Industry Note Equity Research July 27, 2016 Communications Lower Rates Equal Multiple Expansion for High-yielding Telcos Impact: SLIGHTLY POSITIVE TD Investment Conclusion We are increasing our target prices for Rogers, TELUS, and Shaw based on our view that the persistently low interest rate environment is changing the way that Canadian investors perceive and value these stocks. We have always loosely factored the interest rate environment into our assigned target multiples for these stocks, but as of today, we are formally factoring into our valuations the difference between the long-term (15-year) historical average yield for the GoC 10-year bond (3.4%) and the current TD Economics forecast one year out (1.4%). As long as the rates remain at historical lows, we believe that these large-cap stocks, with relatively stable cash flows and dividend yields of over 3%, are likely to continue to trade at valuation multiples that are arguably excessive versus either fundamental growth prospects or historical averages. A summary of the changes to our target prices is presented in Exhibit 1 (note that there are no rating changes), and a brief description of what we have done by company is shown on the next page. Vince Valentini, CFA 416 944 7012 vince.valentini@tdsecurities.com Bentley Cross, CFA 416 983 6399 bentley.cross@tdsecurities.com Brandon Smith, CFA, (Associate) 416 983 1138 brandon.smith@tdsecurities.com Beware of the Risk of Rising Rates The trend in rates recently has been the friend of telecom investors, but there could be risk in the future if one shares our view that valuations have become more correlated with rates. The good news about cable/telco cash flows is that they are largely immune to economic cycles, which tends to command a premium from investors who are looking for stability and safety. The bad news is that these cash flows are unlikely to experience much cyclical growth if the improved economic conditions cause an increase in interest rates over time. In other words, there is not much of a hedge in place to protect these names from rising rates. Using our current valuation methodology (70% of the change in rates being added or subtracted to our base-case multiples in a normalized rate environment), we show in Exhibit 2 how much downside there could be to our target prices if the rates head back towards 2-3% in the future. Exhibit 1. Summary of Target Changes Rating Current Share Price Forecast Dividend New Target Price Old Target Price Forecast Return Rogers BUY $57.44 $1.97 $64.00 $62.00 14.9% TELUS HOLD $44.01 $1.84 $46.00 $43.00 8.7% Shaw BUY $26.34 $1.19 $31.00 $28.00 22.2% Source: TD Securities estimates Please see the final pages of this document for important disclosure information. Page 1 of 7
Rogers: Our target price increases to $64.00 from $62.00, and we note that we had already increased our target multiples on an interim basis when the company reported Q2/16 results last week. We now use 8.9x 2017E EBITDA for wireless (up from 8.75x) and 7.9x 2017E EBITDA for cable/media (up from 7.5x). In a normalized interest rate environment, we would peg the valuation of Canadian wireless assets at 7.5x EBITDA based on: a) FCF growth prospects; b) peer comparisons; and c) historical multiple ranges. A similar analysis for cable assets would get us to a normalized target multiple of 6.5x EBITDA. We then inflate both these multiples by 70% of the difference between the current interest rate forecast (1.4%) and the normalized long-term rate (3.4%). Therefore, for wireless, we take 3.4 minus 1.4 equals 2.0, then multiply by 0.7 to get 1.4, and then we add this to 7.5x to get a target multiple of 8.9x. We have back-tested the relationship between valuation multiples and interest rates over the past 10 years (with more emphasis on the data from 2010 to today, subsequent to the financial crisis, which is shown in Exhibit 3, as that is when the correlations between rates and telco multiples increased) in order to conclude that 70% of the change in rates is a reasonable assumption. TELUS: Our target price increases to $46.00 from $43.00. Similar to Rogers we now use 8.9x for wireless (up from 8.5x). For wireline at TELUS, we are now using 7.4x 2017E EBITDA (up from 7.0x), with our base multiple (preadjustment for rates) of 6.0x being below that of Rogers/Shaw cable at 6.5x owing to both the lack of FCF from this segment at TELUS and our view that the cablecos enjoy superior broadband economics (no need for hefty FTTH capex to deliver 1 Gbps). Shaw: Our target price increases to $31.00 from $28.00. Similar to Rogers, we now use 7.9x for cable (up from 7.25x). For the business telecom and data centre operations, we continue to use 9.5x 2017E EBITDA as these higher growth segments generate less FCF today and therefore we do not believe that more of a premium for low interest rates is justified. There is also no change in our DCF-based valuation for WIND as we do not want to change the terminal value assumptions in 2022 based on the interest rate environment today. Also note that about $1.00 of the increase in our target price for Shaw relates to an error in our model where we had doublecounted $400 million of spectrum purchases within our debt forecast. Other cable/telco names: Given that we are restricted on BCE and MTS, the only two cable/telco stocks under coverage that are not being affected by our valuation changes today are Quebecor and Cogeco. In both cases, we believe that the dividend yields and liquidity are too low for investors to use these stocks as alternatives to bonds in their portfolio; as such, we cannot justify a more direct linkage between interest rates and our target prices at this time. If these companies implement much higher dividends in the future, then we might reconsider our view. Alternatively, if larger-cap comps consistently trade at higher multiples (in part because of low rates), then there could be an upward bias to our target multiples over time even if dividend yields remain relatively low. Page 2 of 7
Exhibit 2. Target Price Sensitivity to 10-year GOC Rate Current Implied Targets at Different Rates Target* 2.0% 3.0% 4.0% Rogers $64.00 $60.00 $53.00 $46.00 TELUS $46.00 $43.00 $37.00 $31.00 Shaw $31.00 $29.00 $27.00 $24.00 * Ascribed multiples based on forecast 10yr GOC rate of 1.40% Source: TD Securities Inc. estimates Exhibit 3. Historical EV/EBITDA Multiples across 10-year GOC Rate Buckets 10yr GOC Range Source: TD Securities Inc. Average Low* High** Data Points 0.5% to 1% 7.87 7.87 7.88 2 1% to 1.5% 7.40 6.85 7.90 241 1.5% to 2% 6.88 5.94 7.80 504 2% to 2.5% 6.66 6.00 7.22 422 2.5% to 3% 6.56 6.16 6.99 224 3% to 3.5% 6.16 5.83 6.60 266 3.5% to 4% 6.10 5.90 6.41 51 10yr GOC Range Average Low* High** Data Points 0.5% to 1% 8.07 8.06 8.07 2 1% to 1.5% 7.90 7.60 8.39 241 1.5% to 2% 7.29 6.44 8.30 504 2% to 2.5% 7.03 6.07 8.05 422 2.5% to 3% 6.51 5.49 7.52 224 3% to 3.5% 5.53 4.86 6.08 266 3.5% to 4% 5.08 4.92 5.20 51 10yr GOC Range RCI.B (1) EV/ EBITDA Multiple T (1) EV/ EBITDA Multiple SJR.B (1) EV/ EBITDA Multiple Average Low* High** Data Points 0.5% to 1% 7.11 7.06 7.28 2 1% to 1.5% 7.54 6.99 8.17 168 1.5% to 2% 7.12 6.30 8.27 502 2% to 2.5% 7.04 6.23 7.87 398 2.5% to 3% 7.09 6.60 7.62 224 3% to 3.5% 6.73 6.42 7.19 266 3.5% to 4% 7.04 6.75 7.49 51 (1) Data from January 2010 to present using TD estimates * 5% percentile value to exclude outliers ** 95% percentile value to exclude outliers Page 3 of 7
Exhibit 4. TD Securities: Telco/Cable Comp Table Source: Capital IQ, company reports, TD Securities Inc. Curr. Div EV/EBITDA P/E P/FCF Company Symbol Price Yield Mkt Cap 2014A 2015A 2016E 2017E 2014A 2015A 2016E 2017E 2014A 2015A 2016E 2017E Canadian Telecom BCE BCE $62.94 4.3% --------------------------------------------------------- RESTRICTED --------------------------------------------------------- TELUS T $44.01 4.2% $26,186 8.7x 9.0x 8.6x 8.1x 18.5x 17.2x 17.9x 17.5x 25.6x 24.6x 35.4x 22.6x MTS MBT $38.53 3.4% --------------------------------------------------------- RESTRICTED --------------------------------------------------------- Rogers Communications RCI.B $57.44 3.3% $29,863 8.4x 8.5x 8.3x 7.9x 19.4x 19.9x 19.4x 18.6x 20.6x 17.7x 17.7x 16.8x TeraGo TGO $5.44 0.0% $80 6.6x 6.5x 6.1x 5.3x nmf nmf nmf 101.7x 63.3x 12.0x 19.2x 16.0x Average (Ex-TeraGo) 8.5x 8.7x 8.4x 8.0x 19.0x 18.6x 18.6x 18.0x 23.1x 21.1x 26.5x 19.7x U.S. Telecom AT&T T $42.38 4.5% $262,332 8.2x 8.1x 7.1x 6.7x 16.9x 15.6x 14.8x 14.1x 26.5x 16.5x 15.1x 14.3x Verizon VZ $54.81 4.1% $223,899 7.3x 7.1x 7.1x 6.9x 16.4x 13.7x 14.0x 13.6x 16.7x 10.6x 15.0x 13.9x Sprint S $6.25 0.0% $24,825 n/a 9.1x 6.9x 5.8x n/a n/a n/a n/a n/a n/a n/a n/a T-Mobile USA TMUS $44.98 0.0% $38,655 10.3x 8.1x 6.7x 5.6x n/a 54.9x 38.0x 23.4x n/a 56.0x 21.4x 11.6x Average 8.6x 8.1x 6.9x 6.2x 16.6x 28.1x 22.3x 17.0x 21.6x 27.7x 17.2x 13.3x Canadian Cable Shaw Communications SJR.B $26.34 4.5% $12,737 7.3x 7.6x 7.6x 7.3x 14.1x 15.6x 23.6x 21.4x 27.1x 24.5x 33.2x 26.5x Cogeco Communications CCA $64.13 2.4% $3,207 6.5x 6.7x 6.2x 5.7x 13.3x 13.3x 12.4x 11.3x 11.4x 11.0x 11.8x 9.4x Quebecor Inc. QBR.B $39.63 0.5% $5,727 6.0x 6.8x 6.6x 6.1x 26.2x 22.3x 17.9x 14.6x 33.5x 29.4x 30.9x 16.4x Average 6.6x 7.0x 6.8x 6.4x 17.9x 17.1x 18.0x 15.7x 24.0x 21.6x 25.3x 17.4x U.S. Cable/International Cable Comcast CMCSA $67.18 1.6% $165,397 9.0x 8.7x 8.2x 7.7x 22.9x 20.7x 19.0x 17.2x 20.3x 16.1x 18.4x 16.6x Charter Communications CHTR $237.98 0.0% $73,964 nmf nmf 9.9x 7.2x n/a n/a nmf 47.0x n/a n/a 18.1x 12.8x Cable ONE CABO $526.16 0.3% $3,057 11.7x 11.0x 10.2x 10.1x n/a 34.2x 26.9x 26.5x n/a 33.9x 22.2x 21.7x Average 10.3x 9.9x 9.4x 8.3x 22.9x 27.5x 23.0x 30.2x 20.3x 25.0x 19.6x 17.0x Other Names Under Coverage Thomson Reuters TRI $57.50 3.1% $46,648 14.1x 13.4x 11.7x 11.2x 27.9x 23.4x 21.0x 17.7x 24.4x 19.0x 19.6x 17.4x Sirius XM Canada XSR $4.73 8.9% $608 9.1x 9.5x 9.0x 7.7x 78.8x nmf 12.1x 15.8x 16.7x 11.0x 11.9x 9.3x Corus Entertainment CJR.B $12.74 8.9% $1,995 6.4x 6.4x 7.9x 7.5x 7.2x 8.1x 12.7x 10.6x 6.2x 5.6x 8.1x 8.7x TVA Group TVA.B $4.22 0.0% $164 9.5x 4.7x 4.6x 3.6x nmf nmf 13.6x 7.7x 23.1x 2.5x nmf 15.2x DHX Media DHX.B $7.15 0.9% $932 23.5x 12.6x 10.5x 9.9x 71.5x 23.1x 20.4x 21.7x nmf 39.5x n/a 29.8x Torstar TS.B $1.66 15.7% $133-0.7x 0.0x 0.1x 1.1x 2.9x nmf nmf nmf 3.2x 20.0x nmf nmf Yellow Pages Y $19.29 0.0% $660 3.3x 3.8x 3.8x 3.4x 4.9x 8.0x 8.6x 7.6x 8.1x 5.0x 5.7x 5.5x Page 4 of 7
Exhibit 5. Communications: Justification of and Key Risks to Target Prices Company Name and Target Risk Rec. Ticker Price Rating Justification of Target Price Key Risks to Target Price TELUS Corp. (T-T) $46.00 HOLD MEDIUM We are using 8.9x 2017E wireless EBITDA and 7.4x 2017E wire line EBITDA, to derive our target price. Our $46.00 target price equates to 8.4x consolidated EBITDA and 18.3x EPS in 2017. Increased competition among the three wireless carriers in Canada; Aggressive pricing or promotions by new wireless entrants; Irrational capex spending on wireless infrastructure, or TELUS s IP network could compromise the company s FCF; Misguided or over-priced acquisitions; Regulatory changes could negatively impact TELUS s operations; Aggressive pricing or promotions from cable providers could impact TELUS wireline profits; As an income vehicle for some investors, higher interest rates would reduce the attractiveness of the company's dividend; An increase in scientific evidence about health risks from radiofrequency signals produced by wireless devices or transmission towers could negatively affect results and/or expose the company to legal claims. Shaw Communications Inc. (SJR.B-T) $31.00 BUY MEDIUM We believe that a segmented valuation is necessary for Shaw owing to the long-term investment cycle for wireless, and owing to the ownership of Corus shares that will not contribute to consolidated EBITDA. In our NAV, we use a 7.9x EBITDA multiple for consumer, 9.5x for Shaw Business (including ViaWest), and a DCF for the wireless business. 1) An increase in OTT disruption; 2) more aggressive TV/Internet pricing by ILECS; 3) execution risk in wireless, which is a new business for Shaw and one which can involve heavy capex and start-up losses; 4) subordinate voting share structure: as with all companies where voting control is not in the market, the controlling shareholder (Shaw family controls 80% of votes) and minority shareholders may not agree on issues that could affect the value of shares held by the minority; 5) increased video cord cutting or shaving by consumers; and 6) as an income vehicle for some investors, higher interest rates would reduce the attractiveness of the company s dividend. Rogers Communications Inc. (RCI.B-T) $64.00 BUY MEDIUM Our target price is based primarily on EV/EBITDA multiples. We use 8.9x 2017E EBITDA for wireless and 7.9x for cable and media to derive our target price. 1) Changes in the regulatory or competitive environment could negatively impact profitability at Rogers Wireless; 2) Increased wireless competition from Bell/TELUS or recapitalized new entrants; 3) accelerated fibre deployments by Bell; 4) Rogers could overpay for an acquisition; 5) some segments of Rogers could be negatively impacted by a prolonged economic downturn; 6) heavier than expected capex; 7) subordinate voting share structure: as with all companies where voting control is not in the market, the controlling shareholder (the Rogers family controls 90% of votes) and minority shareholders may not agree on issues that could affect the value of shares held by the minority; 8) as an income vehicle for some investors, higher interest rates would reduce the attractiveness of the company's dividend; and 9) an increase in scientific evidence about health risks from radiofrequency signals produced by wireless devices or transmission towers could negatively affect results and/or expose the company to legal claims. Source: TD Securities Inc. estimates Page 5 of 7
Industry Note Equity Research July 27, 2016 July 27, 2016 TD Securities Equity Research Disclosures Distribution of Research Ratings^ Investment Services Provided* 75% REDUCE - 3.8% 62.84% BUY - 56.0% 50% 34.97% 25% HOLD - 40.1% 0% 2.19% BUY HOLD REDUCE Definition of Research Ratings ACTION LIST BUY: The stock's total return is expected to exceed a minimum of 15%, on a risk-adjusted basis, over the next 12 months and it is a top pick in the Analyst's sector. BUY: The stock s total return is expected to exceed a minimum of 15%, on a risk-adjusted basis, over the next 12 months. SPECULATIVE BUY: The stock's total return is expected to exceed 30% over the next 12 months; however, there is material event risk associated with the investment that could result in significant loss. HOLD: The stock s total return is expected to be between 0% and 15%, on a risk-adjusted basis, over the next 12 months. TENDER: Investors are advised to tender their shares to a specific offer for the company's securities or to support a proposed combination reflecting our view that a superior offer is not forthcoming. REDUCE: The stock s total return is expected to be negative over the next 12 months. Overall Risk Rating in order of increasing risk: Low (7.4% of coverage universe), Medium (35.6%), High (43.0%), Speculative (14.0%) Research Dissemination Policy TD Securities makes its research products available in electronic and/or printed formats and as soon as practicable distributes them to its institutional clients who are entitled to receive them. The Action Notes are distributed by email, and are available in PDFform on Thomson Reuters, Bloomberg, S&P Capital IQ and FactSet. Research Reports are distributed by email; they are also printed and distributed by courier to our entitled clients. PDFs of Reports are available on Thomson Reuters, Bloomberg, S&P Capital IQ and FactSet. 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