S&P Global Ratings believes Canadian telecom operators are pretty well-positioned to withstand the near-term effects of the COVID-19 pandemic with limited impact on credit quality, given the companies' recurring, subscription-based business models and ability to protect free cash flow through the recession. Larger concerns are the Canadian economy slipping into prolonged recession and potentially more pro-competitive regulatory rules that could hurt longer-term profitability. Some of the operators have elevated leverage, which gives them limited cushion to support long-lead investments and their relatively high dividends if the recession is more prolonged. 

As Canada moves to reopen its economy and provinces start to lift social distancing measures, S&P Global Ratings looks at the impact the pandemic has had on Canadian telecom operators and how balance sheets might perform given COVID-19-related revenue pressure and upcoming investments post-pandemic.

Although The Pandemic Will Hurt Revenue Growth, Free Operating Cash Should Support Balance Sheets In the Short Term

Telecom connectivity, as well as information and entertainment services, is proving to be critical for consumers, businesses, and governments in the current environment of social distancing, quarantines, and work-from-home practices, resulting in lower attrition and fewer sales promotions, as well as lower subsidies on wireless devices. In our view, such benefits, combined with other cost-reduction measures, should allow carriers to mitigate the effect on earnings from lower revenue and rising bad-debt accruals.

Wireless revenue and EBITDA will rebound in 2021

We view mobile devices as a necessity for most, and consumers are unlikely to free themselves from what we view as quasi-utility like wireless services. Nevertheless, with store closures in the past few months and economic uncertainty, net subscriber adds will be lower but so too, we expect, will customer attrition (churn will be lower). With reduced points of sales, benign competition, limited sales promotions, arguably lower immigration, and lower equipment revenue (very low margin), combined with increased sales through the higher-margin digital channels, the costs of acquisition and retention are lower in 2020. However, due to the loss of roaming (3%-5%) and overage (3%-5%) fees, on top of average revenue per unit (ARPU) declines following last year's rollout of unlimited plans, we expect some pressure on network revenues. As a result, industry wireless revenues and EBITDA are likely to decline in the mid-single-digit percentage area for 2020, but EBITDA margins might remain mostly unscathed. More important, we anticipate much stronger growth for 2021 and into 2022 from device upgrades, economic recovery, and, ultimately, the rebound of the travel and related sectors.

If the COVID-19 pandemic causes an extended economic downturn, some subscriber growth of the past couple of years could reverse itself, especially if companies reduce headcount to preserve margins, since a portion of postpaid customer growth might have come from enterprises' distribution of second handsets (smartphones and tablets) to their employees for work. A migration to prepaid from postpaid could also emerge as a less favorable outcome. This development could also lead to lackluster subscriber adds and revenue growth down the road.

Chart 1

The pandemic spotlights the value of wireline broadband

Even though social distancing has been disruptive, high-speed internet connections have been critical in allowing people to remain connected, informed, and entertained even while isolating at home, further strengthening the importance of fast and reliable broadband connections. Assuming remote work, including work-from-home options, proves to be more pervasive post-pandemic, fixed-line broadband will become more valuable. As a result, we expect internet adds to increase this year, and carriers to benefit as subscribers move upmarket to more expensive faster internet speed tiers. The average broadband speed is more than 100 megabytes per second (Mbps) in most urban markets, where operators offer at least 1 gigabyte per second. Furthermore, broadband is very high margin, and is also less capital-intensive than video, with strong cash flow conversion characteristics. In recent years, operators have monetized demand by not only increasing penetration but also moving customers to faster-speed tiers and increasing ARPU. With a largely fixed cost base, incremental revenue has dropped to the bottom line, raising estimated broadband EBITDA margins. During the pandemic, companies have also managed to reduce costs with increasing self-installs and accelerating digital self-service adoption by customers. As people stay at home, cord cutting and shaving along with phone subscriber losses are (temporarily) decelerating from their previous pace. However, we expect the impact to be limited because revenue losses from waived overage fees for metered data plans and deferrals from small and midsize businesses (SMBs) struggling through pandemic-related closures.

Internet service is one of the last things consumers are likely to drop due to economic hardship. Nevertheless, S&P Global Ratings believes the risk to wireline comes from its exposure to video, voice, and business customers. If the recession in Canada is prolonged and unemployment remains elevated, cable subscriber losses could mount as consumers aim to reduce costs by switching to cheaper streaming options. In addition, we expect that against a backdrop of low oil prices, the Alberta economy to generate additional headwinds for telecom and cable operators servicing Western Canada. 

Under normal conditions, we would view wireline operators that have a larger exposure to business customers more favorably than providers that focus on the residential segment. However, in a recession that is underpinned by an expanded pandemic cycle, we would expect many SMB customers to close locations and even go out of business. Furthermore, the spread of the coronavirus could accelerate this process because many small businesses have already faced a period of low-to-zero revenues. An extended macroeconomic downturn could even prompt larger business customers to reduce IT spending and installations. Overall, we expect wireline revenue and EBITDA to decline by the low-single-digit percentage area in 2020 but increase by low-single digit percentage in 2021.

Chart 2

Media drag is likely to be the most severe and will take some time to recover

Advertising revenue is also likely to come under pressure as consumers scale back their spending and companies pull back marketing plans in response, although the duration of the economic impact is still uncertain. S&P Global Ratings has forecast about a 20% drop in advertising (excluding digital) in the U.S., ranging from a decline of 13% for total television to about 24% for radio (see "The COVID-19 Fallout Is Squeezing U.S. Advertising Spending More Than Expected," published May 21, 2020, on RatingsDirect) and it believes similar trends will prevail in Canada. The lack of live sports, as many sport leagues head into what would have been the playoff season, will hurt the media revenues of Rogers Communications Inc. in particular, with BCE Inc. somewhat less affected given the diversity of its media portfolio. Even when the situation normalizes, we forecast advertising and sponsor revenue will resume at a slower pace. The lack of sports could accelerate cord cutting, although we anticipate the possibly temporary nature of the pandemic and the inconvenience of reconnecting will prevent large-scale video losses. Given the high flow-through effect of lower advertising revenue, despite cost-mitigation efforts, we expect profitability and cash flows to decline meaningfully for the next few months, stabilizing by late-fall 2020 and rebounding steadily through 2021. However, given operators' limited exposure to media, we don't expect the earnings drag to affect Canadian operators' credit profile.

The Canadian Economy And The Pandemic Will Dictate Revenue Rebound While 5G Investments Could Continue To Pressure Balance Sheets

Because of the pandemic, we now forecast industry revenue and EBITDA will decline by 3%-4% in 2020, but adjusted EBITDA margins will face minimal pressure. Most of the carriers are trying to manage the EBITDA decline by either reducing capital expenditure (capex), pausing dividend increases, or suspending share buybacks. In addition, the carriers have strong access to the capital markets and in aggregate have issued about C$7.5 billion in unsecured debt year-to-date, either to shore up liquidity or to address upcoming maturities. As a result, we expect leverage for most of the Canadian telecom players to remain close to their fiscal 2019 levels.

We forecast revenues to increase in the low-to-mid single digit percentage in 2021, but the risk remains that some of the revenue loss in 2020 is permanent. On April 17, 2020, S&P Global Economics lowered its Canadian GDP forecast to a 5.3% contraction, with further risk to the downside. We generally believe that economic cycles are less likely to affect our ratings on telecom operators. However, an extended macroeconomic downturn and recessionary environment highlight risks beyond the current coronavirus outbreak--lower corporate spending and higher unemployment can drag on revenues for carriers. The recession can hit SMBs earlier, with closures leading to the cancellation of telecom services, or delayed payments that could hinder operator cash flows. For large enterprises, revenue and EBITDA declines stem from deferred or cancelled projects, workforce cuts, and a reduction in associated telecom needs, and a focus on cost cutting. We incorporate more conservative assumptions during recession cycles that could add headwinds to our forecasts, particularly if we further negatively reassess our macroeconomic projections, and assume business cutbacks intensify and consumer spending on telecom services falls.

Layered on top of potentially lower growth for the Canadian telecom industry are upcoming investments in spectrum auctions and 5G infrastructure, which we believe increase the risk that leverage could be elevated for a longer period should weak economic conditions prevail.

Table 1

In our view, the Canadian telecom industry has performed well in light of the service demand changing practically overnight. The waiving of both roaming and overage fees, increasing connectivity, and keeping services running without restrictions or outages have displayed to both the regulators and consumer advocates the benefit of the industry's investment in critical infrastructure and the need to support financially strong carriers. As a result, we believe the relationship between the lawmakers and the carriers could become more constructive or balanced.

Nevertheless, we expect that the Canadian Radio-television and Telecommunications Commission (CRTC) will continue to focus on increasing competition in the Canadian telecom space. The final rates proposed by the CRTC on wholesale internet access services or third-party internet services (TPIA) were significantly lower and are currently under appeal. We also expect the CRTC to rule for wholesale MVNO access with the most likely outcome, in our view, that it opens up the existing infrastructure network to existing regional operators in Canada such as Shaw Communications Inc., Videotron Ltee (a subsidiary of Quebecor Media Inc.), Cogeco Cable, and Eastlink Inc., versus opening it up to new players. The decision is slated for year-end 2020, before the 3.5GHz spectrum auction, but will most likely be pushed back.

On June 5, 2020, Innovation, Science and Economic Development Canada (ISED) delayed the 3.5GHz spectrum auction by six months to June 15, 2021, and stated that it's open to further changes to spectrum auction timelines, if necessary. This could also potentially delay the mmWave spectrum auction, originally scheduled in 2021, and could push 5G spending back several months to a year. The delay in spectrum auctions has therefore added some flexibility to Canadian telecom operators' balance sheets; nevertheless, we have modeled that the carriers, in aggregate, will spend about C$4 billion for the 3.5 GHz spectrum auctions. Historically, spectrum auctions in Canada have been very competitive and prices for similar spectrum are significantly higher (up to 150%) compared with global values – a trend we expect will prevail. In addition, continued investment in 5G, irrespective of a temporary decline in capital intensity for the next two-to-three years, will be a material use of cash for the companies.

Spectrum auction outcomes will affect financial risk assessments on Canadian telecom carriers

Based on our above discussion, we don't foresee any sustained improvement in leverage for Canadian telecom operators. We expect that, at current capital intensity, most of the carriers will be able to fund their network infrastructure investments and dividend payments. Additional share buybacks, spectrum auctions, and mergers and acquisitions opportunities will require capital market access, most likely debt. The major offsetting deleveraging factor for the increased balance-sheet debt is the industry's pace of revenue and EBITDA growth allowing for 0.1x-0.3x annual decline (leverage burn), probably assisted by few noncore asset dispositions.

Should EBITDA growth slow, companies might have to revisit capex or shareholder return plans to protect their financial flexibility. Even though some operators are already scaling back capex, they could reaccelerate spending and quickly catch up to their capex budgets if the economic or regulatory risks abate. Given the size of these budgets (averaging 18%-20% of revenue over the past three years, when including media), even modest reductions could materially support free operating cash flow and financial flexibility. Also, the delay in the spectrum auction (by six months) could provide some breathing room to telecom operators.

Chart 3

In our view, the Canadian telecom story is slowly shifting from a revenue and EBITDA growth narrative over the next few years pending growth in 5G Internet of Things (IoT; as penetration of wireless unlimited plans increases and wireline markets mature) to a cash flow story as capex moderates in the near term and operating expenditure efficiency initiatives bear fruit. As a result, we don't foresee any sustained improvement in leverage for the next two-to-three years.

Will Sustained Leverage On Balance Sheets Lead Canadian Telecom Carriers To Reflect Financial Policy Priorities?

Rating tolerance of wireless spectrum investment is an area of issuer and investor discussion. We acknowledge the importance of access to spectrum licenses for the sustainability and growth of wireless operations. Generally, spectrum can be deployed quickly, aggregated with other spectrum to offer higher throughput often more efficiently than the alternate of splitting cell sites. In most cases, wireless investments are long-lead investments: cash flow or returns are generated over the long term. Too often they can also be strategic; for example, failure to acquire these investments opportunities means carriers potentially lose them forever or they could be placed at a competitive disadvantage to the extent a peer's service offering improves or other entrants establish themselves in the marketplace. Spectrum also retains good value as an intangible asset. Understandably, such benefits argue for some degree of tolerance or leverage flexibility. In fact, were we to analytically amortize the upfront investment over the tenure of the licenses, the overall impact to financial leverage would be lower, and the investment outflow would better match contributions from new services. Still, unlike how we consider leverage tolerance for infrastructure assets with contracted cash flows against potentially regulated backstops, we view telecom cash flows as higher risk, given more competitive markets and risk to more frequent regulatory intervention, as well as cyclical and technological risks that underscore a greater volatility to cash flow underpinned by the intangible assets.

We acknowledge the critical need for mid-band and high-band spectrum and the potential for the average price to surpass valuations from recent global transactions. While the degree of potential spectrum expenditures by the three national wireless carriers could be quite significant, their participation in the auctions at the range our analysis contemplates isn't likely to spur rating actions assuming underlying business continues to show growth. However, there's a risk that auction outcomes might differ materially from our range of assumptions. Nevertheless, in our view, the credit characteristics of high investment-grade issuers include anticipating such lumpy investments and building adequate financial buffers into their long-range planning to absorb such investments through balanced risk-sharing policies between stakeholders, as well as proactively and transparently acting to ensure policy compliance. Recent equity issuances by Telus Corp. and BCE as well as DRIP programs support such a philosophy although arguably are executed less proactive than we would have anticipated.

If the spectrum auction outcomes differ materially from our range of assumptions, we will need to reevaluate the impact on our assessments of financial risk. How the companies plan to manage leverage while financing ongoing business growth in conjunction with shareholder returns will play a critical role in our assessments. Therefore, we would have lower tolerance for companies that might take a long time to deleverage or pursue shareholder returns. This will likely be reflected by either a more conservative downside trigger or shorter time frame if leverage metrics exceed downside threshold levels.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Table 2

Related Research

• The COVID-19 Fallout Is Squeezing U.S. Advertising Spending More Than Expected, May 21, 2020
• Credit FAQ: Will U.S. Telcos Be Recession Proof This Time Around?, April 8, 2020
• COVID-19: EMEA Telecoms Will Prevail, But Not Completely Unscathed, April 6, 2020
• Amid Secular Pressures, Most U.S. Media Companies' Long-Term Prospects Have Diminished Somewhat, Feb. 19, 2020
• ESG Industry Report Card: Telecoms, Feb. 11, 2020
• Global Telecoms Webcast Slides Highlight ITT Themes Related To 5G And Low Sector Growth, Dec. 10, 2019