Telus cannot cover its dividend obligation: Gallagher

Key Concepts

• Dividend Payout Ratio: The proportion of a company's earnings paid out as dividends to shareholders.
• Dividend Reinvestment Plan (DRIP): A plan that allows shareholders to reinvest their cash dividends into buying additional shares or fractional shares of the company's stock.
• Free Cash Flow (FCF): The cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
• EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization, a measure of a company's operating performance.
• Capital Intensity: The amount of capital required to produce a unit of output.
• Hybrid Debt: A type of debt security that has characteristics of both debt and equity.
• Data Annotation: The process of labeling data to make it usable for machine learning models.
• AI Data Centers: Facilities that house specialized hardware for artificial intelligence computations.
• Modular Approach: A design or construction method that uses standardized, interchangeable components.
• Leverage: The use of borrowed money to finance investments.
• Payout Ratio: Similar to dividend payout ratio, but can refer to other forms of distributions.
• Margin of Safety: The difference between the intrinsic value of an investment and its market price, providing a buffer against potential losses.

Telus's Financial Performance and Dividend Sustainability Concerns

Liam Gallagher, an analyst at Veritas Investment Research, expresses significant concerns regarding Telus's financial health, particularly its dividend sustainability. He notes that Telus's recent third-quarter earnings and sales trailed estimates, leading to its sole "sell" rating on Bay Street.

Key Points:

• Dividend Payout Ratio Misrepresentation: Telus reports its dividend payout ratio on a cash basis, but Gallagher argues this is misleading. He states that two-thirds of Telus's dividend is paid in cash, while one-third is paid via the Dividend Reinvestment Plan (DRIP) with a 2% discount.
• Actual Payout Ratio: When considering the entire dividend obligation, Telus's payout ratio on a trailing 12-month basis is closer to 150%, not the reported 100%.
• DRIP Discount Removal Impact: Telus is considering removing the 2% discount on its DRIP because it is dilutive, creating a 2-3% headwind to free cash flow per share growth. This move would necessitate Telus finding approximately $800 million in incremental free cash flow.
• Projected Payout Ratio: Gallagher estimates that Telus's payout ratio could reach around 100% by 2028, assuming capital intensity falls to 10% and EBITDA grows by 3-4%. Even with these optimistic assumptions, the company might only achieve a 90-95% payout ratio, leaving only about $200 million in excess free cash flow after dividends.
• Inability to Delever Organically: With limited excess free cash flow, Telus would struggle to delever its balance sheet organically.

Debt and Interest Expense

Gallagher highlights a substantial increase in Telus's debt and interest expenses.

Key Points:

• Interest Expense Growth: Interest expense has nearly doubled in the past five years.
• Debt Increase: Debt has increased by $7 billion over the same period.
• Hybrid Debt Issuance: Telus has accessed the hybrid debt market to pay down existing debt. Rating agencies grant hybrid notes 50% equity treatment, meaning the principal doesn't count towards the debt balance.
• Cost of Hybrid Debt: These hybrid notes are issued at a higher rate (around 7%) compared to Telus's existing debt, which has an average cost of around 4%. Gallagher views this as digging a deeper financial hole.

Dividend Growth vs. Cash Flow Growth

A significant disconnect exists between Telus's dividend growth and its operational cash flow growth.

Key Points:

• Amplified Dividend Growth: The issuance of shares through the DRIP amplifies dividend growth. While Telus announced a 4% dividend increase, the actual dividend growth is likely 5-5.5%.
• Historical Discrepancy: Over the past five years, Telus's total dividends declared have grown around 10% annually, while cash flow from operations has only increased at a 1% compound annual growth rate. Gallagher argues this trend is unsustainable for the dividend.

Artificial Intelligence (AI) Initiatives

Gallagher expresses skepticism about Telus's AI ventures, particularly the reported $800 million in AI revenue.

Key Points:

• Vogue AI Revenue: The $800 million AI revenue figure, reported for the first time this quarter, is seen as a current trend for companies to highlight AI involvement.
• Data Annotation Business: A significant portion of this revenue (estimated at $500 million) comes from their data annotation business, with Google as the primary customer. However, revenue from Google has declined 15% year-over-year.
• AI Data Centers: Telus is also entering the AI data center market by renting out compute power.
• Modular Approach: Gallagher approves of the modular approach for data centers, which mitigates risk if supply and demand dynamics shift. This initiative is also within their capital intensity guidance.
• Low Returns on Incremental Capital: Despite the positive aspects of the modular approach, Gallagher points out that Telus's returns on incremental capital over the past five years have been -2%. He advises investors to be skeptical of Telus venturing into non-core areas outside of telecom.
• Competitive Landscape: While Telus has a potential competitive advantage with the "sovereign nature" of its data centers, potentially winning government contracts, Gallagher questions their ability to compete effectively against established data center providers whose core business it is.

Comparative Analysis of Telecom Companies

Gallagher provides his ratings for other major Canadian telecom companies:

• Rogers: Rated "Reduce" due to limited upside. While the MLS acquisition is seen as value-creating, Gallagher believes Rogers should have prioritized debt reduction. The stock is considered to be trading around its intrinsic value.
• Bell: Sees some upside from the Ziply acquisition but is cautious due to Bell's inconsistent capital allocation track record. Tangible evidence of execution is required before recommending Bell shares.
• Quebecor (QBR.A): Highly favored due to its lowest leverage, lowest payout ratio, share buybacks, and strong financial position. Quebecor has also benefited from wireless competition.

Market Performance and Outlook

Despite a positive trading day for all mentioned telecom stocks (BCE up 1.99%, Quebecor up 1.59%, Rogers and Telus also up), Gallagher maintains a cautious outlook.

Key Points:

• Rogers and Bell Stability: He expects Rogers and Bell to remain relatively stable.
• Telus Risk: Gallagher sees significant financial risk with Telus, stating that if the economy deteriorates, Telus would be more exposed to risk with less of a margin of safety.
• Recommendation: For investors seeking exposure to incumbent telcos, Gallagher recommends Rogers or BCE over Telus, emphasizing that Telus "really has to thread the needle."

Conclusion

Liam Gallagher's analysis of Telus presents a critical view of its financial sustainability, primarily driven by concerns over its dividend payout ratio, increasing debt, and the questionable profitability of its non-core AI ventures. He contrasts this with a more favorable outlook for Quebecor and a neutral stance on Rogers and Bell, highlighting Telus's elevated financial risk and lack of a substantial margin of safety.