It’s fair to say that the last eighteen months has been a period to forget for BT Group (LON: BT.A) shareholders. Back in November 2015 the shares were trading at just under £5 each having gone on a tremendous six year run from their 80 pence lows during the financial crisis. Profits were growing, and the company looked fresh having embraced the quadruple offering of mobile, fixed-line, broadband and television. Since then, however, all manner of issues have cropped up to knock the stock price to its current level of just over £3 per share.
First up we’ve had the accounting scandal the has hit the Italian arm of BT’s international operations. Initially the company estimated the damage to be a non-cash charge of £145 million. By January it had grown to around £530 million. That may not seem such a big jump considering BT’s current market-cap is around £30 billion but you can never be sure whether these issues are isolated or a sign of a far deeper problem.
The Italian news was then compounded by an additional profit warning on the back of a slowdown in fresh public sector contracts. Sure enough a few days later BT reported Q3 2016 earnings which showed underlying revenue down 1.5% and underlying EBITDA down 8%. Perhaps more worryingly for shareholders the company dropped its guidance for annual free cash flow from just over £3 billion to £2.5 billion.
Finally, we’ve had ongoing regulatory issues concerning BT’s Openreach operation; the arm of the business which is responsible for the maintenance of the UK’s telecom network. Without going into too much detail there’s been a bunch of criticism surrounding Openreach, including allegations that BT was abusing this monopoly position to benefit its own retail business at the expense of rivals. Regardless of whether this is true or not it was enough to force telecoms regulator Ofcom to take a look at the current structure. Given that Openreach is a particularly profitable, not to mention stable, part of BT’s overall business – its EBITDA margin is around the 50% mark – the fear for BT shareholders was that it may be forced to divest it as a separate enterprise.
Despite all of this I made the case that BT looked like a good value pick at the time. Sure, the above issues had drilled in a large degree of uncertainty with respect to BT’s underlying business. In exchange though you got a stock trading at around 11x forward earnings estimates along with a solid 4.7% dividend projected to grow by 10% in both fiscal years 2016/17 and 2017/18. Take that 4.7% yield as a base, throw in some moderate long-term growth as well as possible value multiple expansion, and you get the right ingredients for decent long-term returns.
That was four months ago. How does that argument stack up today? Well, with annual results having been released a couple of weeks ago now seems like a good time to take a second look.
Full Year Results, Dividend Commitment
Based on January’s revised outlook full year results were in line with expectations. Headline revenue was up 27% compared to fiscal year 2015/16 due to the acquisition of mobile carrier EE. On an underlying basis revenue was down 0.2% on the previous year. Reported pre-tax profit for the year was down 19%, largely due to specific one-time items, but was up 5% on an underlying basis. Basic earnings per share followed a similarly trajectory; down 33% on a reported basis and 9% in underlying terms.
As expected from January’s news the main headwinds seem to be coming from the Global Services and Business and Public divisions. EBITDA was down 11% in the former, including a £250 million impairment against the scandal hit Italian business. In response BT have launched a strategic review with plans to scrap 4,000 jobs as part of a two-year effort to save £300 million. In the Business and Public division EBITDA fell by 10% on the back of the aforementioned slowdown in public sector contracts. Over at Openreach profits were broadly flat over the year, whilst the consumer facing division saw earnings drop by 4%. The major bright spot was free cash flow of £2.78 billion, which came in around £250 million ahead of January’s updated guidance.
All-in-all it’s probably fair to say these aren’t the figures you’d be hoping for as a BT shareholder. Moreover, although management maintained it’s 10% dividend growth target for 2016/17 it scrapped the commitment to do the same in 2017/18. In February I made the point that as it stood this initial commitment was only borderline affordable. Even though the distribution is covered healthily by existing free cash flow (around 2x to be precise), BT’s combined pension deficit and net debt position currently stands at approximately £16.5 billion.
It seems management understands that it makes little sense to retain a 10% dividend growth commitment in the absence of sufficient growth in underlying free cash flow, and so in its place is a simpler goal to pay out a “progressive” distribution. In other words they’ll strive to raise the dividend but don’t expect anything concrete.
Current Valuation & Outlook
Given all of the above it would be easy to take a pretty bearish view of the situation. However as I’ve pointed out several times previously there’s opportunity to be had in seemingly struggling blue chip stocks. The real question is whether BT shares are cheap enough to compensate, and at the current share price I think there’s decent case for answering yes to that.
Prior to January’s profit warning the shares were offering a prospective dividend yield of 4% and were trading at just over 13x annual earnings. Right now they offer a current yield of 5% and trade at around 10.7x adjusted earnings per share. The scrapping of the 10% dividend growth target might seem disappointing at first glance, but when the starting yield is already fairly high it doesn’t take all that much growth to secure some decent long-term returns.
Of course this all rests upon profits being at least stable, and ideally with some future growth to look forward to as well. In the case of BT though we already know we’re facing some pretty material uncertainties. In addition to the major ones mentioned above there’s a worry about how much is being spent to secure broadcasting rights for BT Sport (particularly UEFA Champions League football matches). The draw of being able to watch major sporting events has kept customers locked into BT broadband packages, but the strategy is not without its downside. Rising content costs are starting to eat into profit margins, and with the consumer facing division having been such a strong performer in recent years this trend is worth keeping an eye on.
Ultimately the stand-out figures are BT’s substantial annual free cash flow generation and the attractive looking dividend. As it stands the shares are trading at 11x the former based on the current share price. Add that 5% dividend yield to the mix and there’s enough there to keep the shares attractive in an otherwise expensive market.