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Archive for January, 2010

When searching for great companies I want to find a company with a history of strong free cash flow generation, high return on equity and a history of consistent and growing dividend payments.   My philosophy is based on ideas taken from The Five Rules for Successful Stock Investing by Pat Dorsey, Director of Stock Analysis at Morningstar (see about me).

In this post I am going to examine the Canadian Telco and Cable sector by analyzing the quality of 4 of the largest companies in the space: Bell, TELUS, Rogers and Shaw. Phone, cable, and internet services are considered staples in most households and as such, should provide stable cash flows to companies providing those services. Additionally, the sector is dominated by large, well established firms and so it would be reasonable to believe that it is a good place to find companies with good return on equity and a history of consistent dividend payment.

Let’s begin with a look at free cash flow (FCF). Specifically, I’m looking for a consistent FCF to sales ratio of over 5% and an ability to maintain that ratio for 10 years or more.  This is indicative of a strong economic moat according to Dorsey.  Table 1 gives the 10 year history of free cash flow and illustrates that all four companies were unable to consistently produce positive free cash flow over this period.  FCF was negative at the turn of the century (2000-2002) due mainly to large capital expenditures incurred while building out high speed internet and cell phone networks. Indeed, large capital spending is an ongoing consideration in this sector given the necessity of maintaining up-to-date data delivery systems on an ongoing basis. The cost of doing this is prohibitive and acts as a major barrier to entry for new competitors, however it also makes consistent generation of free cash flow a challenge. None of the companies have been able to maintain a consistent FCF to sales ratio of over 5% for the last 10 years.  Failure to achieve this key indicator implies the companies being analyzed are less likely to have maintainable competitive advantages.  The returns of the last 5 years however, paint a more promising picture as all companies except Rogers have posted FCF/Sales ratios well above 5% (Rogers has a very good 4 year record but in 2005 only managed a FCF/Sales ratio of -1.69%). Shaw,in particular devotes a section of their annual report to a discussion of their focus on free cash flow generation, which is certainly an encouraging sign. Unfortunately, it is difficult to assume that the 5 year record is an indicator of future performance given the rapid pace of technological change in this industry.  At this point in the analysis, strict adherence to Dorsey’s method would suggest looking elsewhere for safer wide moat companies to invest in. Depending on your appetite for risk however, you may decide that the recent 5 year record will more accurately represent the future performance of these companies.   If this is the case, I would suggest that at the very least a greater margin of safety should be demanded when determining an appropriate purchase price given the uncertainty illustrated by the 10 year record.

A second key indicator is the ability of a company to generate a return on shareholder equity (ROE). According to Dorsey, a good indication of a defensible economic moat is maintenance of an ROE greater than 15% for 10 years or more.   Further, the quality of ROE should be evaluated with respect to the amount of financial leverage used.  In this regard, Dorsey considers any company with financial leverage of 3 or 4 as a red flag.  Table 2 displays the 10 year history of ROE as well as the financial leverage for each company over the same period. Again the 10 year and 5 year pictures tell two different stories. None of the companies have maintained an ROE of greater than 15% for the 10 years, although once again, the 5 year picture is improving. The question becomes whether the 5 year picture represents the future or whether some new event will occur (technological change, new regulatory environment etc) that returns these companies to negative returns on equity. The financial leverage for Bell, TELUS, Rogers and Shaw is 2.7, 2.6, 3.4, and 3.6 respectively.  The degree of leverage for both Rogers and Shaw represents a red flag according to principles set out by Dorsey. While it may be that the stability of the cable business justifies a higher leverage I would again consider a higher margin of safety when determining a purchase price to account for this uncertainty.

Although not a key Dorsey indicator, a record of growing dividend payments is something I look for in a company (see about me).  The record of dividend payment for these companies does not reflect the stable operating cash flow characteristic of the business. In fact, dividend payment is a relatively recent development for Rogers (paid regular dividend since 2003) and Shaw (paid regular dividend since 1998). TELUS cut its dividend in 2002 and did not raise it again until 2005 while Bell cut its dividend in 2000 and again in 2008. Table 3 illustrates the dividend record by giving the 10 year history of dividend payment, dividend increase and payout ratio. The current dividend yields for these companies appear attractive, however the seemingly inconsistent nature of free cash flow and the weak history of maintaining dividend payments make me skeptical of relying on their long-term dividend growth.

Dividend Share Price Yield
Shaw $0.79 $20.81 3.80%
Telus $1.90 $34.32 5.54%
Rogers $1.08 $31.37 3.44%
BCE $1.73 $27.84 6.21%

Note all data is as of 10/1/2010

In conclusion, despite the perception that the Canadian telco/cable sector contains solid companies with stable economic moats, my analysis suggests a number of caveats to consider before making an investment. Namely the requirement to take on large capital expenditures in the face of technological change jeopardizes free cash flow, return on equity and dividend payment. Given this point of view, I would require a significant margin of safety before being comfortable making an investment. In a future post I will take a closer look at the earnings of these companies and give my opinion on their future prospects.

Disclosure – no positions currently held in these companies.

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