DBRS Downgrades Shaw Communications Inc. to BBB (low) and Pfd-3 (low), Stable Trends

DBRS Limited (DBRS) has today downgraded Shaw Communications Inc.’s (Shaw or the Company) Issuer Rating and Senior Notes rating to BBB (low) from BBB and its Preferred Shares rating to Pfd-3 (low) from Pfd-3. The trends are Stable. This action follows the closing of the Company’s acquisition of WIND Mobile Corp. (WIND) and the announcement to sell its broadcasting subsidiary, Shaw Media Inc. (Shaw Media) to Corus Entertainment Inc. (Corus). The rating action is caused by a gradual erosion in the core cable business owing to persistent subscriber weakness and the expectation that the recent transactions will result in a material weakening of Shaw’s free cash flow profile over the near to medium term.

The revised ratings reflect the Company’s position as the incumbent cable operator in Western Canada and its exposure to faster-growing data services, while also considering intensifying competition, structural trends affecting wireline operations as well as risks associated with technological and regulatory changes.

On December 17, 2015, DBRS placed Shaw’s ratings Under Review with Negative Implications following the Company’s agreement to acquire WIND for $1.6 billion. Shortly thereafter, on January 13, 2016, the Company agreed to sell Shaw Media to Corus for $2.65 billion. Shaw will receive approximately $1.8 billion in cash (net of taxes and fees) and an equity consideration of $800 million or roughly 71 million Corus Class B Non-Voting Shares (Corus shares). As such, the Company will own roughly 38% of Corus’s outstanding shares and will retain three seats on Corus’s board of directors. Additionally, Shaw has agreed to participate in Corus’s dividend reinvestment program and a 100% lockup of the Corus shares for at least 12 months after the transaction’s close, with specific sale restrictions thereafter.

Since then, DBRS notes that the Company has closed the WIND acquisition (announced on March 1, 2016) using a combination of its committed bridge facility, balance-sheet cash and borrowings under its credit facility. Furthermore, DBRS notes that, on March 9, 2016, Corus’s minority shareholders approved its acquisition of Shaw Media; however, this latter deal is still awaiting regulatory approval. The divestiture of Shaw Media to Corus is expected to be completed in Q3 F2016.

DBRS Analysis

(1) Business Risk Profile
DBRS notes that Shaw’s earnings profile has been under pressure for some time, owing to continued technological substitution of phone and cable services, increased competition from TELUS Corporation’s (TELUS) Internet protocol television (IPTV) offering and, more recently, economic softness in Alberta, regulatory-driven headwinds. Subscriber erosion accelerated in F2015, with a 3.2% decline recorded in total revenue generating units following a 0.8% decline in F2014. As such, Shaw has had to rely more heavily on price increases to drive earnings growth within its wireline business amid an increasingly competitive telecommunications market. Organic growth was weak in F2015, with much of the revenue and EBITDA increases (4.7% and 5.2%, respectively) attributable to the full-year inclusion of ViaWest. DBRS believes that, independent of the recent transactions, because of mounting pressures on subscribers and expectations of less predictable and potentially more strained organic earnings going forward, Shaw is more appropriately placed in the BBB (low) rating category.

That said, DBRS acknowledges that this transaction allows Shaw to enter into the strategically important wireless market in a prudent manner relative to alternatives, such as a greenfield build-out. WIND is Canada’s fourth-largest wireless carrier, with roughly 940,000 subscribers in Q3 2015. It has captured roughly 300,000 net additions over the past two years and is active in highly populated urban centres, with 75% of its subscriber base located in Southern Ontario and the remainder split fairly evenly between B.C. and Alberta (with combined market share of 5% in these regions). WIND is expected to have generated revenues of $485 million and EBITDA of $65 million (an EBITDA margin of roughly 13%) in 2015.

With the acquisition, Shaw gains a valuable portfolio of 50 megahertz (MHz) of mid-band spectrum (20 MHz of AWS-1 and 30MHz of AWS-3) in each of WIND’s operating regions at a cost of roughly $1.06 per MHz-POP (lower than recent spectrum transactions). Shaw will be able to offer quad-play product bundles to existing customers in Alberta and B.C., thereby allowing the Company to better compete with regional rival, TELUS, and possibly reduce churn. Further, it provides access to WIND’s 300+ points of distribution, nearly three quarters of which is located in Ontario, thus allowing Shaw to expand in scale beyond its traditional Western Canada base. Additionally, DBRS notes that the Company will acquire a considerable amount of potential tax pools, which can be used to lower future tax liabilities.

While WIND’s growth characteristics are attractive, DBRS notes that WIND is at a nascent stage. WIND currently operates a 3G wireless network, which is of lower quality (marked by more dropped calls, poorer service quality inside buildings and patchy network coverage) than the largely 4G LTE networks operated by the Canadian wireless incumbents (Rogers, TELUS and Bell). The more limited capacity of its existing infrastructure and relatively inferior network performance have led WIND to pursue an unlimited usage, low-cost packages and pricing model with blended average revenue per user (ARPU) of $35.81 in Q3 2015, notably lower than the roughly $60 APRU levels of the wireless incumbents. Additionally, WIND’s existing infrastructure precludes it from offering certain popular handsets, such as the newest Apple iPhone models.

That said, WIND has a network agreement in place with Nokia Corporation to upgrade its network to 4G LTE at an incremental cost of $250 million by the end of 2017; however, DBRS believes that much of the above-noted benefits and potential operating leverage will be crystalized only once the 4G LTE roll-out is complete. In the meantime, DBRS expects competitive intensity in the Canadian wireless market to remain elevated and incumbent wireless operators, which control roughly 90% of the Canadian wireless market (with over 8 million customers each), will likely act to protect their market share, especially given the ongoing maturation and slowing wireless penetration in Canada.

In terms of the Shaw Media divestiture, the sale will result in a material reduction in the Company’s operating income and cash generation (Shaw Media represented roughly 20% and 14% of revenue and EBITDA, respectively, and had a capital intensity ratio of 11% in F2015). The combined effect of these transactions will result in an entity with over 70% exposure to consumer wireline, along with some exposure to faster-growing data services business (wireless and ViaWest and broadband Internet). In terms of operating margins, DBRS expects the EBITDA margins to decline to within the 41% range from the 43% range by F2017.

(2) Financial Risk Profile
In terms of financial profile, DBRS expects leverage to be reasonable for the revised rating category. As proceeds from the sale of the media assets will be used to pay for the WIND transaction, Shaw will not be required to raise additional debt financing. Pro forma total debt is expected rise to $5.9 billion by year-end F2016 from $5.7 billion in F2015, but this is because of a recent debt-financed tuck-in acquisition by ViaWest. EBITDA, however, is expected to decline with the divestiture of Shaw Media’s operating income and the modest contribution of WIND. As such, pro forma gross debt to EBITDA is expected to peak at roughly 2.8 times (x) by year-end F2017 from 2.4x in the last 12 months Q1 F2016. DBRS notes that the Company has reiterated its long-term target of net debt-to-EBITDA of between 2.0x and 2.5x.

In its January 13, 2016, press release, DBRS noted that the loss of Shaw Media’s material cash-generating capacity, in conjunction with the inclusion of the negative free cash flow wireless and the ViaWest business, will result in free cash flow (after cash dividend payments) turning negative until F2018. DBRS believes that this signals a diminishing of Shaw’s financial flexibility and will make it difficult for the Company to achieve its deleveraging targets without meaningful growth in operating income over the medium term. In fact, Shaw may increase the use of its recently upsized credit facility (to $1.5 billion) to finance any free cash flow shortfall.

With respect to the Company’s equity stake in Corus, DBRS does not attribute significant benefit from the equity income and future cash dividend payments to the credit risk profile. Instead, DBRS views this equity stake as providing a future source of capital if required, particularly after the 12-month lock-up period.

(3) Outlook
Going forward, DBRS believes that the Company will continue to be pressured by broader trends of technological substitution of home phone services as more consumers opt for mobile-only services. On the video side, IPTV competition along with structural trends of cord-shaving and, to a lesser extent, cord cutting in favour of over-the-top services pose mounting challenges to cable operators. Further exacerbating this is the uncertainty associated with how consumers will react to ongoing regulatory changes (skinny basic and pick and pay) though, admittedly, this will affect content providers more than TV distributors. Furthermore, DBRS notes that integrating WIND’s operations, completing the 4G network build and executing on a strategy to raise wireless ARPU over time entails considerable implementation risk. As such, DBRS will continue to pay particular attention to subscriber trends, customer adoption of new product launches and the competitive landscape in Western Canada, especially in light of the current economic slowdown in the Alberta market.

Over the longer term, DBRS believes that additional investments will be required in the wireless business, both in terms of maintenance capex and, more crucially, additional spectrum acquisitions for WIND to build a network of sufficient quality and scale to truly compete with the incumbent wireless operators. DBRS believes that sustained subscriber erosions in the core cable business resulting in weaker-than-expected operating performance, a longer-than-expected period of negative free cash flow after dividends and/or large debt-financed investments would likely result in downward pressure on the ratings. Otherwise, DBRS generally believes that a gross debt-to-EBITDA ratio between 2.5x and 3.0x would be sufficient for the Company to maintain an investment-grade rating at the BBB (low) level (without inclusion of the any equity income/dividends received in Shaw’s EBITDA) because of the potential source of capital provided by the Corus shares. Should the Company divest of its Corus holding in the future, DBRS would expect some level of reduction in debt burden (i.e., lower than 2.5x) to maintain the current ratings.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodologies are Rating Companies in the Communications Industry, Rating Companies in the Television Broadcasting Industry and Preferred Share and Hybrid Criteria for Corporate Issuers, which can be found on our website under Methodologies.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

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