After crashing 20% on Tuesday’s profit warning, shares of BT Group (LSE: BT-A) edged modestly lower to 300p this morning, following the release of its Q3 results. The absence of a major move suggests the results were much as the market was expecting.
BT repeated that “we face a more challenging outlook in the UK public sector and international corporate markets” and reiterated the revised financial guidance for 2016/17 and 2017/18 it had issued with the profit warning. As analysts had anticipated, the group also reported today on “record growth at EE, strong momentum in Consumer, and our highest ever fibre net connections in Openreach”.
The bull case
BT reported a 32% rise in Q3 revenue, thanks to the EE acquisition, but underlying revenue was down 1.5%. Underlying earnings per share declined 24%, pulling the nine-month number down to 6% lower than the same period last year. The figures aren’t inconsistent with the company’s full-year guidance and the bull case for buying the shares today is that the market has overreacted to the profit warning.
The bulls suggest the “inappropriate” accounting practices in the group’s Italian division are a one-off, the current weakness in the UK public sector is likely down to Brexit-related delays rather than a permanent reduction in order flow and that investors should focus on the strong performance of EE, Consumer and Openreach.
The bulls also note BT’s continued commitment to raise the dividend by at least 10% a year for both 2016/17 and 2018/19 as an indication of management’s confidence. And they point out that dividends of 15.4p (giving a 5.1% yield) and 17p (giving a 5.7% yield) are highly appealing, because they will cost £1.53bn and £1.69bn and are well-covered by the company’s guided free cash flow of £2.5bn and £3.0-3.2bn.
The bear case
BT’s debt and pension deficit are a cause for concern. The company suspended its dividend in 2001 and cut it in 2009 when its balance sheet was stretched. On the latter occasion net debt was £10.4bn and the pension deficit £4bn. Today’s results show net debt standing at £9bn and the pension deficit at £11.1bn.
BT’s free cash flow guidance is before “specific items” and hefty pension deficit payments, which leaves real free cash flow cover of the dividend rather thinner than on the numbers given in the guidance.
If the challenging outlook in the UK public sector and international corporate markets proves to be more challenging than the company expects, free cash flow cover could evaporate. A premium price to win the upcoming auction for TV rights to the European Champions League may also stretch resources.
BT could look to take on more debt to support the dividend if there’s a shortfall in free cash flow, but its credit rating would certainly be reduced, making borrowing more expensive. And the market would likely punish the company if it went down that line.
Risky buy
I rate BT as a ‘risky buy’, because earnings visibility isn’t good in parts of the business and the company doesn’t have much of a safety net if its performance falls short of management’s expectations, particularly with regard to the dividend.
More cautious investors may want to put BT on hold and reappraise the outlook after the Champions League TV bidding in March and the company’s full-year results in May.
