Is the Devil going to pay?: An Analysis of Rogers' Acquisition of Shaw Communications

Last month, I checked the bill for my mobile services, which was $70. I was surprised; despite having a prepaid package where I pay $40 a month, they had added $20 for a 12 minutes call to the US. I just thought about it for a moment and paid the bill apprehensively. It also made me think about the Canadian telecommunications industry and how consolidated it is because they are indeed charging a lot. I looked up the market capitalization of the telecommunications industry in Canada, and I came to know that Rogers, Bell and Telus have 91% of the market share. Rogers communications are the biggest one out there, and last year, they announced that they would acquire Shaw Communications, a small yet significant part of this realm. I was curious about this deal and whether it was done just to acquire more market share, even if it comes at an exorbitant premium. So, I found some interesting things about this deal and many such things. In this blog, I will discuss this acquisition and my feelings about things going forward. I have also tried to value the acquisition to the best of my capabilities, which involves valuing the merged entity and estimating the transaction's synergies. 

INTRODUCTION

The telecommunications industry in Canada is almost $55 billion, and it is a highly consolidated one. It is also broadly divided into two segments, wireline and wireless, where the wireline segment accounts for about 55% of the revenue and wireless accounts for the rest. It is expected to grow at a 3-3.5% rate over the next few years. This could be because the services in Canada are highly overpriced, and it is obvious when only three companies, Rogers, Bell and Telus, are driving the entire industry comprising 35 million subscribers. 

Rogers Communications Inc. is a Canadian telecommunications company operating primarily in wireless communications, television services and the internet, with significant additional telecommunications and mass media assets. Rogers has its headquarters in Toronto, Ontario. Shaw Communications Inc. is a Canadian telecommunications company which provides telephone, internet, television, and mobile services. Headquartered in Calgary, Alberta, Shaw provides home telecommunications services primarily in Alberta and British Columbia and satellite television nationally.

In March last year, Rogers Communications announced that they would acquire Shaw Communications for $40.50 for all the outstanding shares, except 60% of shares owned by the Shaw family. At that time, Shaw Communications was trading at $24, and the premium offered on every share was 70%, yes, 70%. As you might know, most of the acquisitions are heavily overpaid for, and there is a simple rationale behind the whole idea of it. A smaller company will not accept a lower value than its market capitalization, even if the actual value of the company is way less. The company will also expect a premium over the equity/enterprise value, which can worsen things. Now, there can be acquisitions at a discount, where the target company can be acquired for a price lower than its actual value, but it seldom happens. In this case, Rogers will pay $40.50 for every outstanding share except 60% of shares owned by the Shaw family, which will be exchanged for 0.70 shares of Rogers Communications share for each share of Shaw Communications. This means that Rogers will pay about $19 billion in cash, about $560 million in implied premium of exchange of shares and debt (including leases) worth $6 billion will also be acquired. 

FINANCIALS AND MUCH MORE

Looking at the financials of both these companies revealed several things; some were pretty standard, and some were alarming and surprising; say whatever you wish. Here are a few aspects of the financial structure of both organizations:

Shaw Communications-

• For the financial year 2021, the total revenue is $5.5 billion, operating margins were $1.27 billion, and the net income was $996 million. The total revenue has grown at 3% CAGR for the last 4 years, and the net income margin was a very healthy 18% for 2021, but the margins were uneven in this course. The number of wireline subscribers has declined significantly over the last 5 years, and the churn is likely to continue. This point is worth considering because wireline services account for 75% of the total revenue. On the other hand, Wireless services are likely to increase steadily, and the prices are supposed to go up for the next couple of years.

• As far as reinvestment is considered, the company has been heavily reinvesting and for most of the years, the reinvestments are more than 100% of the NOPAT. Since the return on capital is around 8.5%, the investment in their projects might be viable, and the capital is being used effectively. However, once the revenue growth starts slowing down and the perpetuity growth becomes 0% at the end of the projected period (according to my assumptions), the company will have to divest to some extent, especially in the wireline sector since the number of subscribers is constantly decreasing.

• For the financial year 2021, the total revenue was $14.65 billion, operating margins were $3.3 billion, and the net income was $1.56 billion. The main thing here is that the total revenue for 2017 was $14.37 billion, and the margins were much better. Even for 2018-2020, the revenue growth was hardly 1.4%, and several reports about decreasing revenue due to the pandemic in 2020-21. which might be a reason but not the only cause. Even the net income has constantly decreased since 2018, so there is hardly any cost reduction, and the churn rate has been close to 4%. The wireless customer count has been increasing, and so are the cable subscribers count, but the cable services are not available beyond two provinces in the east part of the country. 

• The company has been reinvesting consistently, and there is a shift towards reinvesting in the wireless sector. Unfortunately, the return on invested capital has been around 4.5%, which is less than the discount rate I assumed. In any case, the discount rate will be higher than 4.5%, and when this happens, the company is not investing in viable projects or is incurring expenditures that do not have apt returns. This means that after a couple of years, they will have to divest because of specific segments not doing well and their subscription count plateauing. However, they have claimed to invest an additional $2.5 billion to build 5G infrastructure.

Shaw Communications-

These are the operating metrics that I have assumed for Shaw Communications. The wireline subscribers are estimated to decrease at a rate of 1.5% each year for three years and 1% after that, which is somewhat optimistic. Still, my logic here is the idea that the loyal or the actual subscribers do stay with the same service. Many of them are filtered out in a couple of years, but the base remains there. I think the need for wireline services is consistently reducing, and most companies and people are moving towards alternatives. The capital expenditure rates have also decreased in the last five years, implying slow or no growth. These services also include cable TV services, which frankly do not make sense nowadays and are expensive. Go for Netflix or Prime Video at $10/month, not for cable services at $70 a month, offering 30 channels on a television set.

On the other hand, wireless subscribers are meant to increase. It is obvious because there is a tectonic shift and adoption of wireless technology and how efficient it can be. Even the prices for wireless services are meant to increase for the first few years, but then, there should be some sort of reduction. The reasons for this are probably going to be increased competition and achieving economies of scale in some way. The subscriber growth will not be massive. You cannot make it 4% a year in a country where the population growth rate is expected to be 1% yearly. I have taken 2% for the next three years and 1% after that because of an assumption that they are offering some mobile plans that are cheaper than its competitors and target a younger set of people. Apart from this, wireless services have postpaid and prepaid services, which would offset the growth rate as prepaid services are declining and are projected to increase.

I have taken the weighted average cost of capital (WACC) for the discounted cash flow analysis to 8.1%. The cost of equity comes out to be 10%. Now, the WACC is also coming out to be lower, as the debt/equity ratio is 0.96, and despite the levered beta being high, it still affects the discount rate. The free cash flows are also increasing over the next 6 years. Still, the growth rate is meant to slow down once the revenue starts slowing down, leading to a decrease in capital expenditures and further decreasing the depreciation ad amortization expenses. The cash flows at the end of the projected years are $1.175 billion. The perpetuity growth rate that I have assumed is 0% because I think that a considerable chunk of their business is dependent on cable services and wireline services, which is a declining sector. It is going to be a strenuous task to completely shift their primary focus to the wireless industry. The implied share price comes out to be around $21, which is not too bad considering it was trading around the same level before the acquisition was announced. 

Rogers Communications-

Mr. Aswath Damodaran (his website) talks about the word 'synergies' and how abused this word is. He has spoken about acquisitions and the fundamental issues with why businesses are acquired, and so have at his material. I completely agree with that, as most of the time, it is nothing but an excuse to justify a bad deal. Think of it as buying an expensive watch, and your friend asks you what value it provides, buy a $100 watch that would still look good. You say things like 'what will I do with the excess money that I have or 'this symbolizes how successful I am or 'my prospective clients will be impressed and might consider me for a job. This happens when acquirers are asked about the entity they have acquired, they will say synergies. Hardly any effort is made to explain the kind of synergy and the quantitative explanation behind it. Here, the main reason for the accusation is related to operating synergy and expanding their cable operations on the West Coast. Since this is a horizontal acquisition, gaining the market share and having an increased number of customers have to be the two biggest drivers.

• Government interventions will play a big part in the telecommunications industry, and they have been on it to reduce the prices of mobile plans nationwide. In January this year, the Minister of Innovation and Science and Industry of Canada said, "In 2022, it's simply a matter of fairness that all Canadians be connected at a price they can afford. Our government has met its commitment to reduce the costs of cell phone plans by 25%, but we won't stop there because Canadians still pay too much for their internet and cell phones. We'll continue to push aggressively to generate innovation, improve coverage and reduce the costs of telecommunications services using every tool we have." This clearly shows that the regulations will strengthen, and there will be price control on the prices of these services. Such an intervention can never be suitable for any organization, despite having the largest market share and pricing power for some time. The decision to opt for these services is also a subscriber's personal choice; ultimately, value supersedes every single thing. With the coming of 5G, they would want to increase prices, but I highly doubt the power Rogers will possess over this and how price reductions will come in place.  

• Another reason why it is overpriced is that it is priced and not valued. In January of 2021, Bell Communications, one of the biggest telecommunications companies, offered to buy Shaw Communications for $37 a share after Rogers made an initial offer to buy Shaw for $35. Then, Rogers went ahead and offered another $3.5 a share to Shaw, and this ultimately was the deal that was finalized. It almost seemed like an auction, as if they were betting on Shaw communications, where the highest bidder takes all. An additional $5.5 a share means another $2.5 billion, over the price they offered a month before. Losing Freedom mobile's customers is also a significant deterrent to Rogers' power and should have been considered beforehand.

• In my opinion, Rogers communications is not an efficient company, and there are several justifications for that. The primary reason is that it does create value per se, as the return on invested capital is way below the cost of capital for the company. For the past three years, the return on invested capital has been lower than 5%, and the cost of capital is more than that, 8% in my case. The company has piled up $22.8 billion worth of debt, which will increase this year by $10 billion. This can prove outright inefficient as the revenues and margins do not display the results for taking on enormous debt. Even the interest coverage ratio for Rogers has not increased in the past five years, implying the underutilization of capital and making their debt riskier. Shaw Communications have been much more efficient with the capital, and despite having significant debt, the return on invested capital is close to 8.5%. Even the interest coverage ratio has gone up, making their debt cost lower. Along with all this, there are simply no synergies regarding the value of control that Rogers brings to the table. The acquisition could have been more valuable if there had been significant reforms through outstanding management and effective use of capital.

• One crucial factor that most acquisitions consider is whether the transaction will be accretive or dilutive. For some context, an accretive transaction is the one in which the EPS rises for the acquirer after acquiring the target, and when the EPS goes down, it is classified as a dilutive deal. Conventionally, accretive deals are considered the right ones, and the opposite is deemed insufficient, which is not entirely true. Several factors come into play while evaluating whether the accretion is relevant or just a technicality. For example, how companies finance deals play a big part. Deals in which a lot of debt is involved, both to finance the sale and acquire the underlying obligation of the target firm, will tend to be expensive for the acquirer. In addition, if the company turns out to be riskier, the value would further plummet as the default risk premium on the market value of debt will be much higher. Higher short-term treasury yields will make financing using cash much less valuable and harder to justify. Also, the fascination with P/E ratios and making accretion or dilution dependent on those is a futile argument. There is no guarantee of how the markets will react to the combined firm and, subsequently, the share prices. If the combined firm projects synergies and a good revenue profile but the needs do not think alike, the P/E ratio can be lowered on a short-term basis and can affect the whole nature of the deal. If the target company's shares start going up, driving the P/E up, and the acquirer's price starts going down, which does happen most of the time, the point of the deal being accretive can disappear. 

Only time will tell the actual effect of this decision and how it will affect a customer personally, but it will be instrumental for this industry in Canada. Though, it is highly probable that this acquisition will face many issues from the Competition Bureau, which will try to get this deal down considering how this industry is headed for its consumers. 

YET ANOTHER OVERPRICED ACQUISITION?

Most acquisitions fail, and there has been ample research on this. The reasons are also clearly mentioned, including inappropriate valuation, limited involvement of owners and delegating the tasks to other intermediaries, integration issues, or just not having a backup plan. What could be why will be recognized here after a couple of years? It is the issue of putting a very high value on the target, the external problems in the telecommunications industry, and how the Canadian government will react to it. Now, I am not going to talk about the pricing multiples like the EV/EBITDA multiple or the EV to sales multiple because pricing hardly makes sense when we talk about acquisitions. However, most people who value or price companies are a big bone of contention, perhaps a right one. Companies are just looking at the market price of the target company's shares, offering a premium. What if the target is already treated at a price higher than what it deserves? You have offered a premium on an overpriced company, an excellent deal for the target company. 

For Rogers, there are three main segments, the wireless segment, cable services and media services. The wireless feature is divided into postpaid and prepaid services, where the prepaid subscriptions are assumed to decline by 3% every year, and the postpaid services are deemed to grow by 1.5% annually, going down to 0% after that. First, mobile companies do not make much money on prepaid services. For the customers, using prepaid services sometimes comes with unexpected charges, along with limited reach and data usage. Postpaid services are seeing an increase in the number of subscribers all over the place. The subscribers will probably grow at a slower rate because of an existing large customer base and with people moving towards cheaper alternatives. The cable services are restricted and, again, are becoming redundant with every other day passing. The media segment works in broadcasting, intelligent home monitoring, networking and providing cloud-based services to businesses. This particular segment is assumed to grow considering it is not highly dependent on the low growth segments, and a lot of it also comes from providing sports and media entertainment services. 

I have calculated the weighted average cost of capital (WACC) to be 8.2%. The cost of equity comes out to be about .5%, and the risk-free rate is the 10Y treasury yield in Canada and the US. Here, the WACC is coming out below as the debt/equity ratio is 2.17, and despite the levered beta being high, it still affects the discount rate. That is an enormous amount of debt that the company has taken, and it highly affects the cost of capital, not particularly the absolute risk, as having more debt can be pretty harmful sometimes.

The free cash flows are increasing over the next 6 years. Still, the growth rate is meant to slow down, eventually going down to 0.5% for the perpetuity growth rate, as I think this company is at the steady stage of its life cycle because the game has become about value. Despite having a market share, they struggle to bring the customers in. The cash flow at the end of the projected years is $3.75 billion, and the implied share price comes out to be $47. 

The core issue of this deal is the creation of synergies and how overestimated they are. Rogers claimed that Shaw Communications will bring in $1 billion worth of synergies annually, which seems a bit far-fetched. First off, Shaw communications' wireless service Freedom Mobile is supposed to be much more economical than any other service in Canada. To pass the regulatory requirements, Rogers will have to sell off Freedom Mobile for the deal to move forward. It simply takes a whole of customers with it right away, and this is going to take a hit on the future earnings of Rogers. Shaw Mobile, the second wireless service, would have to maintain that average billing price in a particular range if they want to retain the existing customers. Otherwise, even that can be disastrous. Secondly, Shaw is the leading cable service provider in the country, especially in Western Canada, but it is a declining sector. Cable services are either seeing minimal growth or an actual decrease in the number of people opting for them. The essence of cable services is fading away, with another point being how expensive it can get. 

I valued the firms individually and combined them to form a single entity, then added the benefits of pricing power and better margins to reflect the additional benefits. According to the valuation, the synergies are close to $2.7 billion in totality, and even this seems a bit of a gamble considering how regulated the industry can become soon. The value can come in the form of better margins due to the increased pricing power in the short run and the existing infrastructure they can use. As far as the premium is concerned, in my opinion, Rogers is paying $6.4 billion over the value of Shaw Communications (Enterprise Value + Expected Synergies).

FINAL THOUGHTS

This acquisition is touted as one of the biggest corporate deals to ever take place in the country, and it is undoubtedly a massive one considering that a telecommunications giant is being acquired by a titan. Most people believe this deal involves nothing but telecommunications, but most people perceive it to be of great value. It is genuinely good that Rogers is not going out there and acquiring a company in some entirely different realm. However, there are many complications and hurdles regarding working in telecommunications in Canada and how it will fit into the bigger scheme. In my opinion, the acquisition has a high chance of not going through, especially looking at the concentration ratios of the telecommunications sector and Canada having no such precedents. I have to state though, that Canada is a funny place and operates with an underlying layer of pseudo-capitalism, which might push this sector to ultimately be a duopoly game and this deal to pass through. The other fact is that the industry has such high barriers to entry, that the natural elimination of smaller competitors would be inevitable, only God and the Competition Bureau know what's going to happen going forward.

You can find the valuation spreadsheet linked here:

Rogers-Shaw Acquisition Model

UPDATES

May 14, 2022- The Competition Bureau has filed an application to block Rogers Communications Inc. from purchasing Shaw Communications Inc., saying the transaction would result in higher prices, poorer service quality and fewer choices, particularly in wireless services. The bureau challenged the $26 billion acquisition Monday by asking the Competition Tribunal to prevent it from proceeding. The bureau's investigation determined the proposed acquisition would eliminate "an established, independent and low-priced" competitor in Shaw-owned Freedom Mobile. It says it would also prevent competition in wireless services in Ontario, Alberta and British Columbia and suppress further competition in areas, including 5G.

"The Competition Bureau conducted a rigorous investigation of the proposed Rogers-Shaw merger and concluded that it would substantially prevent or lessen competition in wireless services," said the Commissioner of Competition in a statement. "Eliminating Shaw would remove a strong, independent competitor in Canada's wireless market – one that has driven down prices, made data more accessible, and offered innovative services to its customers. We are taking action to block this merger to preserve competition and choice for an essential service that Canadians expect to be affordable and high quality." Rogers and Shaw have 45 days to file a response with the Competition Tribunal.

June 3, 2022- Rogers Communications Inc. and Shaw Communications Inc. say they will oppose a hearing by the Competition Tribunal. Still, they have agreed not to close their $26-billion merger until objections by the Competition Bureau are resolved. On Monday afternoon, Rogers and Shaw said the agreement with the competition commissioner, Matthew Boswell, "allows the parties to focus on addressing (his) concerns with the transaction to reach a settlement." On May 9, the competition commissioner filed an application to block Rogers' purchase of Shaw, arguing that the transaction would lead to worse service and higher consumer prices. He also alleged that removing Shaw as a competitor would undo the progress made on competition in Canada's telecom sector over the years. Rogers and Shaw said their transaction is in the best interest of Canadian consumers, businesses and the economy. A settlement is the "best path" to ensuring those benefits are expeditiously realized.

February 8, 2023- As expected, I was quite wrong with the valuation part as I opted for the book value of equity in some cases for Rogers and Shaw. After making the changes in the market value of equity and lowering the risk-free rates and equity risk premium in the last 8 months, I arrived at the decision that the deal is actually a fair one for both Rogers and Shaw in this context. Whether the synergies really play out or not is for us to find out, but the deal does not seem overvalued, as it was implied before. The exchange rate for the shares might have been a bit high, considering the premium offered, but since the deal is heavily financed through cash, the acquisition is accretive in nature.