The Canadian telecom sector helped ease the Consumer Price Index (CPI) to 2.8% in February by making cellular and internet services cheaper by 26.5% and 13.2% year over year. A PwC report found that the sector’s five-year average annual capital spending on network infrastructure was $12.1 billion. The increasing investment improved network quality, coverage, and resiliency while reducing costs.
The telecom sector is crucial for Canada’s economy as it contributed $76.7 billion to its GDP in 2022. According to the PwC report, the sector has the potential to contribute another $112 billion by 2035. Despite these improvements, telco stocks have been on a decline for the last two years.
Why are telco stocks trading at their lows?
Stocks of BCE (TSX:BCE) and Telus (TSX:T) are trading at their multi-year lows as two headwinds have been discouraging private investments.
High interest expense
As you saw earlier, telcos spend a significant amount of their revenue on building fibre networks in the vast geographical stretch of Canada. Connecting these sparse lands is no easy feat. They fund their capital spending from debt and cash reserves. However, the interest rate hike, which began in April 2022, increased the cost of financing these investments.
Interest expense of Telus and BCE increased 49% and 28.7%, respectively, in 2023. Higher interest expense impacted their cash flows, and the dividend-payout ratio exceeded their target range. Telus had a dividend-payout ratio of 77% and BCE of 111% in 2023. BCE’s high ratio even made some investors question its ability to sustain dividend growth.
The rising interest expense is cyclical and can be resolved by restructuring debt when interest rates fall.
Regulatory headwind
However, the bigger concern for the two telcos is the telecom regulator’s decision in November 2023 asking them to give independent competitors access to their fibre network at discounted prices in Ontario and Quebec within six months. BCE is contesting this decision, stating that such a ruling will discourage private investment in network infrastructure.
The telcos are bearing the risk of high interest rates, capital spending, and damage to network infrastructure from natural disasters. If other competitors get access to this network without taking any of the above risks, it puts BCE and Telus at a disadvantage. BCE will reduce capital spending in fibre infrastructure and cut jobs to shift focus to less-regulated areas of cloud and security services.
Till this regulatory issue is resolved, BCE and Telus stock prices might face pressure.
Two ultra-high-yield telco stocks to buy hand over fist
There is never a better time to buy these dividend stocks than now. If you invest a significant amount in these stocks now, you can lock in 8.6% and 7% yield, respectively. The interest rate is at its peak, and rate cuts are expected later in the year. As for the regulatory headwind, some settlement may be reached as Canada cannot afford to reduce network spending in the 5G era. If the cellular and internet quality deteriorates, it will have a significant direct and indirect impact on the economy.
In the meantime, the telcos will continue to pay dividends by lowering their capital spending and channelling that cash flow towards dividends. In the worst-case scenario, they might pause or slow their dividend growth. Once the two headwinds resolve, their stock price could soar to the normal trading price, creating an opportunity for a 35-40% capital appreciation. You can also opt for the dividend-reinvestment option (DRIP) and compound your returns.
A telco stock to avoid
While BCE and Telus are screaming buys, Rogers Communications is a stock you might want to avoid. Since its merger with Shaw Communications, Rogers’s priority is to reduce its significant debt. And its 3.6% yield is not attractive enough for a range-bound stock when it is closer to the lower end of the price range.
