Telus Corp. (TSX: T, NYSE: TU) is one of our highest-rated Dividend Champions, and it boasts an outstanding track record of dividend payments. However, growing debt and lower free cash flow raise questions about whether the company will be able to sustain and grow its dividend over the next few years.

Our Favorite Oligopoly

Telus is one of Canada’s Big Three, the oligopoly of telecom giants that controls the country’s wireless market. The company has 13 million customers spread across mobile phone, landline, Internet, and pay-TV.

In 2015, Telus generated revenue of C$12.5 billion, accounting for just over 20% of all Canadian telecommunications (excluding media) revenue.

Telus divides its operations into two segments: wireless (mobile) and wireline (fixed line) communications. In 2015, wireless delivered 56% of revenue and 66% of profits, which shows how important this division’s performance is for the overall company.

Growing Debt

Over the past five years, Telus significantly increased its capital spending as it moved to secure crucial spectrum in government auctions, while also building out its networks. In total, Telus spent more than C$15 billion between 2012 and 2016 to purchase spectrum licenses and upgrade and expand its infrastructure. The CapEx intensity ratio (i.e., capital expenditures as a proportion of revenue) almost doubled during this period.

Even the company’s characteristically strong cash-flow generation was not nearly enough to cover capital expenditures, the dividend, and share buybacks. As a result, Telus’ debt has ballooned, with net debt nearly doubling over the five-year period.

Fortunately, Telus is finally past the peak of its capital progam, and free cash flow (i.e., operating cash flow minus capital expenditures) should start to improve from 2018 onward.

A Safe Dividend

Telus has a phenomenal record of dividend growth. Over the past five years, the company has increased its dividend by more than 10% annually, and it’s targeting further dividend growth of between 7% and 10% annually through 2019.

However, we see several risks to this ambitious plan. Rising debt has pushed Telus’ debt-to-capital ratio to 60%, while interest coverage has declined over the past few years. One of the board’s stated objectives is to protect the company’s investment-grade credit ratings, so a further deterioration of the balance sheet may force it to curtail dividend-growth plans.

With such heavy borrowing, Telus has been a major beneficiary of the historically low interest rate environment that’s prevailed over the past few years. But that could change if rates rise meaningfully from current levels. Under such circumstances, the board may decide to reduce debt rather than increase dividends.

The company also regularly repurchases shares from the market and says it intends to continue buying up to C$250 million worth of shares per year. However, the buyback program could be suspended if balance sheet pressure continues to build.

Putting all these factors together, we believe that Telus will be able to maintain its payout, but that dividend growth will fall short of its targeted rate, to around 5% annually (as our estimates show in the accompanying graph). 

Attractive Valuation

Despite these caveats, Telus has numerous qualities to recommend it, including a consistent record of high returns on capital, strong cash flow, and superior growth.

The stock currently yields 4.5%, with the prospect of further dividend growth of 5% annually through 2019. This could result in a total return of 7% to 11% per year.

Aside from the dividend-based valuation, other metrics indicate Telus’ valuation is in line with its Canadian peers, with an enterprise value to EBITDA (earnings before interest, taxation, depreciation, and amortization) ratio of 8 times and a price-to-earnings ratio of 16 times. In absolute terms, this is an attractive valuation for a high-quality company. We estimate Telus’ fair value at C$50, or US$38.