 to 6 per cent market share and they are one of the biggest public IT service companies in North America so it's a very fragmented industry that continues to see consolidation…. What we like about CGI is that historically, they have not messed up on large transactions. To me, that commitment and management attentiveness to how they drive accretion from large transactions [allows] me to sleep at night.
The book-to-bill ratio dipped below 100 per cent to 94.3 per cent in the third quarter – does that concern you?
Not at all. When you look at it from a trailing 12-month basis, and that is how we look at it, it's still nicely above 100 per cent.
Do you have any concerns that you would recommend investors watch ?
The risk at CGI is government spending decisions…. Sometimes, there are timing issues when it comes to elections, when it comes to referendums, those kind of political issues sometimes hurt bookings on a quarterly basis, but over time, governments tends to go back to spending because they need to support services to their citizens…. It's more timing issues sometimes.
Your target price is $74, how do you arrive at that?
We use an average of three valuation methods. The first one is a DCF [discounted cash flow] valuation, which we get about $82. The second one is a P/E [price-to-earnings] valuation on fiscal 2018, we use a 17 times multiple, that gets us $71.50. The third one is an EV/EBITDA basis valuation, we apply a 10 times multiple and that gets us about $69, so the average of the three is $74…. It is important to highlight that we don't include any acquisitions and we are using fiscal year 2018, which has already started. As we start to look at [fiscal] 2019 and with EPS growth expected to be north of 10 per cent, those kinds of valuations should transfer into a higher valuation on the stock down the road.
You believe the positive price momentum will continue.
The most important driver for stock performance for CGI is EPS growth. I think what's taking place right now is investors are starting to look forward to that EPS growth rate that we talked about in [fiscal] 2018, and starting to include that in their valuation and that's driving the stock price higher. Earlier this year, if you had looked at CGI stock in March/April, you would not have been very enthusiastic because EPS growth was negatively being affected as we talked about [due to] margin pressure, currency [headwinds], and no stock buybacks.
We think now they are in a nice sweet spot where if they don't do acquisitions, the stock buyback program is going to start becoming much more aggressive to deploy that $1.4-billion of cash they generate and margin improvement and less currency headwinds are going to help drive EPS growth.
I continue to be positive on the name because the cycle now is shifting nicely to their favour. There isn't much that governments or enterprise can do without information technology.
Anything you would like to add on CGI before we move on?
Management is top notch. If I look at the companies I cover in the technology space, I can say that without any doubt, that the management team knows how to deploy their resources, knows how to deploy acquisitions, and financial ratios are very well controlled by how they operate the business. The fact that the chairman of the firm continues to have such a high ownership in the name gives us confidence that they won't make any rash acquisitions in the future.
Stingray Digital Group – why do you like it ?
It's a small cap story much smaller than the other two [companies] we have been discussing but potentially nice growth opportunities here.
Stingray ... came from a business [model] that was mainly a TV music driven service but they are shifting towards music on handsets, music on mobile, and also on direct SVOD (subscription video on demand) for services like jazz and classical music concerts.
The big interest in Stingray is that if you are a TV subscriber you get it for free. If you want to listen to live music with no advertising through subscriptions to other online services you have to pay a fee of $7 to $10 per month. It is a service that people use, about 20 to 30 per cent of TV subscribers actually listen to music on TV, and through our research talking with telco companies, they see the service as a strong retention tool to their customer base and it costs them practically a few cents per subscriber to offer this service to their customers. So it's the law of large numbers. Stingray charges less than $1 per subscriber to the telcos but the service is a nice retention tool for these companies that are trying to protect their TV market from declining, but as we talked about, now they are now expanding beyond TV and into other service delivery segments like wireless and when you look at wireless per se, they charge a few cents per subscriber to telecom providers and we've seen data that showed that churn at these telcos would decline by half if you offer a music service [is offered] to their customer base.
What percentage of their revenue is from TV cable providers?
Their business is 75 per cent consumer, 25 per cent commercial. The 25 per cent we didn't talk about is in-store music entertainment. When you walk into a shopping mall or store and you listen to music, many stores that have many locations don't want to leave their radio selection process to the employees of that store. They actually like to have it [be the same] all across their locations, same type, same messaging so companies like Stingray offer the service of music in-store. Seventy-five per cent is consumer, of that closer to 80 per cent of it is generated from TV subscriptions. We are not seeing a decline in that segment even though subscriptions in TV services in North America is declining 1 to 2 per cent per year. They operate also in Europe in developing countries where cable subscriptions are actually increasing unlike North America ….
They just did that $40-million equity financing, which I would assume is earmarked to expand their business.
In terms of M&A (mergers and acquisitions), the company's goal every year is to add 10 to 15 per cent growth in revenue from M&A. This year, they've been able to already do that in the first six months of the year. So what they're looking at is continuing this M&A drive. We think the strategy going forward is to own more content to drive higher margins in the future for their subscription video on demand in classical music and jazz. We think they are going to buy more content libraries … if they own more content, they can become even more relevant and charge higher prices for that content.
Their M&A strategy has two goals. One goal is to own more companies like Stingray in other countries across the globe. In every country, there are mini "Stingray's" that offer music services to TV subscribers. That historically has been the strategy of the company – to buy these small companies in different countries and integrate them. Now also you have a second branch of M&A where you can own more content to become the de facto provider for specific types of music, especially jazz and classical music.
You mentioned that they have already reached their acquisition growth target, so that equity raise leads me to believe that management must have a target in mind?
We believe there are likely multiple companies they might be trying to pursue in the mid single digit ($3-million to $5-million) in size, mainly content driven companies.
Your target price is $10.
That's correct, but when you look at how our one-year target price has evolved, if the company continues to grow their revenues 10 to 15 per cent per year, we think the stock has the potential to be a $15 stock a few years down the road. There is ample opportunity here for the company to continue its M&A strategy. Leverage right now is very low so they have a lot of firepower that they can deploy.
What is the stock's valuation? Is it a three-tiered approach once again?
Yes. For Stingray, we use a DCF, that's $10.60; a 15 times multiple on EPS, and that's $10; and 12 times on EBITDA, that's $9.50. That's based on fiscal year 2019.
Summarize your investment thesis for this company?
Very solid technological platform that allows the company to gain synergies from their build and buy strategy. Large niche library content that provides strong growth in the SVOD (subscription video on demand) market in the U.S. M&A is an important driver for future growth and the company's free cash flow profile is very solid driven by EBITDA growth and that drives dividend growth as well.
The company's dividend yield is currently around 2 per cent.
We expect it to grow at 10 per cent per year for the next couple of years.
Are there litigation risks that investors should be aware of?
The company has a lawsuit going on. They've sued a company and the same company is suing them, its called Music Choice in the U.S. It's the largest music TV provider in the U.S. They (Stingray) have tried to buy them in the past. It's an opportunity in the future for them to acquire. We don't think at this point in time the risk is large because some of the owners of Music Choice (i.e., cable companies) are actually moving some of their business to Stingray because of its better technological platform.
Are the EBITDA margins high?
We are looking at 30 per cent, approximately. Below that line, there is not a lot of capital investment that takes place…. It's a very high free cash flow generation company.
Anything else you would like to add on Stingray before we end the conversation?
[They have a] very energetic management team with high stakes in the business. We think their strategy to deploy into M&A has and should continue to provide investors with growth and right now we see the stock as still a good buying opportunity as management's strategy is being deployed.