Trust Fever Spurs These Telecom Stocks

Both BCE and Telus have unveiled plans to convert into income trusts, which helped spark a rise in their stock prices. Canada’s other big telecom company, Manitoba Telecom, moved up on rumors that it too would convert.

The trust structure will let BCE and Telus avoid a big tax increase in the next few years as certain tax shelters expire.

But investors have higher payout expectations of a trust compared with a regular company. Telecom companies must invest large sums in new equipment, or risk losing customers. These costs could hurt BCE’s and Telus’s ability to raise future cash distributions.

The temptation to fund new investments by selling more units could also hurt the value of the existing units.

Other risks include deregulation of the phone industry, which has already eroded the core business of these three companies. Concerns over lost tax revenue from big corporations like BCE could prompt the government to change the way it taxes cash distributions.

We feel the gains from converting to a trust outweigh these risks, and see all three telecom stocks as buys for long-term gains.

BCE INC. $33 (Toronto symbol BCE; Conservative Growth Portfolio, Utilities sector; SI Rating: Above average) is Canada’s largest provider of traditional telephone services, with over 12 million customers in Ontario and Quebec. It also provides Internet access (Sympatico), satellite TV (Bell ExpressVu) and wireless services (Bell Mobility).

In the past few months, the company has moved to unlock some of its value. It recently sold most of its interest in Bell Globemedia, the private company that owns The Globe and Mail and CTV Television. BCE also plans to sell a minority stake in satellite operator Telesat to the public.

In July 2006, BCE merged its rural telephone business with 53.2%-owned subsidiary Aliant Inc. into a new income trust called Bell Aliant Regional Communications Income Fund.

BCE now plans to eliminate its holding company structure, and convert its remaining operations into a trust early next year.

Each shareholder will receive one unit of the new Bell Canada Income Fund for each share held. The trust will pay an initial annual cash distribution of $2.55 a unit (7.7% yield), up from BCE’s current $1.32 dividend (4.0% yield). Investors will be liable for capital gains taxes on the conversion.

Thanks to its recent moves, BCE will soon get over half of its revenue from faster-growing businesses such as wireless. That should give it plenty of cash to fund capital spending and distributions. The company also plans to redeem all of its preferred shares, which should also help free up cash.

BCE still aims to cut its annual expenses by $2 billion. In the three months ended June 30, 2006, this plan saved it $172 million. If you exclude restructuring and other one-time items, BCE’s earnings in the latest quarter fell 6.9%, to $0.54 a share (total $482 million) from $0.58 a share ($538 million) a year earlier. (These figures include the assets transferred to Bell Aliant.) Revenue crept up to $4.8 billion from $4.76 billion.

The stock gained 5% on the Bell Canada trust announcement, and now trades at 17.4 times the $1.90 a share its should earn this year.

BCE is a buy.

TELUS CORP. (Toronto symbols T $62 and T.A $62; Conservative Growth Portfolio, Utilities sector; SI Rating: Above average) is the main provider of telephone service in Alberta, British Columbia and parts of Quebec, with roughly 4.5 million customers. It also operates a national wireless service under the Telus Mobility banner.

Back in October 2000, Telus acquired wireless provider Clearnet Communications Inc. This gave Telus an instant national network, and let it avoid having to build its own network from scratch. Demand for wireless services has soared since the acquisition, and now supplies half of Telus’s revenue and two-thirds of its cash flow.

Along with the Clearnet business, Telus acquired substantial tax loss carryforwards, which is could use to offset its taxable income. However, the company is now close to using up all of the tax loss carryforwards. Rather than let its tax rate shoot up, the company unveiled plans in September to convert itself into an income trust. The stock shot up on the news.

The plan calls for each common and class A non-voting share to become one trust unit. The new trust will have a single class of units, which will improve liquidity.

Telus’s current annual dividend of $1.10 yields 1.8%. After its trust conversion, it plans to distribute about 90% of its cash flow, which implies an initial annual payout of about $4.00 a unit, for a 6.5% yield.

Telus feels it will generate enough cash to increase the payout. However, a high payout could hinder its ability to expand.

The trust conversion will trigger a capital gain. However, Telus may give investors the option of taking new securities that are convertible into units. Investors would only be liable for capital-gains taxes when they sell these exchangeable securities.

Telus is a buy.

MANITOBA TELECOM SERVICES INC. $49 (Toronto symbol MBT; Conservative Growth Portfolio, Utilities sector; SI Rating: Average) is the leading provider of telecom services in Manitoba, with 1.8 million customers. It also provides telecom services to businesses across Canada through its MTS Allstream division.

Manitoba Tel acquired Allstream in 2004 as way to cut its reliance on residential customers in a single province. However, the business telecom market is extremely competitive, and Allstream has not been as profitable as the company hoped.

Based on the favourable reaction to BCE’s and Telus’s trust conversion plans, it’s more likely that Manitoba Tel will follow the same path. It would probably try to sell or spin off Allstream first, since the division’s uncertain cash flows would limit its appeal as a trust.

If Manitoba Tel decides to hang on to Allstream, however, it can use Allstream’s substantial tax losses to cut its own tax bill until 2014.

In the meantime, Manitoba Tel is focusing on cutting costs. It has already saved $70 million a year, and should reach its goal of $100 million in annual savings by the end of 2007.

Due to restructuring costs, Manitoba Tel lost $0.02 a share (total $1.2 million) in the second quarter of 2006. It earned $1.64 a share ($111.5 million) a year earlier. If you exclude unusual items, per-share income was unchanged at $0.75. Revenue fell slightly, to $500.0 million from $502.2 million, as lower local and long distance revenue offset gains from wireless and Internet access.

In October 2006, Manitoba Tel sold its telephone directories business for $281 million. The sale is a good idea, since this business faces growing competition from Internet search engines.

The company will probably use the proceeds to pay down its long-term debt of $851.4 million (0.6 times equity).

Lower interest charges will help the company maintain its $2.60 dividend, which yields 5.3%. The stock now trades at 18.9 times the $2.59 a share Manitoba Tel should earn in 2006.

Manitoba Tel is a buy.