DBRS Confirms TELUS at A (low) and R-1 (low); Trends Stable

DBRS has today confirmed both the long- and short-term ratings of TELUS Corporation (TELUS or the Company) at A (low) and R-1 (low), respectively, and the Senior Debentures rating of TELUS Communications Inc. (TCI) at A (low). The trends are Stable. The confirmation reflects the Company’s diversified business risk profile, with a focus on its growing wireless and data segments, a competitive residential and enterprise fixed-line operation, strong cash flow from operations generation and a reasonable financial risk profile.

TELUS continues to invest in its wireless and wireline businesses, which, in DBRS’s view, has enhanced its operating position in these highly competitive markets. While DBRS expects TELUS to continue to operate in a competitive landscape for all of its services, its network investments should continue to neutralize or at least mitigate the advantages that the Company’s competitors have had in the past with their networks. However, DBRS notes that following these network deployments, TELUS faces significant customer acquisition and retention costs, which could pressure its EBITDA margins. This will also require additional capex in the short term – for its wireless 4G deployment and to cover improved capacity requirements. This, in addition to a mix shift away from high-margin voice services to newer services such as video, is likely to pressure wireline EBITDA margins over the medium term. Wireless, meanwhile, appears to have stabilized at the 40% level, reflecting higher acquisition costs associated with a focus on postpaid subscribers and smart phones.

TELUS continues to enhance its position in the wireless market in Canada, which, in DBRS’s view, has become polarized with the arrival of new entrants in recent years. TELUS is the third largest wireless carrier in Canada and generates over half of its total revenue and EBITDA from its wireless segment. While the new entrants and the incumbents’ response have pressured wireless voice average revenue per user (ARPU) levels in Canada, the three national carriers, including TELUS Mobility, have with their national and advanced networks (on 3.5G HSPA+ platforms), sought to focus largely on the high end of the market, particularly on smart phones and the associated wireless data revenue. Despite higher subscriber acquisition costs in the near term, this has allowed TELUS to shift its wireless revenue mix to include more data services, allowing it to stabilize blended ARPU levels while keeping blended churn levels reasonable (slightly above the 1.5% per month level, which is strong for a wireless carrier). DBRS notes that TELUS is currently beginning to focus on the deployment of its 4G network (based on the Long-Term Evolution platform, or LTE), which is expected to be launched by early 2012. As a result of these factors, DBRS expects that TELUS should be able to retain wireless EBITDA margins at or above the 40% level over the medium term – healthy for a North American wireless carrier. This level of EBITDA margins, along with very reasonable capital intensity in wireless and more than half of its revenue and EBITDA generated from this segment, supports TELUS’s free cash flow generation.

In the wireline segment, DBRS notes that TELUS continues to face strong cable competition in its incumbent territories for residential and small and medium-sized business customers, in addition to technology substitution (wireless for wireline). Both of these factors continue to reduce TELUS’s access lines, albeit at a declining rate as the addition of video has enhanced its wireline bundles. DBRS believes that by adding video services to its bundle (both Internet Protocol television (IPTV) through Optik TV and satellite television service for other regions), TELUS should be better equipped to compete with cable operators by offering its current and potential subscribers four main services as part of a bundle. This should continue to reduce some of the voluntary access-line erosion caused by cable competition. However, DBRS notes that, just as in the wireless business, adding residential video and high-speed Internet subscribers requires a significant initial investment in terms of acquisition costs (especially in video), a portion of which is both expensed (weighing heavily on EBITDA margins) and capitalized (adding to capex levels). Therefore, DBRS believes that as TELUS continues to load residential video subscribers and lose high-margin voice services while focusing on further efficiency initiatives, its wireline EBITDA margins will likely experience pressure, taking them down to the lower end of the 30% range.

In light of the above dynamics, including continued growth in wireless, data and video, ongoing competition and technology substitution, and higher customer acquisition and retention expenses, DBRS expects that TELUS should be able to modestly improve EBITDA over the next couple of years, toward the $4 billion per year mark (on a DBRS-adjusted basis, which is before restructuring and pension expenses). This level of EBITDA, along with capital intensity returning to more normal levels (mid-to-high teens as a percentage of revenue versus nearly 22% in 2009), is expected to more than cover the Company’s dividend growth as it targets a payout range of 55% to 65% of sustainable earnings. This should result in healthy and steady free cash flow levels of between $300 million and $400 million per year over the next few years. This should give TELUS the flexibility to pursue additional investments such as the likely acquisition of wireless spectrum in the upcoming 700 MHz spectrum auction while keeping leverage within its target range (1.5 times to 2.0 times net debt-to-EBITDA). DBRS also expects TELUS’s coverage metrics to continue to improve modestly (currently above 8.0 times EBITDA and 4.0 times EBIT coverage) in 2012, with lower interest costs and modest EBITDA growth and while cash flow-to-debt improves closer to 0.40 times.

Going forward, DBRS expects the operating environment to remain competitive, but believes that it should be manageable for TELUS even with higher acquisition costs – especially since its network investments should better position its wireless and wireline businesses vis-a-vis competitors. This manageable business risk profile is expected to be accompanied by a steady financial risk profile. Should these expectations for TELUS change as a result of competitive, regulatory or technological changes and/or a change in financial profile, the end-result could be pressure on TELUS’s ratings in the future.

Note:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating Communications, which can be found on our website under Methodologies.