Rating agency Standard and Poor’s is relaxing its recent warnings about the debt burdens shouldered by Canada’s largest telecom companies, easing the financial pressure on BCE Inc., Rogers Communications Inc. and Telus Corp. as they spend tens of billions of dollars to build out their 5G networks.
S&P’s rationale, in a nutshell, is a rather Canadian one: The three giants dominate the country’s telecom market, and that gives them pricing power. While their oligopoly can frustrate customers, it is helpful for healthy balance sheets – and it is extremely beneficial to dividend investors, who have long relied on the telecoms’ hefty payouts.
If the telecoms had their debt ratings downgraded, they probably could not keep hiking their dividends as frequently.
“All three telecoms enjoy a favourable industry structure with room to expand, a balanced share of a growing broadband market and low customer churn,” S&P analysts Aniki Saha-Yannopoulos and Madhav Hari wrote in a new note, explaining the agency’s change of heart.
What that means: The telecoms can raise prices if need be, and lately all three have done so, with hikes to their monthly internet plans. The companies also have few startup rivals to compete with.
S&P’s newfound comfort with the telecoms’ adjusted debt levels, which currently average slightly below three times earnings before interest, taxes, depreciation and amortization, marks a reversal for the rating agency. Six months ago, S&P assessed the North American telecom industry and warned that the race to build 5G networks was “putting balance sheets at risk.”
For Canadian telecoms, this latest debt worry was a burden was over and above pre-existing concerns. Rogers, Bell and Telus are all focused on increasing their dividend payments, and they have been spending heavily on spectrum auctions. In 2016, multiple debt rating agencies went public with some debt warnings, and Moody’s Investors Service put Telus on notice for a possible downgrade.
The telecoms took action to start rectifying things. BCE sold nearly $1-billion worth of new shares in early 2016, its first share sale since 2002; Rogers surprised investors and analysts by not raising its dividend that same year; and Telus sold its stake in an international call centre to generate cash.
But in the three years since the telecoms have faced new spending demands, largely driven by building 5G networks. S&P has cautioned that large Canadian telecoms have spent about $50-billion since the mid-1980s on wireless communications infrastructure, yet between 2020 and 2026 consultancy Accenture expects these companies to spend $26-billion on 5G infrastructure.
Yet, after fielding questions from investors in recent meetings, the rating agency decided to re-examine the industry’s dynamics. In doing so, S&P found that Canadian telecoms are rather unique.
Even after paying for 5G investments, “we expect robust free cash flow to sufficiently improve to support modest dividend growth and provide the telecoms with flexibility for strategic investments," S&P noted. “In our view, these factors position BCE, Rogers and Telus within the top quartile of their global peers in terms of growth, profitability, and return of capital measures.”
In an interview, Mr. Hari said investors should not assume S&P is giving the telecoms a free pass to raise their debt levels substantially. While the agency is more comfortable with the status quo, the debt-to-earnings ratio it will accept is “not necessarily a large number,” he said. “There’s not a whole lot of room” for change.
Mr. Hari also noted that one reason for the relaxed outlook is a pending change to global accounting rules, which will see telecom debt levels rise slightly, because they will have to capitalize operating leases as debt.
But the structure of the Canadian market, and the profits it provides, is the driving force. The telecoms’ “competitive position allows for lower earnings volatility and, in our opinion, supports higher debt leverage, all things being equal,” S&P wrote in its ratings report.
In that way, the telecoms are a lot like Canada’s largest banks, railways and grocers. In a recent study, analysts at CIBC World Markets examined the returns of these oligopolies, relative to the broader Canadian market. Over the past 30 years, these four industries posted average annual total returns ranging from 11.4 per cent for the telecoms to 13.9 per cent for the rails, while the S&P/TSX Composite returned an average of 8.2 per cent over the same time frame.