I first made the value case for BT (BT) just over three years ago on Seeking Alpha. Needless to say, the share price performance since then has made a dog’s dinner of that call. The shares changed hands for somewhere in the region of 310p each at time of publication (early-2017), but you can buy them on the London Stock Exchange for around 150p each as I type. Not good. The only tiny sliver of good news is that the telecom giant has not yet slashed its dividend, though that may not last much longer.
So, what has gone wrong here? Three things are proving an acute issue, the first of which is the firm’s investment program. Capital spending has shot up as the company rolls out fibre-optic broadband directly to homes and offices. BT was adding around 26,000 of these connections every week at the end of its 3Q20. It plans to have around four million direct-to-premises connections in place by early-2021, with that figure rising to around fifteen million by the mid-2020s.
A quick look at the cashflow statement reveals the financial impact of all of this. BT is currently spending around £1b more each year on capital investments compared to a few years ago. Although it has announced offsetting cost-cutting measures, underlying cashflow has not risen significantly in that time. The net result is less cash left over for things like dividends and debt reduction.
To make matters worse, the company has had to divert cash to plug a ballooning pension deficit. It has made around £4.2b in pension deficit payments over the last four or so years by my count. Much of that came last year, while it plans to make annual top-up payments of £900m between FY21 and FY30. This all comes out straight out of the cashflow line, putting further pressure on free cash flow.
At the risk of stating the obvious, declining cash flow and rising capital spending does not make a good combination for shareholder dividends. BT reckons it will generate around £1.9b worth of free cash flow on a normalised basis in its 2019/20 financial year. Just by way of comparison, the company was on course for around £3b in normalised free cash flow when I penned that first piece back in 2017.
These normalised figures obviously exclude any scheduled pension deficit payments, not to mention cash dividends to stockholders. Together, those two will take up around £2.75b worth of cash this financial year (£1.25b in pension deficit payments plus £1.5b 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. 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 the company’s net debt position. Financial debt stood at around £12b net of cash and short-term investments at the end of 2019, and it carries a further £5b or so in additional capital lease obligations.
The attraction of a dividend cut at this point is therefore fairly obvious. Assuming the company reduced it by 50%, then it would retain an extra £750m per year for other purposes. At the same time, anybody in the market for shares today would still be on for a 5% dividend yield. 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. I mean, BT is trading at less than 7x annual profit right now. Let’s call that an earnings yield of nearly 15%, which is slightly better than what you can get in the bank right now!
That kind of aggressive discount usually implies one of two things in my opinion. The first is financial distress, which has been touched on above. At 3x cash flow, the debt load here doesn’t look particularly outrageous for a telecom, especially since most of that debt is due after 2026. Interest rates are also still at record lows and could be for some time to come. BT’s interest and lease payments cost it around £720m per annum right now, equivalent to circa 20% of operating profit. That ratio looks fairly comfortable to me. The company also has some non-core foreign operations that it could sell to help pay down debt too.
The second thing to take away from the low profit multiple is the potential for declining profits. Of course, 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. If BT simply holds its current earnings power, then its shares could easily deliver quite attractive returns going forward.
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