The Motley Fool

How Much Upside Potential Is There for the Canadian Telcos?

North American telecommunications companies (“telcos”), including BCE Inc (TSX:BCE)(NYSE:BCE) and Telus Corporation (TSX:T)(NYSE:TU) trade at valuation multiples that are considerably lower than companies from other economic sectors with similar risk and growth characteristics.

Investors clearly award premium valuations to companies that deliver stable and growing profits and dividends. Some examples are Canadian National Railway, TransCanada Corporation, and Fortis Inc. These companies typically operate in monopolistic or oligopolistic industries with substantial barriers to entry as a result of either government regulation or substantial capital requirements or a combination of these factors. These businesses have also built franchises that are hard if not impossible to replicate, leaving them in a position where profit and dividend growth is reasonably stable combined with attractive returns on capital.

The industry characteristics of the Canadian telcos are not dissimilar to the railroads, utilities, and pipeline companies. An oligopolistic structure, partial government regulation, and huge capital demands are certainly identifiable characteristics in the telecommunications industry.

From a financial perspective, the telcos also stack up well on factors such as profit and dividend growth and return on equity. In fact the profit and dividend growth and return on equity of the telcos were better than that of TransCanada and Fortis although lower than Canadian National over the past five years.

Based on the valuation measures indicated below, the telcos trade at valuation discounts of between 15%-35% to the railways, pipelines and utility companies. Are these discounts justifiable given the industry and financial performance similarities between these companies?

Company EV/EBITDA 2015 Price/Earnings 2015 Dividend Yield 2014
Canadian National Railway 11.9x 19.0 1.3%
TransCanada 12.5x 21.0 3.6%
Fortis 10.3x 20.3 3.4%
BCE 8.0x 17.2x 4.3%
Telus 8.0x 16.5x 3.7%

Source: Thomson Reuters

Markets are forward-looking and it is therefore important to consider possible business and operating risks as well as the expected profit and dividend growth.

All these companies face considerable operational and business risks. In the case of the telcos, the government clearly would like to see more competition in the domestic market and rule changes and spectrum auctions will favour increased competition. However, the oligopoly has weathered many threats over the years and has built franchises that will be expensive and difficult to replicate. Other companies are certainly not without challenges – consider the six-year ongoing battle of TransCanada to get the Keystone XL pipeline approved.

The industries mentioned above are mature and are not considered high growth areas of the economy. Market expectations for profit and dividend growth for the next few years are indicated below.

Company Annual EBITDA Growth, 2013-2017 Annual Earnings per Share Growth, 2013-2017 Annual Dividend Growth, 2013-2017
Canadian National Railway 10% 14% 15%
TransCanada 8% 11% 7%
Fortis 12% 8% 4%
BCE 4% 7% 6%
Telus 6% 11% 10%

Source: Thomson Reuters

Apart from Canadian National, which is expected to grow profits and dividends faster than the other companies, the differences are not meaningful and certainly do not justify the ascribed valuation differentials.

How much upside for the telecoms stocks?

As evidenced by the information above, investors place a considerable premium on companies that offer stable profit and dividend growth. However, the historical and expected financial performance of the Canadian telcos justify similar valuations to the other comparable companies mentioned . In my view, the telcos offer better value and higher expected returns given the cheaper valuations.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Deon Vernooy, CFA holds shares in BCE, Telus and TransCanada. David Gardner owns shares of Canadian National Railway. The Motley Fool owns shares of Canadian National Railway. Canadian National is a recommendation of Stock Advisor Canada.

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss an important event.

Iain Butler and the Stock Advisor Canada team only publish their new “buy alerts” twice a month, and only to an exclusively small group.

This is your chance to get in early on what could prove to be very special investment advice.

Enter your email address below to get started now, and join the other thousands of Canadians who have already signed up for their chance to get the market-beating advice from Stock Advisor Canada.