I first made the value case for telecom giant BT (BT) on Seeking Alpha just over three years ago. Needless to say, the share price performance since then has made a dog’s dinner of that call. I mean at time of publication (early 2017) the shares changed hands for somewhere in the region of 310 pence each. As I type, you can buy BT shares on the London Stock Exchange for around 150 pence each. Not good. The only tiny slither of good news is that the company has not yet slashed its dividend, though that may not last much longer.
So, what has gone wrong here? Broadly speaking I think three things are proving an acute issue, the first of which is the company’s investment program. Put simply, BT’s capital spending has shot up as the company rolls out fibre-optic broadband directly to homes and offices. It was adding around 26,000 of these connections every week as things stood at the end of 3Q20. BT plans to have around 4m direct-to-premises connections in place by early-2021, with that figure set to rise to around 15m by the middle of the decade.
To put some monetary numbers on all of this just head over to the cashflow statement. These days, BT is spending around £1,000m more each year on capital investments compared to a few years ago. Although it has announced cost-cutting measures to offset this, underlying cashflow is not up significantly over the same timeframe. The net result means less cash left over for things like dividends and debt reduction.
Just to make matters worse, BT has had to divert cash in order to plug a ballooning pension deficit. By my count the company has made somewhere in the region of £4,200m in pension deficit payments over the last four years or so. Much of that came last year (circa £2,000m), while the company plans to make annual top-up payments of around £900m between fiscal 2021 and 2030. This all comes out straight out of BT’s cashflow line, putting further pressure on free cash flow.
Dividend, Balance Sheet
At the risk of stating the obvious, declining cash flow and rising capital spending does not make a good combination for shareholder dividends. On a normalised basis BT reckons it will generate somewhere in the region of £1,900m worth of free cash flow in its 2019/20 financial year. By way of comparison the company was on course for around £3,000m in normalised free cash flow when I penned that first piece back in 2017.
Now, this normalised figure obviously excludes any scheduled pension deficit payments, not to mention cash dividends to stockholders. Together, those two will take up around £2,750m worth of cash this financial year (£1,250m in pension deficit payments plus £,500m for the dividend). Pension deficit payments will come down a notch starting in 2021, though overall free cash generation will still be tight relative to the dividend.
From the above it’s not hard to see why the question of a dividend cut has increasingly focused on ‘when’ rather than ‘if’. Compounding matters is the not-so small issue of BT’s net debt position. Financial debt stood at around £12,000m net of cash and short-term investments at the end of 2019. The company also carries a further £5,000m or so in capital lease obligations.
The attraction of a dividend cut at this point is fairly obvious. Assuming BT reduced it by 50%, the company would have an extra £750m per year with which to fund its other obligations. At the same time, anybody in the market for shares today would still be on for a 5% dividend yield. Obviously that’s not much comfort for those who bought three years ago, though their yield on cost would still be 2.5%.
Despite the above I am optimistic at these prices. At 150 pence per share BT is trading at less than 7x annual profit. Call that an earnings yield of nearly 15% – slightly better than what you can get in the bank right now! As far as I am concerned that kind of aggressive discount usually implies one of two things.
The first is financial distress, which has been touched on above. At 3x cash flow I don’t think BT’s debt load is particularly outrageous for a telecom. For a start most of it is due after 2026. Interest rates are also still at record lows and will be for some time in my view. BT’s interest and lease payments cost it around £720m per annum right now, equivalent to circa 20% of operating profit. That is pretty comfortable. Of course a dividend cut would alleviate any fears given the substantial implied savings. The company also has some non-core foreign operations that it could sell too.
The second thing to take away from BT’s low profit multiple is the potential for declining profits. Obviously national telecom companies don’t usually exhibit much by way of growth in the best of times. That said, a 7x profit tag implies considerable decline on top of that. If BT simply holds its current earnings power, its shares could easily deliver quite attractive returns going forward.