Thursday, June 26, 2008

The stagflation equivalent of Canadian ownership: BCE is the worst of both worlds

By: Brent Fullard
Catalyst Asset Mangement Inc.

Once again we have the Globe and Mail to thank for confusing theory with reality. This time it’s Andy Willis up to bat, espousing all the great things to be learned form the Red Wilson report. The following passage caught my attention:

“In what's sure to be one of the more controversial recommendations coming from Lynton (Red) Wilson and his blue-chip team, the federal Competition Policy Review Panel will recommend knocking down restrictions on foreign ownership of sectors such as air transport and telecom. The economic underpinnings of Mr. Wilson's thesis are undeniable. Increasing competition and lowering the cost of capital can only work in our favour.”

So Red Wilson and the Globe would have us believe that reducing foreign ownership restrictions will lead to a lower cost of capital. How do you suppose this will play out for Telus in a post BCE-LBO world? Or BCE itself?

Telecom is a highly capital intensive business, made more so by the fact that technology is constantly changing. BCE and Telus have had no constraints whatsoever in accessing capital here at home. Their incremental need for foreign capital investment is zero, as they both testified in 2005 before the Industry Committee. Taking these companies private will bring about the highest conceivable cost of capital, since as in the case of BCE their debt will go from investment grade credit to deep junk bond status, easily adding 300 – 400 basis points to their cost of debt, in a balance sheet comprised of some 88% debt. Meanwhile the 12% sliver of equity on which these companieS will operate will be owned by private equity whose return expectations will be in the order of 30%+.

As such, we have the worst of both worlds. Increased foreign ownership in exchange for dramatically higher cost of capital. This is the stagflation equivalent of Canadian ownership and the higher cost of capital will translate into higher cost of service for consumers and lower competitiveness and slower roll out of new services.. Meanwhile had BCE adopted the Catalyst Proposal (which it failed to disclose to shareholders) l it would have preserved the existing Canadian ownership of BCE, while simultaneously achieving the lowest conceivable cost of capital, as its debt would have been preserved as investment grade credit and its incremental cost of equity would have been 6.00%, which would be the running yield for a security that paid $2.55 per annum and which trades at $42.50.

At $1.00 for his services, perhaps Canadians got what they paid for with Red Wilson, or what Flaherty is fond of calling “value for money”.

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