BCE Outlook - Is it a Sinking Ship?
Navigating Financial Challenges: BCE's Strategic Moves Amidst Higher Interest Rates and Market Competition
There has been a concerning downtrend in Bell Canada (BCE) ever since the all-time highs in April of 2022. Amidst rising interest rates, the company's growth has been stifled by its substantial debt. Additionally, limited revenue expansion due to increased competition and disappointing performance in other divisional segments has compounded the issue.
Telecommunications companies inevitably rely on debt to finance their operations and network expansion due to the capital-intensive nature of the industry. Constructing, maintaining, and upgrading telecom infrastructure, including cell towers, fiber-optic cables, and data centers, demands significant investment. These costly projects are frequently funded through debt. Additionally, regulatory constraints, such as those encountered by Bell in Canada, can further limit growth and reduce the incentive for continued investment in high-quality networks.
Wholesale Access to Fibre Networks: The Canadian Radio-television and Telecommunications Commission (CRTC) mandated that Bell Canada, along with other major telecom companies, provide competitors with workable wholesale access to their fibre networks by February 2025. This move was intended to stimulate competition and offer consumers more choices and lower prices for internet services.
Bell’s problems could already be foreseen just by analyzing their growth trends in a few areas like revenue, earnings per share (EPS), payout ratios, and long-term debt (LTD) to equity ratios.
Even post-recovery from the COVID-19 pandemic, revenue growth was minimal. With growth rates of only 3% over three years and 1% over five years, it was evident that the business was facing challenges.
The EPS metric has not recovered since the pandemic. The increase in interest rates has significantly hindered this growth, which was previously performing well. Bell has experienced a negative growth rate of 6% over both three-year and five-year periods.
Payout ratios have surged significantly. Previously, a comfortable range of 70-80% was maintained from 2017 to 2020, but it escalated sharply to 112% in 20231. The ratio remains elevated at present.
LTD-to-equity followed the same pattern rising from 95% to 154% between the period of 2017 and 2023.
Investing in Bell was primarily attractive because of its dividend growth. It stood out as an excellent choice for income investors looking for a higher yield that consistently increased by at least 5% annually. This characteristic positioned the stock as a bond proxy. Yet, recent decisions by the management have deprioritized this aspect.
Rewind
Bell recently announced in September 2024 that it sold its 37.5% stake in Maple Leaf Sports & Entertainment (MLSE) to Rogers Communications for $4.7 billion. Bell invested approximately $533 million in August 2012 acquiring its stake from the Ontario Teachers’ Pension Plan. This results in a return on investment (ROI) of approximately 20%. Impressive, to say the least. But what was the objective of this sale?
Debt Reduction: Bell aims to use the proceeds from the sale to reduce its debt.
Transformation Strategy: The sale supports Bell's ongoing transformation from a telecommunications firm to a tech company.
Financial Flexibility: The deal provides Bell with greater financial flexibility to invest in its core business areas and future growth opportunities.
Yes, debt reduction was the primary purpose. This can even be seen from their press release on their website2.
Merger and Acquisition Announcement
Bell recently announced its acquisition of Ziply Fiber, a leading fiber internet provider in the Pacific Northwest of the United States. The acquisition is valued at approximately $7 billion (CAD), which includes $5 billion in cash and the assumption of $2 billion in debt. This acquisition marks Bell's expansion into the U.S. market, significantly increasing its fiber footprint. Bell aims to extend its reach to over 12 million fiber locations across North America by the end of 2028.
How will this be funded?
Indeed, the entire proceeds from the sale of Bell's MLSE stake are allocated to finance the acquisition3. Consequently, there will be no reduction in debt; rather, more debt will be incurred. Nonetheless, Bell's management assures that the net debt leverage ratio is anticipated to stay relatively stable in comparison to its present net debt leverage ratio.
Dividend Impact
Upon this announcement, there is also an additional impact that comes at the expense of Bell’s dividend growth. It is being paused in 2025, and will only increase once BCE's dividend payout and net debt leverage ratios are tracking towards our target policy ranges. Their selling feature is now gone. Not to mention a further implementation of a DRIP program that will further dilute shareholders.
A Dividend Reinvestment Plan (DRIP) is a program that allows investors to reinvest their cash dividends into additional shares or fractional shares of the underlying stock on the dividend payment date.
Stock Price Impact
The initial divestiture, despite being controversial, was perceived as a positive move, with the stock price experiencing a slight increase following the news. Conversely, the announcement of the acquisition resulted in an adverse reaction. The management's direction appears to be perplexing to both the market and investors.
Balancing Both Sides of the Argument
Every business decision involves weighing two aspects: the opportunities and the risks. Decisions are founded on these considerations, yet individuals prioritize them differently based on the impact they anticipate—some prioritize opportunities over risks, while others are more risk-averse.
Following the announcement of Ziply's acquisition, it is crucial to consider the arguments for and against to assist both current and prospective investors in determining their response to this development.
Opportunities
Growth and Diversification: The acquisition provides Bell with a foothold in the large, underpenetrated U.S. fiber market, enhancing its growth profile and strategic position. Reallocating capital into a fiber asset with significant growth opportunity, which is likely Bell’s bread and butter.
Fiber-First Strategy: The acquisition represents a major investment in BCE's growth strategy, designed to boost long-term growth through expansion into the underexplored U.S. fiber market. It also signifies a strategic shift away from its traditional copper-based operations.
Moving Away from Regulatory Impacts: The limited growth opportunities in Canada, stemming from regulatory constraints, reduced immigration rates, and a saturated market, present a new market with less regulatory scrutiny. This allows for the penetration of a unique vision distinct from that of major competitors like Telus and Rogers.
Other Avenues to Raise Cash: Rogers Communications has recently sold a minority stake in its wireless backhaul network infrastructure for $7 billion, setting a precedent in Canada where telecom giants traditionally own their infrastructure. An opinion piece4 in The Globe and Mail suggests that Bell and Telus may emulate this move, potentially selling off towers, fiber networks, and data centers to reduce debt.
Credit Quality: The proposed transaction is neutral to BCE's credit quality (BBB/stable outlook).
Risks
Debt Reduction Stalled: There will be no short-term debt reduction, deviating from the initial plan for the proceeds from the sale of Bell's MLSE stake. A significant amount is due in 2025 and is expected to be refinanced at higher interest rates, which will persistently affect Bell's financial performance.
Weak Canadian Dollar: The Canadian dollar (CAD) is currently weak against the U.S. dollar (USD), requiring more CAD to purchase USD. This disparity could have ongoing effects if the CAD's value continues to decline.
Trade-Off: Retaining the MLSE stake as opposed to adopting an aggressive expansion strategy into a new market presents a compelling case. The return on investment from the MLSE stake was robust, suggesting that maintaining this asset could have yielded further appreciation and presented a less risky option for shareholders.
Dividend Pause: The end of a 14-year streak of dividend growth raises concerns about potential future cuts if financial conditions don't improve. High yields may indicate worsening financial health, often leading to reduced dividends. Additionally, the current dividend is not keeping pace with increasing inflationary pressures.
Recession Ahead?: The possibility of an impending recession, particularly in the U.S. market, carries significant global implications. Should this scenario unfold, it could exert additional downward pressure on Bell's stock price, potentially resulting in adverse outcomes for this decision.
Shortfall: Taking into account the Q2 2024 quarterly report, if we consider the debt repayment of $525 million, the remaining free cash flow would be insufficient to cover the dividends of $910 million. This would result in a deficit of $276 million, necessitating financing through additional debt.
Summary
The market anticipated debt reduction and a possible dividend cut to improve Bell's balance sheet. However, an unforeseen acquisition occurred, leading to additional downward pressure on Bell's stock price, which is likely to persist in the short term.
This signifies a shift in Bell's strategy. The company is moving away from its role as a secure option for income investors and is now focusing on growth strategies. Execution will be key.
Bell management appears to have altered their strategy from prioritizing debt repayment with the proceeds from selling their MLSE stake. They may view this as a superior growth opportunity compared to reducing their substantial debt amidst falling interest rates. It is a risk/reward play. Additionally, this could signal a lack of confidence in Canadian investment prospects. Ultimately, Canada may be the true casualty, as the investment shifts to its southern neighbors.
These calculated payout ratios are the ones used by Bell in their financial reports.