Investors May Want To Look For Other Opportunities (TSX:CCA:CA)

Investment Thesis

Cogeco Communications (OTCPK:CGEAF) (TSX: “CCA”) is likely going to experience lower valuation than its long term average in the near-term due to 1) slower Internet subscribers growth in a post-COVID world; 2) free cash flow declining due to significant capital investment projects to expand its network; and 3) above debt level that will limit its growth by acquisition strategy. Although its shares are currently trading below its long-term average, we think there are better opportunities elsewhere.

Earnings and Growth Analysis

Main Growth Driver Decelerating and Declining

It is widely known in the communications industry that the primary growth driver comes from Internet subscribers growth and the need to increase its speed and bandwidth. In the past, this growth in Internet segment has always helped to offset the structural decline in telephony and cable TV businesses. However, it appears that the pull-forward effect that has accelerated the Internet segment growth has finally come to an end. As can be seen from the chart below, its Internet customer growth in Canada has decelerated to about 2,463 adds in its Q1 F2023.

Moreover, its American Internet subscriber adds also endured the same headwind its Canadian segment endured. The headwind was much more severe due to the residual impact of the customer management and billing systems’ migration in Ohio in late May 2022. As a result, its subscriber adds were negative 14,173 in Q1 F2023 (see chart below). While we think the residual impact will eventually subside, the strong growth Cogeco has once enjoyed during COVID lockdowns will likely not reappear in the near term. The demand for Internet and higher speed will continue to support its growth in revenue in the long-term.

Network expansion will likely suppress its free cash flow (FCF)

Despite slower growth anticipated in the near-term, the company still generates excess operating cash flows. However, the company is in the midst of a capital intensive project to expand its network. Hence, its FCF has declined by nearly 13% in F2022 due to C$157 million of capital investment. In F2023, management expects its capital investment to be in the range of C$180 ~ C$230 million. Hence, its FCF will decline by about 2% ~ 12% in F2023. Therefore, we do not think the company is able to spend a lot of its cash on share buybacks that it once did in the past.

Cogeco’s leverage is elevated

In the past few years, Cogeco has been executing its expansion strategy through a combination of organic growth and acquisitions. Its acquisition strategy is beneficial as it can result in operational synergies. However, its debt to EBITDA ratio of 3.3x is towards the high end of the range in the past 10 years. Its debt ratings of BBB- and BBB (low) by S&P Global and DBRS respectively are at the borderline of investment grade rating. Hence, the company will likely not be able to pursue any major acquisitions to expand its business, unless it wishes to risk falling into non-investment grade ratings.

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 enjoyed in the past 3 years. Its current EV to EBITDA ratio is also lower than its cable peer Quebecor’s (OTCPK:QBCRF) 7.4x. Therefore, we believe Cogeco is now undervalued compared to its peers. Its share price likely already discounted its weak near-term growth potential and declining FCF. However, this near-term weakness will likely continue for a while given that its major shareholder Rogers Communications (RCI) is near the end of its merger with Shaw Communications (SJR) and hence may elect to sell some portion of its stake on Cogeco.

Risks and Challenges

One major risk that investors of Cogeco need to be aware is the impact of rising inflation on its operations and the share price. Inflation may result in higher capital spendings than originally anticipated. It can result in lower free cash flow in the near-term. Inflation can also result in higher labor cost and further increase its operating expenses and thus reduce its operating margin.

The effort to tame inflation by Bank of Canada will result in anticipated higher treasury yield. This will weigh on Cogeco’s valuation, especially because its share price is often inversely correlated to the government’s treasury yield.

Investor Takeaway

Cogeco appears to be trading at a discount right now. However, this discount is not unwarranted as its near-term growth outlook appears to be weak. At this point in time, we prefer communication companies with higher percentage of revenue on wireless services as people start to move again (e.g. travel, immigration, international students, etc.). Unfortunately, Cogeco does not have a presence in the wireless market and cannot reap the benefit of the reopening of the economy. Therefore, we think near-term weakness may continue for a while. Investors may want to research on other communication companies instead, especially on companies with higher proportion of wireless revenue.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.