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TELUS CAPITAL STRUCTURE

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by

Patrick Leo

on 7 March 2014

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Transcript of TELUS CAPITAL STRUCTURE


Carolyn Chung
Maggie Wang
Tom (Ming) Zou
Patrick Leo

TELUS CAPITAL STRUCTURE
CANADIAN TELECOM INDUSTRY (2001)
HIGH DEBT LEVELS

Acquired Clearnet for $6.6 billion and QuebecTel for $285 million to strengthen national presence
$6.25 billion debt increased Telus' leverage
Capital investments to upgrade wireline network in 2000-'01
Operational Efficiency Program (OEP)
DEBT CONCERNS
AS A BOND INVESTOR
Interest coverage ratio is just over the recommended 1.5 minimum
Ability to meet debt obligation in a recession is questionable
High Debt/EBITDA ratio of 4.2 flags default warnings
DEBT DOWNGRADE
In 2002, Moody’s forewarned of a one-notch downgrade to BAA1 if the debt to EBITDA ratio did exceed 3.8x

June 5, 2002 – rating outlook stable

June 14, 2002 – under review for possible downgrade
QUESTIONS
1. How does TELUS' capital structure compare with other telcos?
Bondholders
Shareholders
2. Was Moody's downgrade appropriate?
3. What specific actions should McFarlane take? Why?
TELUS CAPITAL STRUCTURE
1998 - Q2 2002

TELECOM INDUSTRY
Deregulation of long distance and data services
Increasing competition decreased revenues and market share
Price cap regulatory regime in 2002
Fragile state of the telecom industry
WorldCom Inc. bankruptcy
Call-Net enterprises Ltd net loss of $1.4 Billion
Microcell Telecommunications Inc. delisted from NASDAQ
Higher than Aliant and MTS but lower than Bell Canada's 5.0 ratio
EBIT/Interest Expense of 1.8 indicates ability to meet debt obligations
From a Bondholder perspective, TELUS is overleveraged
AS AN EQUITY INVESTOR
Could translate to decreased liquidity and financial flexibility
Debt provides tax advantages and increases EPS
Equity investors would like to see a healthy proportion of debt that reduces WACC
Focus on Return on Investment
Capitalization ratio of 55.2% is in line with BCE and Aliant
July 25, 2002 - Two notch downgrade from BAA2 to BA1
Non-investment grade with negative outlook
Regulation which reduced EBITDA by $300MM annually
DOWNGRADE IMPACT
Price of TELUS bonds fell from $96 to $66
Total borrowing costs increased by $3.7MM
TELUS shares fell from $9.82 to all-time low of $7.00
FACTORS FOR THE DOWNGRADE
Economic and Industry factors
General economic slowdown
Demand
Weak Telco industry from WorldCom accounting scandal
Customer demand for fibre-optic network hadn't materialized
Adverse Regulatory Decisions
$300MM annualized reduction in EBITDA from CRTC regulation
High Debt Level
Capitalization ratio at 58.6% following acquisitions
Cash Flow
Decreased DRIP and ESPP participation
Challenges in renewing bank credit facility
Modest free cash flow after interest, taxes and dividends to repay debt
FACTORS AGAINST THE DOWNGRADE
Nature of Telecom Industry
Intense capital investment
Rating Discrepancies
Optimistic fibre-optic outlook
Inconsistent with S&P, DBRS, and Fitch ratings
Improvements in Credit Profile
Divesture of non-core assets (i.e. Yellow pages and small leasing company
Increased Liquidity
Increased accounts receivable securitization program from $150M-$500M
Positive Cash Flow Forecast
FY2003 forecast predicted surplus over the target
Modest free cash flow after interest, taxes and dividends to repay debt
Reduction of dividend from $0.35 to $0.15 to combat regulatory expenses
Annual savings from Operational Efficiency Program (OEP)
CONCLUSION: MOODY DOWNGRADE
Was the Moody's downgrade appropriate?
It was appropriate for Moody’s to downgrade TELUS’ rating, however, the rating should have been more aligned with other rating agencies and remained within the investment grade range.

ALTERNATIVE #1
Repurchase $400M in bonds through equity
ALTERNATIVE #2
Swap TELUS bonds for shares
Exchange bonds for shares to repurchase debt without using cash
ALTERNATIVE #1
Quantitative Analysis
ALTERNATIVE #1
Quantitative Analysis
ALTERNATIVE #2
Pros
Improve D/E Ratio
No need to use up any cash
Cover the position against a declined share price
Cons
Bondholders have to agree to the swap
Shareholders will be diluted without a buyback
ALTERNATIVE #3
Do Nothing
Fully implementing the OEP and reducing capital expenditures
ALTERNATIVE #2
Pros
Improve D/E Ratio
No need to use up any cash
Cover the position against a declined share price
Cons
Bondholders have to agree to the swap
Shareholders will be diluted without a buyback
Pros
Cons
No compensation for market devaluation
Management shakeup possible without an action plan
Relies on accurate forecasts and a stable economy
Cash reserves fall as debt is paid
Preserves cash in the short term
Doesn't introduce uncertainty
A focus on reducing overhead
DECISION MATRIX
Recommendation
Issue Equity to reduce Debt obligations
Issue $400M in equity and use it to pay down debt
Diluted shares will lower the stock price in principle
Risk of bankruptcy will be reduced substantially
Debt/EBITDA ratio decreases from 3.6 to 3.4

EPS decreases to 0.07 due to dilution of shares
Rational investors will view this as a positive signal
ACTUAL OUTCOME
In fall 2002, TELUS successfully completed a $337MM equity issue and concurrent debt buyback
Repurchased $410MM of debt for a cash outlay of $318MM
QUESTIONS
AGENDA
Introduction
Bondholders vs Shareholders
INTRODUCTION
On July 25, 2002 Moody’s downgraded TELUS’ rating from Baa2 to Ba1, affecting $6.4Bn debt
OTHER RATIOS
Lower ROE due to lower net income relative to equity from high interest expenses
Lower P/E ratio due to lower market value per share relative to equity due to lower investor perception from high leveraging
TELUS CAPITAL STRUCTURE
Compared to other major Candian Telcos
Higher Debt to EBITDA
Higher Debt to Total Capitalization
High capital expenditures
High debt financing costs
Low EBITDA to interest ratio
ROE lower than industry average
AS AN EQUITY INVESTOR
Target LT Debt to Capitalization
Optimal debt level is 50%
WACC = D/V(Kd) + E/V(Ke)
Equity investors prefer a safe debtload that reduces WACC
Bond price fell from
$96 to $66
FUTURE PROSPECTS OF TELUS
2003 forecast predicted sufficient liquidity
Increased accounts receivable
Increasing EBITDA due to Operational Efficiency Program
DRIP re-investment of dividends
Reduced expenses by $450MM
Further improvements to Debt to EBITDA ratio
Achieved through debt reduction
KEY ISSUES
1. Regain confidence from capital markets
2. Increase credit rating
3. Optimize the cost of capital
4. Maintain adequate liquidity
POSSIBLE NEXT STEPS
1. Equity issue with concurrent debt buyback
2. Debt for Equity SWAP from Hedge Fund
3. Do nothing
SUMMARY
High debt ratio of 58.3% flagged liquidity concerns
Moody's downgrade increased the cost of borrowing and put pressure on the stock price
TELUS issued equity to balance its capital structure
Financial performance has since improved
Analysis of TELUS capital structure
Moody's Downgrade
Factors for and against the downgrade
Outcomes
Future outlook
Recommendation
Summary
WHO IS TELUS
TELUS CORPORATION (TSX: T, T.A; NYSE: TU) is one of Canada's leading telecommunications companies providing a full range of telecommunications products and services that connect Canadians to the world.
The company is the leading service provider in Western Canada and provides data,Internet Protocol, voice and wireless services to Central and Eastern Canada.
Prior to this, the CEO of TELUS (McFarlane) was working on a contingency plan to mitigate the possible effects of the downgrade
Now that the downgrade has occurred, his task is to determine a course of action to propose to the audit committee
ACTUAL RESULTS
ACTUAL RESULTS
Full transcript