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Dave Ebner


TORONTO (GlobeinvestorGOLD) — Manitoba Telecom Services Inc. is set to create Canada's third-largest phone company with its $1.7-billion agreed bid for Allstream Inc., but the merged entity faces a hotly competitive telecommunications market, making it an uncertain bet at best for investors.

Winnipeg-based MTS, which until now enjoyed market dominance in the province of Manitoba, plans to fight aggressively for business across Canada with the Allstream acquisition, set to close in early June. It has focused its ambition on selling services to large businesses, which is what Allstream presently does.

Allstream's business plan remains intact under the MTS umbrella. With market share of about 11 per cent, its managers say that while the business telecom market is not growing, the company can post decent results by increasing its share to 14 per cent or so.

Allstream's performance over 12 months

But the fact remains that the market for business telecom services is moribund. New technology, such as Internet protocol, is cited by MTS-Allstream as a competitive advantage and while it may be when trying to win new business, IP is definitely pushing prices down.

"I don't think anyone is forecasting a lot of growth in telecom," said Iain Grant of consultancy SeaBoard Group. "All their customers are expecting to pay less."

Allstream's problem, after emerging from a creditor-protected restructuring, was that it didn't have much cash to invest in its future. MTS had a lot of cash but not many prospects beyond Manitoba. Allstream had about $3-billion in unused tax losses, which MTS will use to avoid about $80-million in taxes a year for most of the rest of the decade.

MTS' performance over 12 months

All told, MTS is buying Allstream for $1.7-billion. But if you subtract the value of the tax losses and the $300-million in cash on Allstream's books, MTS's cost for Allstream's actual business is less than half of the headline purchase figure.

This suggests the business itself is not worth all that much, given its declining results and unclear future. And combining Allstream with MTS's mostly steady and monopoly-like business in Winnipeg and environs doesn't help much.

More than half of MTS-Allstream's estimated 2004 sales of $2-billion come from two market segments: data (Internet and other information transport) and long-distance. In the fourth quarter of last year, combining the results of MTS and Allstream shows that data sales fell 8 per cent to about $150-million and long-distance sales plummeted 19 per cent to about $150-million.

This does not constitute a firm foundation for a growth business, which is what MTS wants to be. It has shunned the option to convert itself into an income trust, a structure that pays the bulk of profit to investors, in favour of national expansion.

BMO Nesbitt Burns Inc. said in a report in March that it sees little growth for MTS-Allstream in 2005. It predicted sales growth of about 3 per cent (not much more than the rate of inflation) and operating profit growth of 3.3 per cent (as measured by earnings before interest, taxes, depreciation and amortization).

In light of uncertain business prospects, MTS on April 5 succumbed to shareholder pressure and raised the annual dividend — after the Allstream deal is done — to $2.60, up from its initial projection of $2.20 on March 18. The dividend is close to 60 per cent of projected 2004 free cash flow.

That payout ratio will be closer to 50 per cent in 2005, BMO said in an April report, and it believes "there is greater certainty regarding a further dividend increase in 2005."

The increased dividend was seen by analysts as necessary to compensate investors for the greater risk they face investing in a telco such as MTS-Allstream compared with, say, BCE Inc. BCE owns Bell Canada, the country's largest telephone company, and its stock as of early April yielded 4.2 per cent. At $2.60, MTS would yield about 5.1 per cent.

Bell until March had had a friendly relationship with MTS and it owned 22 per cent of the stock. The future of that stake is uncertain now that MTS is going head-on-head with Bell but what is clear is that it will be a tough fight. Bell is more than eight times bigger than MTS-Allstream and is dominant in Toronto, the nexus of all Canadian telecom business spending.

(BCE also owns Bell Globemedia, owner of The Globe and Mail, CTV television and Trade by Numbers.)

Greg MacDonald, a telecom and cable TV analyst at National Bank Financial Inc., advises his clients to only consider telco stocks with a significant dividend given the low-growth outlook for the industry. He has included MTS-Allstream in this list but still picks BCE as his No. 1 recommendation, citing its more diverse business segments.

Buying MTS-Allstream for the dividend alone is a bold investment given the fact the company may not increase sales materially in the next couple years — and possibly see sales decline. The dividend certainly offers what is called "downside protection," but the question is, Where's the upside? And, when? As John McLennan, Allstream's chief executive officer said in an interview, things at MTS-Allstream are "not going to change that dramatically in the beginning."

If an investor wants to take a stake in just one Canadian telco, perhaps MTS-Allstream shouldn't be the first on the list, as NBF advises. And if it's really all about the fat dividend, and potential for dividend increases, the corporate bond market might be a better place to look for the right combination of higher yields mixed with tangible risk.

Dave Ebner writes about phone companies and network equipment makers for The Globe and Mail's Report on Business.

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