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Cogeco Communications (OTCPK:CGEAF) (TSX: “CCA”) is likely to experience a valuation below its long-term average in the near term due to 1) slower Internet subscriber growth in a post-COVID world; 2) Free cash flow decrease due to significant network expansion investment projects; and 3) above the level of debt, which limits growth from the acquisition strategy. Although its shares are currently trading below their long-term average, we believe there are better opportunities elsewhere.
Yield and growth analysis
Key Growth Drivers Slowdown and Decline
It is well known in the communications industry that the primary growth driver comes from the growth in Internet subscribers and the need to increase their speed and bandwidth. In the past, this growth in the Internet segment has always helped to offset the structural decline in the telephony and cable TV business. However, the pull-forward effect that accelerated the growth of the Internet segment appears to have finally come to an end. As can be seen in the chart below, Internet subscriber growth in Canada slowed to approximately 2,463 new additions in Q1 2023.
Created by the author
Additionally, its American Internet subscribers suffered the same headwinds that its Canadian segment endured. The headwinds were much more severe due to the residual impact of migrating Ohio’s customer management and billing systems in late May 2022. As a result, Q1 F2023 subscriber additions were minus 14,173 (see chart below). While we expect the remaining impact to eventually wear off, the strong growth Cogeco once experienced during the COVID lockdowns is unlikely to recur anytime soon. Demand for internet and higher speeds will continue to support revenue growth over the long term.
Created by the author
Grid expansion will likely depress free cash flow (FCF).
Despite expected near-term slower growth, the company still generates excess operating cash flow. However, the company is in the midst of a capital-intensive project to expand its network. As such, its FCF has decreased nearly 13% in fiscal 2022 due to $157 million in capital investments. In fiscal 2023, management expects its capital investments to be between $180 million and $230 million. Therefore, his FCF will decrease by about 2% to 12% in F2023. As such, we don’t think the company has the ability to spend much of its cash on share buybacks, which it has historically done.
Q1 F2023 Investor Presentation (Company Website)
Cogeco’s leverage is increased
In recent years, Cogeco has implemented its expansion strategy through a combination of organic growth and acquisitions. The acquisition strategy is advantageous as it can lead to operational synergies. However, the debt-to-EBITDA ratio of 3.3x is at the high end of the 10-year range. Its debt ratings of BBB- and BBB (low) from S&P Global and DBRS, respectively, are borderline investment grade. As a result, the company likely won’t be able to make any major acquisitions to expand its business unless it wants to risk falling into sub-investment-grade ratings.
corporate website
Valuation Analysis
Cogeco is currently trading at an EV to EBITDA ratio of 5.9x. This is lower than the average of 7.2x it has had over the past 3 years. Its current EV-to-EBITDA ratio is also lower than 7.4 times that of its cable competitor Quebecor (OTCPK:QBCRF). As such, we believe Cogeco is now undervalued relative to its peers. The share price has likely already discounted its weak near-term growth potential and declining FCF. This short-term weakness is likely to continue for a while, however, as major shareholder Rogers Communications (RCI) is nearing the end of its merger with Shaw Communications (SJR), and as such may decide to sell some of its stake in Cogeco.
YCharts
risks and challenges
A key risk that investors in Cogeco need to be aware of is the impact of rising inflation on its operations and stock price. Inflation can lead to higher capital expenditures than originally expected. This can result in lower free cash flow in the short term. Inflation can also lead to higher labor costs and further increase operating costs, thus reducing operating margin.
The Bank of Canada’s efforts to tame inflation will result in expected higher Treasury yields. This will weigh on Cogeco’s valuation, especially given that its stock price is often inversely correlated with government bond yields.
Investor Takeaway
Cogeco currently appears to be trading at a discount. However, this discount is not unjustified as near-term growth prospects appear weak. As of this writing, as people move again (e.g. travel, immigration, international students, etc.), we favor communications companies with a higher percentage of revenue from wireless services. Unfortunately, Cogeco is not present in the mobile market and cannot benefit from the reopening of the economy. As such, we believe the near-term weakness could continue for a while. Investors should instead look to other communications companies, particularly those with a higher percentage of wireless revenue.
Editor’s note: This article covers one or more securities that are not traded on a major US exchange. Please be aware of the risks associated with these stocks.
Source: seekingalpha.com
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