Are Lagging Canadian Telcos a Buy Now?

Ruth Saldanha: Canadian telecom companies have been longtime investor darlings, but in 2020, despite the run-up in equities, the sector has lagged. Is this a buying opportunity? Morningstar equity analyst Matthew Dolgin covers the sector and he’s here today to share his thoughts.

Matthew, thank you so much for being here today.

Matthew Dolgin: Thanks for having me Ruth.                                          

Saldanha: Despite the run up in equity markets, the three major Canadian telecom companies are trading below their fair value estimates. What are some of the reasons for the stocks’ underperformance? 

Dolgin: Well, essentially the businesses of these three companies have been hurt quite a bit by the pandemic, especially their wireless businesses have really faced a tough time because of what's going on. There are a few reasons for that. The lockdowns earlier in the pandemic caused fewer people to upgrade or change new wireless services, so net additions were down quite a bit. But actually, the bigger thing was that these companies lost essentially all of their roaming revenue and overage revenue. So, revenues took a very big hit because of the pandemic, and that's both, because there is much less international travel that's gone to almost zero. And then also these companies to the extent that their customers would be using the overage or roaming services and have fees associated with those. They were suspended so that they wouldn't have to -- customers wouldn't take that. They were basically forgiven. 

So these actually have caused major headwinds to the wireless revenue and that's been especially hurtful to Rogers, BCE also had, it was probably the next most hurt, and TELUS a little bit less so. But essentially each of their wireless businesses really did get affected quite a bit by the pandemic, and it's not certain how quickly they'll come back. Certainly, whenever the pandemic lets up a little bit, it’s going to make a big difference, but we might be looking at a couple of years until we get back to 2019 revenue. So to me, the stocks are down quite a bit because the businesses really have been hurt, but in my opinion, the stocks are probably down too much and they may be overcompensating for these near term headwinds which over the long term I do think will subside and will get back to normal.

Saldanha: Despite these short-term headwinds, all three of the companies have earned a narrow economic moat. What are some of the competitive advantages that you see for these three companies? 

Dolgin: For these big companies, the two sources of the moat that we have are efficient scale and cost advantages. So the efficient scale really comes in because whether you're talking about a wireline or wireless network, there are really high costs to build those, so these firms that have these networks already have significant advantages over those that might want to come in and compete, because it's really almost too big of a task for somebody to come in and decide to put in all of those startup costs to not really necessarily have any edge or be able to compete with the firms that are already there. There's not really a compelling reason for others to come in, so the networks that these companies have in and of themselves form a moat in our opinion.

And then cost advantages come along with that because of the size of these companies and the scale they've got, so many customers that they're able to spread their fixed costs. And there are high fixed costs in telecom. These fixed costs are spread across much bigger customer bases. Again then smaller upstart competitors might have. So, we see these incumbents as having significant advantages over more upstart type of competitors, and we think they're protected for that reason.

Saldanha: Despite these advantages, one of the companies has a negative moat trend that is Rogers. The other two don't. Why does Rogers earn a negative moat trend?

Dolgin: Well, both BCE and TELUS started building Fiber-to-the-Premises, so they are the legacy phone companies and they had copper networks and those copper networks weren't as good as cable networks and the cable networks are the ones that Shaw and Rogers have. BCE and TELUS started building out those fibre networks which to me made them more competitive. Now Rogers competes in their geography with BCE primarily, and so they were facing greater competition, to me, Rogers had a superior network previously and that's no longer the case. BCE has closed the gap quite a bit because of that fibre build-out. Now, that alone probably wouldn't have been enough to bring it to a negative moat trend, and Shaw, which competes most predominantly with TELUS we don't have, as you mentioned a negative moat trend on them.

The difference with Rogers is they are also facing increasing competition in wireless. Now each of the Big Three wireless companies is, because Shaw bought Wind Mobile a few years ago and subsequently changed the name to Freedom Mobile and I kind of compare them to what several years ago in the United States T-Mobile was. They were this insurgent company, they were willing to take losses. They cut prices to take some market share and we saw in the U.S. that has worked out pretty well for T-Mobile, and Shaw began a few years doing that with their Freedom Mobile wireless unit. So when you combine the headwinds that we thought that Rogers had because of the wireline network with BCE, and on top of that the general wireless headwinds that the three incumbents had. It was both of those sides getting it, and that's what led us to the negative moat trend the increasing competition in really both major parts of their business.

Saldanha: We spoke about some of the short-term headwinds, especially around the pandemic, but what are some of the long term risks that you see to the sector?

Dolgin: Really, in telecom, the longer-term risks that just persist are potential regulatory risks. So one thing in Canada that has been a harder topic in the last year or so is the potential for mandatory MVNO pricing. And what that means is you would force the incumbent, the big incumbent wireless companies to wholesale network capacity to MVNOs, which are mobile virtual network operators. So they don't necessarily own their own networks, but they can run a network, and there are several of those in Canada already. But the point of this would be to increase competition. And that would, from the government's point of view, who want to bring prices down for consumers, and that is really the pervasive headwind that’s just always present in telecom. Other than that, as you said because of the pandemic causing the stocks to come down quite a bit I think they are each undervalued and are good buys right now and are really building in some of the risks that are out there but again the regulatory risk is what's just always there. I think it's probably a little bit overblown, but nonetheless it's present.

Saldanha: So you mentioned all the stocks are currently undervalued. What's your top pick in Canadian telecom and why do you like it?

Dolgin: Well, I mentioned earlier that BCE and TELUS were building out Fiber-to-the-Premises, so for quite awhile those have been our favourite two, because we think -- we think the wireless business is not as great right now. We think there's a lot of competition. We don't think there's a lot of opportunities or upside to growth there for any of the companies as much. We think wireline is the place where they can really distinguish themselves and make differences, and that's where we think TELUS and BCE have the advantage. Because they will have a higher quality network than they've had in the past, it will be more efficient, so it'll cost less. They should be able to charge more because it will be a higher quality network and we expect them to take some share from their primary competitors.

BCE is the one that we see as most undervalued, so I do think that's a good buy right now. TELUS is a little bit less undervalued. However, the really interesting thing about TELUS which I really like quite a bit, is that they have two units kind of hidden within their wireline segment, and those units are TELUS Health, and TELUS International, so they're not telecom businesses. And I think they have been ignored a little bit, but they're becoming sizable. They're good growth industries, and in time we expect them actually to be carved out and to be independent companies themselves. And we think that could provide some upside to TELUS. So, although we don't see it as undervalued as BCE right now. BCE took a little bit more of a hit because of the pandemic their business got hurt a little bit more, and therefore the stock went down a bit more. We do really like TELUS quite a bit also. So those would be the two companies that I would point to first.

Saldanha: So BCE and TELUS those are the ones we’ll keep an eye on. Thanks so much for joining us today, Matthew.

Dolgin: Thank you Ruth.

Saldanha: For Morningstar, I’m Ruth Saldanha.