Telus trust could attract takeover wolves

Telus did an admirable job keeping the market -- analysts, investors, investment bankers, the financial press -- off guard. While everyone knew Telus was mulling the income trust option, hardly anyone attached more than a 20-per-cent probability to the scenario. Telus was not like BCE, owner of Bell Canada. BCE was pumping out trusts like so many sausages and the share price went nowhere. Telus would learn from its rival's zero-sum exercise and stay the course.

In retrospect, the market had the IQ of a rotary phone. Telus was always trust bound, not just because of the dead obvious reason -- trusts don't pay taxes -- but because it has the right asset mix and performance to support the new structure. Telus is converting now only because the taxman comes knocking next year, because $800-million of tax losses associated with the Clearnet purchase will have come to their glorious end. If the company had become taxable last year, or the year before, CEO Darren Entwistle would have hit the trust button then.

It's all about wireless. Shortly after Mr. Entwistle bought Clearnet for $6.6-billion in 2000 to create Canada's biggest wireless operation, the market lost interest in Telus (and Mr. Entwistle, the decidedly boyish boy wonder who had just arrived from Britain's Cable & Wireless). The shares went from about $40 that year to less than $8 in 2002. Of course, the dot-com implosion, the credit crunch and the mini recession in the U.S. did their bit to propel the fall. But there was no doubt investors were punishing Telus for having made a highly expensive acquisition.

In retrospect, Clearnet was a brilliant deal. Telus needed to make an instant splash in the wireless market. It could do so by spending a fortune to buy wireless spectrum in a government auction. Or it could do so by picking off a company -- Clearnet -- that came ready-made with wireless spectrum, a managed network and paying customers.

Clearnet has been a phenomenal growth story. Telus's wireless business now accounts for 64 per cent of overall cash flow. Wireless EBITDA (earnings before interest, taxes, depreciation and amortization) is growing at 18 per cent a year and the revenue margin hit a phenomenal 50 per cent in the last quarter, that is, for every dollar in sales, Telus earned 50 cents in profit. Numbers like this can certainly make a trust attractive to investors. Even better, Telus thinks it can maintain the wireless growth rates, which means the trust cash flow payout ratio, which may be as low as about 70 per cent at the onset, potentially has room to go to 80 or 90 per cent.

The Telus trust has something else going for it, and that's the all-or-nothing philosophy. BCE has pursued a piecemeal strategy. It created the Yellow Pages trust, the Bell Nordiq trust and the new Bell Aliant trust; the main company, composed of Bell Canada's wireless and land-line businesses, was left intact as a dividend-paying corporation. The waning share price tells you BCE's approach failed, probably because to many investors it smacked of cynical financial engineering.

Telus is putting the whole whack into the trust. Mr. Entwistle believes in full integration of network services, from Telus TV and cellphones to Internet products and home security systems. Integration can't happen if various businesses are hived off into various trusts, with separate management teams, separate tax structures and fresh pains in the butt, like determining transfer pricing between the various businesses. Inefficiencies would be created. A holding company discount would appear, as it has with BCE.

Finally, Mr. Entwistle determined that there was no political risk in going really, really big. With a market value of about $20-billion, the Telus trust would be three times larger than Yellow Pages, the reigning business trust gorilla, and one-third bigger than Canadian Oil Sands Trust, the No. 1 royalty trust. Terrified of alienating the pensioners' vote, the Liberals did not have the nerve to shut down the trust market, although they initially gave every indication they would do so. The Tories would be crazy to tamper with trusts if they hope to form a majority in the next election. In other words, there is no political risk in turning Canada's second-biggest telecommunications company into a tax-free entity.

Will Mr. Entwistle's blockbuster plan work? Probably, but not necessarily.

Any investor knows that hedge funds and private equity players are playing bigger and bigger roles in the market. Private equity groups are banding together to take out firms worth many billions of dollars. As the targets become fewer, these groups will move up the food chain and go after larger targets. Size is no object.

The speculation is that a private equity group -- Gerry Schwartz's Onex? -- has mulled offering about $65 a share to take Telus private, load it up with debt and watch the return on equity figures go through the roof as the wireless business goes from strength to strength.

Perhaps Mr. Entwistle thought a trust could shoot the shares even higher. If he did, he guessed wrong. The shares closed yesterday at $59.79, up $7.25. Some analysts think the shares have nowhere to go but up, as investors warm to the trust idea. If they don't, Mr. Entwistle should watch out. He could lose the company that put BCE's performance to shame to a raider.

ereguly@globeandmail.com