BT: There Goes The Dividend

by The U.K. Income Investor

British telecom giant BT (BT) has been my worst call by some distance. I first made the positive case back in early-2017, at which point the shares traded for around 310 pence each. I followed that up with a piece on this site almost four months ago. The stock traded for around 150 pence back then, way above its current level of circa 101 pence. A lot has obviously happened in those four months, but still – this has been a dog of an investment in recent years and the share price chart shows it.

Let’s cut to the biggest news as far as income investors are concerned: the BT dividend is no more. Well, temporarily no more anyway. Its final dividend covering FY19/20 has been suspended, as have all dividends covering FY20/21. It plans to resume payouts next year, albeit at a reduced annual rate of 7.7 pence per share. Its previous annual dividend clocked in at circa 15.4 pence per share, so it has essentially halved its future payout.

None of the above should come as much of a surprise. Net financial debt stood at circa £18,000m at the end of March, albeit inclusive of circa £6,500m worth of lease liabilities. At Baa2/BBB, the company needs to keep an eye on its investment grade credit rating. The planned level of dividend cuts should see BT save around £3,250m over the next two years.

Moreover, the company faces a couple of other pressing issues. Firstly, it is committed to making top-up payments to plug its pension deficit. BT paid around £1,275m last year, which obviously came straight out of its cash generation. It also has to budget for increased capital spending as it upgrades the nation’s infrastructure. At circa £3,900m, CapEx was around 60% higher last year compared to 2015. The company also plans to have around 20m direct-to-premises fibre connections in place by by the middle of the decade, up from an earlier target of 15m.

Debt Reduction

Let’s deal with the debt issue first of all. The good news is that the vast majority of its financial debt is due after 2026. It has around £2,800m of borrowings due this year, plus a further £1,700m or so from lease liabilities and pension deficit payments.

On the flip side, BT reported circa £6,600m in cash and short-term investments on its balance sheet at the end of last year. Because this year’s dividend has been scrapped, the company will also retain any free cash flow it generates. Oh, and it also has access to a £2,100m credit facility, maturing in 2025, which remained undrawn as of March. Liquidity looks ample here.

Going forward, the reduced dividend implies circa £750m in terms of annual cash outflow. Assuming BT can make around £2,000m each year, it should retain around £1,250m or so after shareholder dividend distributions.

On that note, imagine if BT reduced its net debt load by circa £4,000m over the next five years. At its current rate of interest – around 4% or so – it would save around £160m in recurring interest expense by then. That figure then runs down to the pre-tax profit line. Assuming normalised earnings power remains steady, then we could be on for a further £130m in after-tax income each year just from saved interest payments. It’s not the highest returning endeavour, but it would help.

Valuation

On that basis, I think BT is a long-term steal at the current share price. I will avoid the immediate COVID-19 impact because it is impossible to gauge; the company also refrained from providing guidance for this year. Some areas, such as its BT Sport channels, face an obvious hit. No live sport means advertising and subscription revenues will be way down. That said, most folks will carry on paying their monthly broadband and phone bills. I think the company will hold up relatively well on that basis.

Here’s the thing – its normalised EBITDA is somewhere in the £7,900m per annum area. The current market value of its share count is circa £10,000m, while its enterprise value is £28,000m. The latter figure simply incorporates net debt onto that market value figure. On that basis, BT currently trades for just 3.5x annual EBITDA. Indeed, much of the share price destruction here has been caused by a severe contraction to the valuation multiple. It appears the market is pricing in serious earnings power erosion.

Anyway, let’s work with that £4,000m in net debt reduction over the next five years. We will also assume its EBITDA generation and EV/EBITDA ratio remain steady. Because debt would fall under this scenario, then BT’s stock price must rise in order to maintain its current enterprise value. Back of the envelope calculations would put BT’s stock price at 140 pence under those conditions. We could tack on a further 30 pence per share in cumulative dividend cash based on the company’s revised payout. Against the current 101 pence share price, I think it looks attractive.

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